BCA Indicators/Model
Highlights Four ghosts of 2016 are knocking at the door: Brexit, Trump, Brazil, Italy. President Trump and U.S. trade policy are keeping uncertainty high. Upgrade the odds of a no-deal Brexit to about 33%. Expect limited stimulus from Italy and Germany – for now. Brazil’s pension reform is entering its final stretch – buy the rumor, sell the news. Feature Four major political events of 2016 are returning to affect the global investment landscape this fall – though only two of these ghosts are truly frightening. In order of market relevance: Trump: The election of Donald J. Trump as U.S. president, November 8, 2016 Brexit: The U.K. referendum to leave the European Union, June 23, 2016 Italy: The Italian constitutional referendum, December 4, 2016 Brazil: The removal of Brazilian President Dilma Rousseff, August 31, 2016 Italy and Brazil are producing market-positive political results in the short run. Brexit and Trump pose substantial and immediate risks to the global bull market. A pivot by Trump is the headline risk to our view that no trade agreement will be concluded by November 2020, as we outlined in a Special Report last week. At the moment tensions are still escalating. President Trump has ordered an increase in tariffs (Chart 1) and threatened to invoke the International Economic Emergency Powers Act of 1977, which would give him the ability to halt transactions, freeze funds, and appropriate assets. China is retaliating proportionately and virtually incapable of softening its tone prior to its National Day celebration on October 1. The next round of negotiations, slated for Washington in September, could be a flop like the talks in July, or it could be canceled. Investors should stay defensive. The equity market will have to fall to force Trump to stage a tactical retreat. Meanwhile China could intervene violently in Hong Kong SAR. That possibility, the nationalist military parade on October 1, and U.S. actions toward the South China Sea and Taiwan, show that sabers are rattling, causing additional market jitters. Chart 1Trump's Latest Tariff Salvo U.S.-China tensions underpin our tactical safe-haven trade recommendations. But we are not shifting to a cyclically bearish stance until we get clarity on Trump’s and Xi’s handling of their immediate predicament. Brexit is the other acute short-term risk. This was true even before Prime Minister Boris Johnson opted to prorogue parliament from September 10 to October 14, shortening the time that parliament has to either pass a law forbidding a no-deal exit or bring down Johnson’s government in a vote of no confidence. We are upgrading the odds of “no deal” to no higher than 33%, using a conservative decision-making process (Diagram 1). No-deal is not our base case because parliament, the public, and even Johnson himself want to avoid a recession, which is the likely outcome, even granting that the Bank of England will not stand idly by. We are upgrading the odds of “no deal” Brexit to about 33%. Diagram 1Brexit Decision Tree (Revised August 29, 2019) From a bird’s eye point of view, the pound is very attractive (Chart 2). But in the near-term the twists and turns of Britain’s political struggle imply that we will see wild volatility. Our foreign exchange strategists expect that a no-deal Brexit would cause GBP/USD to collapse to 1 after October 31. Assuming our one-in-three odds of such an outcome, the probability-weighted average of cable is about 1.2. Hence investors should not short sterling from here, unless they strongly believe we are underrating the odds of no-deal exit. In the worst-case scenario, a no-deal Brexit will cause an economic shock at a time when Europe is on the brink of recession – Italy and Germany are virtually there. This means there is a substantial risk of additional deflationary pressure piling onto German bunds and sustaining the global bond rally. This pressure will be sharply reduced if Johnson loses an early no confidence vote, but that is a 50/50 call so we would not call time on this rally yet. Stay cautious. Chart 2Pound Can Only Go So Low Italy: Stimulus … Without A Bruising Brussels Battle Italy has avoided a new election by producing an unusual tie-up between the establishment Democratic Party and the anti-establishment Five Star Movement (M5S). The coalition still needs to clear some internal hurdles and an online vote by Five Star members, but an agreement is to be presented to President Sergio Mattarella as we go to press. This is the most market-friendly outcome that could have been expected, as is clear through the sharp drop in Italian government bond yields (Chart 3). Our GeoRisk indicator for Italy is also collapsing. Chart 3Markets Cheer New Italian Coalition This development marks the climax of a story line that we outlined in 2016, when Prime Minister Matteo Renzi lost a constitutional referendum that aimed to strengthen Italian governments to enable deeper structural reforms (he subsequently resigned). At that time we argued that Italy would emerge as a market-relevant political risk due to rampant anti-establishment sentiment, but that this risk would subside when Italy’s populists were shown to be pragmatic at heart, i.e. unwilling to push their conflicts with Brussels to a point that truly reignited European break-up risk. This view is now vindicated – and not only for the short-term. The new coalition comes at the nick of time, with Europe teetering on recession and the risk of a no-deal Brexit rising. The new government will have to deliver the 2020 budget to the European Commission by October 15. The budget will aim to provide fiscal support, including a delay of the legislatively mandated hike in the Value Added Tax from 22% to 24.2%, already rolled over from 2019. The Five Star Movement will demand as a price for its participation in the coalition that social spending go up; the Democratic Party will have learned a lesson while out of power and will be more fiscally permissive and strike a tougher tone with Brussels. The Italian budget talks will be a non-issue: the coalition will cooperate with Brussels. The episode demonstrates that the Italian risk to financial markets is overrated. This point goes beyond the fact that the Democrats and Five Star were able to cooperate. Italy’s leading populist parties have already shown that they are pragmatic and will play the game with Brussels to avoid a financial breakdown. In May 2018, the newly formed populist coalition proposed a gigantic “wish list” budget that would have increased the budget deficit to roughly 7.3% of GDP in 2019. They also appointed a euroskeptic economy minister who almost prevented government formation. The ensuing conflict with Brussels triggered considerable turmoil (Chart 4). Ultimately, however, the populists did precisely what we expected: they bowed to the severe financial constraint on Italy’s banking system. They agreed to a 2019 and 2020 deficit of 2.04% and 2.1%, respectively (Chart 5). Chart 4Italian Populists Prove Pragmatic Chart 5Even Salvini Compromised On Budget Clash At present, the market is relieved that an election was avoided that might have seen Salvini and the League form a government with a much smaller right-wing party (Fratelli D’Italia) (Chart 6) – but the truth is that Salvini had already capitulated to the EU, both on budget matters and the euro currency. He was hardly likely to push for a budget more aggressive than that of the initial proposal in 2018. The clash with Brussels would have been a flash in the pan; the result would have been greater fiscal thrust, which would have been market-positive in the current environment. Chart 6Election Would Have Meant More Stimulus ... And More Political Risk M5S will also push for more spending and has also moderated their stance on the euro. A coalition with the Democrats will not work if the purpose is to push a euroskeptic agenda. There will be a focus on counter-cyclical fiscal policy, pragmatic reforms that the two can agree on, and fighting corruption. The budget talks will be a non-issue: the Democratic Party is an establishment party and the coalition will cooperate with Brussels. Furthermore, the context has changed since 2018 in a way that will reduce budget frictions. There is a need for countercyclical fiscal policy in light of the global slowdown, so the European Commission will have to be more flexible on the budget. This is particularly true if Germany itself loosens its belt on a cyclical basis. The risk to the above is that the coalition shaping up between the Democrats and Five Star is an alliance of convenience that will break down over time. Five Star will remain hard-line on immigration, which is driving anti-establishment sentiment. Italian elections are a frequent affair. Salvini and the League will be waiting in the wings, especially if Brussels proves too tight-fisted or if the Democrats do not toughen their stance on immigration. But as outlined above, Salvini’s own evolution on the euro, on northern Italy, and on the budget and financial stability shows that the economy will have to get a lot worse before Italian euroskepticism presents a renewed systemic risk. Bottom Line: The tentative coalition taking shape in Italy will produce a modest increase in fiscal thrust with minimal frictions with Brussels. As such it is the most market-friendly outcome that could have occurred from Salvini’s push to seize power. Beneath this episode of government change is the political arrangement taking shape in Italy, and across Europe, which calls for a commitment to the European project and currency. The price of this commitment is a tougher line on immigration from European leaders. Germany: Fiscal Loosening, But Not For The States (Yet) Our GeoRisk indicator for Germany is pointing to an increase in risk in recent weeks. Germany is threatened by a potential technical recession and while fiscal stimulus is in preparation, there will not be a fiscal game-changer until Merkel steps down in 2021 – barring a total collapse in the economy that forces her hand in the meantime. The outlook is not improving (Chart 7, top panel). The economy shrank by 0.1% in Q2 2019, exports are falling, and passenger car production is at the lowest level ever recorded (Chart 7, bottom panels). Chart 7German Economy Gets Pummeled Chart 8Germany: Expect Orthodox Stimulus For Now Finance Minister Olaf Scholz has announced that Germany could increase government spending by $55 billion within the context of European and German budget constraints. Split proportionally between 2019 and 2020, this additional spending would not put Germany in violation of the “black zero” rule – a commitment to a balanced budget that limits the federal structural deficit to 0.35% of GDP – even without any additional revenue (Chart 8). There will not be a fiscal game-changer in Germany until Merkel steps down – barring a crisis. The German Chancellery reports that it does not see the need for stimulus in the short term – as long as trade tensions do not escalate and there is no hard Brexit. At present, however, trade tensions are escalating and the odds of a no-deal Brexit are increasing. Moreover China’s economy and stimulus efforts continue to disappoint. In this context Germany’s ruling coalition is putting together a climate change package that would entail additional spending (while stealing some thunder from the increasingly popular Green Party). Given the European Commission’s forecast of Germany’s 2020 budget surplus, 0.8% of GDP, the government could ultimately go further than Scholz’s ~$50bn. This is because the black zero rule provides for exceptions in case of recession (or natural disasters or other crises out of governmental control) with a majority vote in the Bundestag. Hence we are not so much concerned about the magnitude of the stimulus as its timing. First, Merkel and her coalition typically move slower than the market would like in the face of financial and economic challenges. Second, according to the black zero rule, which is transcribed in the German constitution (the Basic Law), the Länder cannot run budget deficits from 2020. Amending the constitution to delay this deadline requires a two-thirds majority in the Bundestag and the Bundesrat – a much taller order than the simple majority needed to boost federal deficits. The governing coalition currently holds 56% of the seats in the Bundestag. If the Greens were brought on board, which they would be inclined to do, this number falls just short of two-thirds at 65.6%. In order to obtain a two-thirds majority in the Bundesrat, the Social Democrats, Christian Democrats, and the Greens would need the support of another party, either the Left or the Free Democrats. This could be done but it would require political will, which is only likely to be sufficient if the German and global economy get worse from here. Meanwhile financial markets will have to settle for the gradual implementation of a stimulus package on the order of 1% of GDP – the one the government is planning. Bottom Line: While Germany will likely roll out a stimulus package by Q4, if third quarter GDP data confirm that the country is in a technical recession, Merkel’s hesitation and budget limits mean that this stimulus will likely be moderate. A marginal upside surprise is possible but it will not represent a true “game changer” on fiscal policy in Germany. The game changer is more likely after Merkel steps down in 2021. The Green Party is surging in Germany and could possibly lead the next government. Even if it doesn’t, its success and Europe-wide developments are pushing German leaders to become more accommodative. Brazil: Reform Or Bust Political turmoil in Brazil over the past five years has ultimately resulted in a right-wing populist government under President Jair Bolsonaro. Bolsonaro is pursuing a pension reform that is universally acknowledged as necessary to straighten out Brazil’s fiscal books, but that the previous government tried and failed to pass. On this front the news is market-positive: having cleared the lower Chamber of Deputies, the pension reforms are now likely to pass the senate. This will lift investor confidence and give Bolsonaro an initial success that he may then be able to translate into additional economic reforms. The Brazilian economy and financial markets are moving in opposite directions. The currency and equities staged a mid-year rally despite negative data releases – shrinking retail sales and industrial production amid high unemployment (Chart 9). More recently these assets relapsed despite tentative signs of improvement on the economic front (Chart 10). All the while, chaos and controversies surrounding Bolsonaro’s government have weighed on his approval rating, ending the honeymoon period after election (Chart 11). Chart 9Brazil: Signs Of Improvement Chart 10Brazil: Markets Sold Despite Pension Progress Chart 11Bolsonaro’s Honeymoon Is Long Gone The mid-year equity re-rating was driven by an improvement in sentiment on the back of the government’s pension reform. The relapse occurred despite the passage of the pension reform bill in the lower house, indicating that global economic pessimism has dominated. The bill’s next step goes to the senate where it faces two rounds of voting before enactment (Diagram 2). It should clear this hurdle by a large margin, though we expect delays. Diagram 2Brazil: Pension Reform Timeline In the second round vote in the lower house on August 6 – which had a smaller margin of victory than the first round – deputies voted largely in line with party alliances (Charts 12A & 12B). Assuming legislators in the senate behave in the same way, the reform should gain the support of 64 of the 81 senators – easily surpassing the 49 votes needed. Even in a more pessimistic scenario where all opposition parties and all independent parties vote against the bill – along with two defecting senators from government-allied parties – the reform would pass by 56-25. Chart 12APension Bill Sailed Through Lower House ... Chart 12B... And Should Pass Senate In Time This favorable outlook is also supported by popular opinion, which indicates that the majority of those polled agree that pension reforms are necessary (Chart 13). This leaves two questions: How soon will the bill clear the senate? According to senate party leaders’ proposed timetable, the bill will undergo its first upper house vote on September 18 with the second round slated for October 2. This is ambitious. The strategy of Senator Tasso Jereissati – who has been appointed senate pension reform rapporteur – is to approve the text in its current form and create a parallel proposed amendment to the constitution (PEC) which will bring together the amendments that senators make to the original text. Dozens of amendments have been filed with the Commission on Constitution and Justice. These will prolong the enactment of the final bill and dilute its impact. We doubt the senate will let Jereissati have his way entirely and hence expect delays and dilution. Chart 13Brazil: Public Now Favors Pension Reform Chart 14Brazil: Pension Reform Not Enough How much savings will the bill generate? Will the reforms be sufficient to improve public debt dynamics in Brazil? The Independent Fiscal Institute of the senate estimates that the reform will generate BRL 744 billion of savings. This is significantly less than the BRL 1.2 trillion initially proposed, and lower than the BRL 860 billion that Economy Minister Paulo Guedes has indicated as the minimum fiscal savings required. Our Emerging Markets strategists argue that the bill falls short of what is needed. While the plan will reduce the fiscal deficit and slow debt accumulation, it will be insufficient to generate primary surpluses over the coming years (Chart 14).1 Moreover, estimated savings in the final bill will likely be further revised down as the bill undergoes more amendments in the senate. What comes after pension reform? The market has focused almost exclusively on this issue to the neglect of Bolsonaro’s wider economic reform agenda. The agenda includes privatization, trade liberalization, tax reforms, and deregulation. Here we are more skeptical. First, Bolsonaro will have spent a lot of political capital on pensions. Second, while the economy and unemployment are always important, they are not the foremost concern for Brazilians (Chart 15). Chart 15Bolsonaro Will Lose Political Capital After Pension Bill Third, the economic agenda is often at odds with Bolsonaro’s social, foreign, and environmental policies: The new Mercosur-European Union trade agreement and ongoing trade negotiations between Mercosur and Canada are positive developments. However the G7 summit in France highlighted that the deal with the EU is at risk due to dissatisfaction with Bolsonaro’s response to the Amazon fires. France and Ireland have threatened to withhold support of the ratification. With world leaders concerned about the political risks of trade liberalization, and with Trump having issued a license to foreign leaders for trade weaponization, an escalation of tensions between the Europeans and Bolsonaro could lead to punitive measures even beyond the delay to the Mercosur-EU deal. Brazil’s China problem: Bolsonaro has been cozying up to President Donald Trump while striking a more aggressive tone with China. This is a risky strategy as it may undermine Brazil’s economic interests. The country’s exports are much more leveraged to China than to the U.S. and have been benefitting on the back of the trade war as China substitutes away from the U.S. (Chart 16). The president’s planned trip to China in October reveals an attempt to mend ties after having accused China of dominating key Brazilian sectors during his election campaign. But it is not clear yet that Bolsonaro will stage a retreat. And if President Trump backtracks on his trade war in order to clinch a deal, Bolsonaro may have lost some goodwill with China without receiving the benefit of China’s substitution effects. Hence Bolsonaro will have to soften his approach to China to make progress on the trade aspect of the reform agenda. Chart 16Brazil: Time To Mend Ties With China Bottom Line: We expect the passage of a diluted pension reform bill that will slow the growth of public debt to some extent. However global headwinds are persisting. And any success on pensions should not be extrapolated to other items on the economic reform agenda. Bolsonaro’s trade liberalization faces difficulties on the surface. Other domestic reforms are even more difficult to achieve in the wake of painful pension cuts. Reforms that enjoy public support and do not require a complicated legislative process are the most likely to be implemented, but even then, legislation and implementation are likely to be long-in-coming in Brazil’s highly fractured congress. As a result we share the view with our Emerging Markets Strategy that the pension reform is a “buy the rumor, sell the news” phenomenon. Housekeeping We are booking gains on our long BCA global defense basket for a 17% gain since inception in October 2018. The underlying thesis for this trade remains strong and we will reinstitute it at an appropriate time, though likely on a relative basis to minimize headwinds to cyclical sectors. We are also finally throwing in the towel on our long rare earth / strategic metals equity trade. The logic behind the trade is intact but it was very poorly timed and the basket has depreciated 24% since inception. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 Please see BCA Research’s Emerging Markets Strategy Weekly Report “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Geopolitical Calendar
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 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 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 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 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, ... Chart 5... 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, ... Chart 7... As Slack Has Been Absorbed, ... Chart 8... And Demand Is Robust 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 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, ... Chart 12... 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.
Feature GAA DM Equity Country Allocation Model Update Chart 1GAA 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 Table 2Performance (Total Returns In USD %) Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA 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 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) Table 4Current Model Allocations 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 So What? Key geopolitical risks remain unresolved and most of the improvements are transitory. Maintain a cautious tactical stance toward risk assets. Why? U.S.-China relations remain the preeminent geopolitical risk to investors and President Trump remains a wild card on trade. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. USMCA ratification is not a red herring for investors. We expect USMCA will pass by year’s end but our conviction level is low. Trump’s threat to withdraw from NAFTA cannot be entirely ruled out. Remain long JPY-USD and overweight Thailand relative to EM equities. Feature Chart 1U.S. And Chinese Policy Growing More Simulative We maintain our cautious tactical stance toward risk assets despite improvements to the cyclical macro outlook. American and Chinese monetary and fiscal policy are growing more stimulative on the margin – an encouraging sign for the global economy and risk assets. We have frequently predicted this combination as a positive factor for the second half of the year and 2020. With the Federal Reserve likely to deliver a 25 basis point interest rate cut on July 31, the market is pricing in positive policy developments (Chart 1). Yet in the U.S., long-term fiscal and regulatory policies are increasingly uncertain as the Democratic Party primary and 2020 election heat up. And in China, the trade war continues to drag on the effectiveness of the government’s stimulus drive. President Trump remains a wild card on trade: the resumption of U.S.-China talks is precarious and will be accompanied by heightened uncertainty surrounding Mexico, Canada, Japan, and Europe in the near term. Even the USMCA’s ratification is not guaranteed, as we discuss below. Even more pressing are the dramatic events taking place in East Asia: Hong Kong, Japan, the Koreas, Taiwan, and the South and East China Seas. These events each entail near-term uncertainty amid the ongoing slowdown in trade and manufacturing. Our long-running theme of geopolitical risk rotation from the Middle East to East Asia has come to fruition, albeit at the moment geopolitical risk is rising in both regions due to the simultaneous showdown between Iran and the United States and United Kingdom. The market recognizes that geopolitical risks are unresolved, according to this month’s update of our currency- and equity-derived GeoRisk Indicators. This is in keeping with the above points. We regard most of the improvements as transitory – especially the drop in risk in the U.K., where Boris Johnson is now officially prime minister. We are therefore sticking with our cautious trade recommendations despite our agreement with the BCA House View that the cyclical outlook is improving and is positive for global risk assets on a 12-month horizon. What Is Happening To East Asian Stability? A raft of crises has struck East Asia, a region known for political stability and ease of doing business throughout the twenty-first century after its successful recovery from the financial crisis of 1997. The thawing of Asia’s frozen post-WWII conflicts is a paradigm shift with significant long-term consequences for investors. The fundamental drivers are as follows: China’s rise is not peaceful: President Xi Jinping has reasserted Communist Party control while pursuing mercantilist trade policy and aggressive foreign policy. The populations of Hong Kong and Taiwan have reacted negatively to Beijing’s tightening grip, exposing the difficulty of resolving serious political disagreements given unclear constitutional frameworks. Recent protests in Hong Kong are even larger than those in 2014 and 1989 (Table 1). Table 1Hong Kong: Recent Protests The Largest Ever America’s “pivot” is not peaceful: The United States is determined to respond to China’s rise, but political polarization has prevented a coherent strategy. The Democrats took a gradual, multilateral path emphasizing the Trans-Pacific Partnership while the Republicans have taken an abrupt, unilateral path emphasizing sweeping tariffs. Underlying trade policy is the increased use of “hard power” by both parties – freedom of navigation operations, weapons sales, and alliance-maintenance. America is threatening the strategic containment of China, which China will resist through alliances and relations with Russia and others. Japan’s resurgence is not peaceful: Japan’s “lost decades” culminated in the crises and disasters of 2008-11. Since then, Japan’s institutional ruling party – the Liberal Democrats – have embraced a more proactive vision of Japan in which the country casts off the shackles of its WWII settlement. They set about reflating the economy and “normalizing” the country’s strategic and military posture. The result is rising tension with China and the Koreas. Korean “reunion” is not peaceful: North Korea has seen a successful power transition to Kim Jong Un, who is attempting economic reforms to prolong the regime. South Korea has witnessed a collapse among political conservatives and a new push to make peace with the North and improve relations with China. The prospect of peace – or eventual reunification – increases political risk in both Korean regimes and provokes quarrels between erstwhile allies: the North and China, and the South and Japan. Southeast Asia’s rise is not peaceful: Southeast Asia is the prime beneficiary in a world where supply chains move out of China, due to China’s internal development and American trade policy. But it also suffers when China encroaches on its territory or reacts negatively to American overtures. Higher expectations from the U.S. will increase the political risk to Taiwan, South Korea, Vietnam, and the Philippines. This is the critical context for the mass protests in Hong Kong and the miniature trade war between Japan and South Korea, and other regional risks. Which conflicts are market-relevant? How will they play out? The U.S.-China Conflict The most important dynamic is the strategic conflict between the U.S. and China. Its pace and intensity have ramifications for all the other states in the region. Because the Trump administration is seeking a trade agreement with China, it has held off from unduly antagonizing China over Hong Kong and Taiwan. President Trump has not fanned the flames of unrest in Hong Kong and has maintained only a gradual pace of improvements in the Taiwan relationship.1 But if the trade war escalates dramatically, Beijing will face greater economic pressure, growing more sensitive about dissent within Greater China, and Washington may take more provocative actions. Saber-rattling could ensue, as nearly occurred in October 2018. Currently events are moving in a more market-positive direction. Next week, the U.S. and China are expected to resume face-to-face trade negotiations between principal negotiators for the first time since May. China is reportedly preparing to purchase more farm goods – part of the Osaka G20 ceasefire – while the Trump administration has met with U.S. tech companies and is expected to allow Chinese telecoms firm Huawei to continue purchasing American components (at least those not clearly impacting national security). We are upgrading the odds of a trade agreement by November 2020 to 40% from 32% in mid-June. With this resumption of talks, we are upgrading the odds of a trade agreement by November 2020 to 40%, from 32% in mid-June (Diagram 1). Of this 40%, we still give only a 5% chance to a durable, long-term deal that resolves underlying technological and strategic disputes. The remaining 35% goes to a tenuous deal that enables President Trump to declare victory prior to the election and allows President Xi Jinping to staunch the bleeding in the manufacturing sector. Diagram 1U.S.-China Trade War Decision Tree (Updated July 26, 2019) Note that these odds still leave a 60% chance for an escalation of the trade war by November 2020. Our conviction level is low when it comes to the two moderate scenarios. Ultimately, Presidents Trump and Xi can agree to a trade agreement at the drop of a hat – no one can stop Xi from ordering large imports from the U.S. or Trump from rolling back tariffs. Our conviction level is much higher in assigning only a 5% chance of a grand compromise and a 36% chance of a cold war-style escalation of tensions. We doubt that China will offer any structural concessions deeper than what they have already offered (new foreign investment law, financial sector opening) prior to finding out who wins the U.S. election in 2020. Beijing is stabilizing the economy even though tariffs have gone up. As long as this remains the case, why would it implement additional painful reforms? This would set a precedent of caving to tariff coercion – and yet Trump could renege on a deal anytime, and the Democrats might take over in 2020 anyway. The one exception might be North Korea, where China could do more to bring about a diplomatic agreement favorable to President Trump as part of an overall deal before November 2020 – and this could excuse China from structural concessions affecting its internal economy. The takeaway is that U.S.-China trade issues are still far from resolved and have a high probability of failure – and this will be a source of strategic tension within the region over the next 16 months, particularly with regard to Taiwan, the Koreas, and the South China Sea. Hong Kong And Taiwan August can be a crucial time period for policy changes as Chinese leaders often meet at the seaside resort of Beidaihe to strategize. This year they need to focus on handling the unrest in Hong Kong, and the Taiwanese election in January, as well as the trade war with the United States. Protests in Hong Kong have continued, driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. Even the groups that are least sympathetic to the protesters – political moderates, the elderly, low-income groups, and the least educated – are more or less divided over the controversial extradition bill that prompted the unrest (Chart 2). This reveals that the political establishment is weak on this issue. Chief Executive Carrie Lam is clinging to power, as Beijing does not want to give the impression that popular dissent is a viable mechanism for removing leaders. But she has become closely associated with the extradition bill and will likely have to go in order to satiate the protesters and begin the process of healing. As long as Beijing refrains from rolling in the military and using outright force to crush the Hong Kong protests, the unrest should gradually die down, as the political establishment will draw support for its concessions while the general public will grow weary of the protests – especially as violence spreads. Hong Kong has no alternative to Beijing’s sovereignty. The scene of action will soon turn to Taiwan, where the January 2020 election has the potential to spark the next flashpoint in Xi Jinping’s struggle to consolidate power in Greater China. A large majority of Taiwanese people supports the Hong Kong protests – even most supporters of the pro-mainland Kuomintang (KMT) (Chart 3). This dynamic is now affecting the Taiwanese election slated for January 2020. The relatively pro-mainland KMT has been polling neck-and-neck with the ruling Democratic Progressive Party (DPP), which has struggled to gain traction throughout its term given diplomatic and economic headwinds stemming from the mainland. Similarly, while popular feeling is still largely in favor of eventual independence, pro-unification feeling has regained momentum in an apparent rebuke to the pro-independence ruling party (Chart 4). However, the events in Hong Kong have changed things by energizing the democratic and mainland-skeptic elements in Taiwan. President Tsai Ing-wen is now taking a slight lead in the presidential head-to-head opinion polls despite a long period of lackluster polling (Chart 5). A close election increases the risk that policymakers and activists in Taiwan, mainland China, the United States, and elsewhere will take actions attempting to influence the election outcome. Beijing will presumably heed the lesson of the 1996 election and avoid anything too aggressive so as not to drive voters into the arms of the DPP. However, with Hong Kong boiling, and with Beijing having already conducted intimidating military drills encircling Taiwan in recent years, there is a chance that past lessons will be forgotten. The United States could also play a disruptive role, especially if trade talks deteriorate. If the KMT wins, then anti-Beijing activists will eventually begin gearing up for protests themselves, which in subsequent years could overshadow the Sunflower Movement of 2013. If the DPP prevails, Beijing may resort to tougher tactics in the coming years due to its fear of the province’s political direction and the DPP’s policies. In sum, while the Hong Kong saga is far from over and has negative long-run implications for domestic and foreign investors, Taiwan is the greater risk because it has the potential not only to suffer individually but also to become the epicenter of a larger geopolitical confrontation between China and the U.S. and its allies. This would present a more systemic challenge to global investors. Japan And “Peak Abe” Japan’s House of Councillors election on July 21 confirmed our view that Prime Minister Shinzo Abe has reached the peak of his influence. Abe is still popular and is likely to remain so through the Tokyo summer Olympics next year (Chart 6). But make no mistake, the loss of his two-thirds supermajority in the upper house shows that he has moved beyond the high tide of his influence. Having retained a majority in the upper house, and a supermajority in the much more powerful lower house (House of Representatives), Abe’s government still has the ability to pass regular legislation (Chart 7). If he needs to drive through a bill delaying the consumption tax hike on October 1 due to a deterioration in the global economic and political environment, he can still do so with relative ease. While the Hong Kong saga is far from over ... Taiwan is the greater risk. Clearly, the election loss will not impact Abe’s ability to negotiate a trade deal with the United States, which we expect to happen quickly – even before a China deal – albeit with some risk of tariffs on autos in the interim. The problem is that Abe’s final and greatest aim is to revise Japan’s American-written, pacifist constitution for the first time. This requires a two-thirds vote in both houses and a majority vote in a popular referendum. While Abe can still probably cobble together enough votes in the upper house, the election result makes it less certain – and the dent in popular support implies that the national referendum is less likely to pass. Constitutional revision was always going to be a close vote anyway (Chart 8). If Abe falls short of a majority in that referendum, then he will become a lame duck and markets will have to price in greater policy uncertainty. Even if he succeeds – which is still our low-conviction baseline view – then he will have reached the pinnacle of his career and there will be nowhere to go but down. His tenure as party leader expires in September 2021 and the race to succeed him is already under way. Hence, some degree of uncertainty should begin creeping in immediately. Abe’s departure will leave the Liberal Democrats in charge – and hence Japanese policy continuity will be largely preserved. But the entire arc of events, from now through the constitutional revision process to Abe’s succession, will raise fundamental questions about whether Abe’s post-2012 reflation drive can be sustained. We have a high conviction view that it will be, but Japanese assets will challenge that view. What of the miniature trade war between Japan and South Korea? On July 4, Japan imposed export restrictions on goods critical to South Korea’s semiconductor industry in retaliation for a South Korean court ruling that would set a precedent requiring Japanese companies such as Mitsubishi and Nippon Steel to pay reparations for the use of forced Korean labor during Japanese rule from 1910-45. Chart 9Japan Has A Stronger Hand In The Mini Trade War Japan has the stronger hand in this dispute from an economic point of view (Chart 9). While the unusually heavy-handed Japanese trade measures partly reveal the influence of President Trump, who has given a license for U.S. allies to weaponize trade, it also reflects Japan’s growing assertiveness. Abe’s government may have believed that a surge of nationalism would help in the upper house election. And the constitutional referendum will be another reason to stir nationalism and a recurring source of tension with both Koreas (as well as with China). Therefore, Japanese-Korean tensions and punitive economic measures could persist well into 2020. Bottom Line: U.S.-China relations remain the preeminent geopolitical risk to investors, especially if the Taiwan election becomes a lightning rod. Japan’s rising assertiveness in the region will also produce clashes with the Koreas and possibly also with China. We are playing these risks by remaining long JPY-USD and overweight Thailand relative to EM equities, as Thailand is more insulated than other East Asian economies to trade and China risks. Keep An Eye On The USMCA Last week we highlighted U.S. budget negotiations and argued that the result would be greater fiscal accommodation. The results of the just-announced budget deal are depicted in Chart 10. One side effect is an increased likelihood of eventual tariffs on Mexico if the latter fails to staunch the influx of immigrants across the U.S. southern border, since President Trump has largely failed to secure funding for his proposed border wall. Meanwhile, the administration’s legislative and trade focus will turn toward ratifying the U.S.-Mexico-Canada trade agreement (USMCA). There is an increased likelihood of eventual U.S. tariffs on Mexico ... since President Trump has largely failed to secure funding for his proposed border wall. Ratification is not a red herring for investors, since Trump could give notice of withdrawal from NAFTA in order to hasten USMCA approval, which would induce volatility. Moreover, successful ratification could embolden him to take a strong hand in his other trade disputes, while failure could urge him to concede to a quick deal with China. Chart 11Trade Uncertainty Supports The Dollar Further, trade policy uncertainty in the Trump era has correlated with a rising trade-weighted dollar (Chart 11), so there is a direct channel for trade tensions (or the lack thereof) to influence the global economy at a time when it badly needs a softer dollar – in addition to the negative effects of trade wars on sentiment. The signing of the USMCA trade agreement by American, Mexican, and Canadian leaders last November effectively shifted negotiations from the international stage to the domestic stage. Last month Mexico became the first to ratify the deal. The delay in the U.S. and Canada reflects their more challenging domestic political environments ahead of elections, especially in the United States. Ratification in the U.S. has been stalled by Speaker of the House Nancy Pelosi, who is locked in stalemate with the Trump administration. She is holding off on giving the green light to present the agreement to Congress until Democrats’ concerns are addressed (Diagram 2). Trump, meanwhile, is threatening to withdraw from NAFTA – a declaration that cannot be entirely ruled out, even though we highly doubt he would actually withdraw at the end of the six-month waiting period. Diagram 2Pelosi Is Stalling USMCA Ratification Process Republicans are looking to secure the USMCA’s passage before the 2020 campaign goes into full force in order to claim victory on one of Trump’s key 2016 campaign promises. The administration’s May 30 submission of the draft Statement of Administrative Action (SAA) to Congress initiated a 30-day waiting period that must pass before the administration can submit the text to Congress. But the administration is unlikely to put the final bill to Congress before ensuring that House Democrats are ready to cooperate.2 House democrats are in a position of maximum leverage and are using the process to their political advantage. House Democrats are in a position of maximum leverage – since they do not need the deal to become law – and are using the process to their political advantage. If the bill is to be ratified through the “fast action” Trade Protection Authority (TPA), which forbids amendments and limits debate in Congress, then now is their only chance to make amendments to the text, which was written without their input. Even in the Democrat-controlled House, there is probably enough support for the USMCA to secure its passage. There are 51 House Democrats who were elected in districts that Trump won or that Republicans held in 2018, and are inclined to pass the deal. Moreover 21 House Democrats have been identified from districts that rely heavily on trade with Canada and Mexico (Chart 12).3 If these Democrats vote along with all 197 Republicans in favor of the bill, it will pass the House. This is a rough calculation, but it shows that passage is achievable. What is more, there is a case to be made for bipartisan support for USMCA. Trump’s trade agenda has some latent sympathy among moderate Democrats, and Democrats within Trump districts, unlike his border wall. Democrats will appear obstructionist if they oppose the bill. Unlike trade with China, American voters are not skeptical of trade with Canada – and the group that thinks Mexico is unfair on trade falls short of a majority (Chart 13). Since enough Democrats have a compelling self-interest in securing the deal, and since Trump and the GOP obviously want it to pass, we expect it to pass eventually. The question is whether it can be done by year’s end. Once the bill is presented to Congress and passes through the TPA process, it will become law within 90 days. Assuming that the bill is presented to the House in early September, when Congress reconvenes after its summer recess, the bill could be ratified before year-end. Otherwise, without the expedited TPA process, the bill will no longer be protected against amendment and filibuster, leaving the timeline of ratification vulnerable to extensive delay. The above timeline may be too late for Canada’s Prime Minister Justin Trudeau, who faces general elections on October 21. The ratification process has already been initiated, as Trudeau would benefit from wrapping up the entire affair prior to the national vote.4 However, the process most recently has been stalled in order to move in tandem with the U.S., so that parliament does not ratify an agreement that the U.S. fails to pass. Canadian Foreign Affairs Minister Chrystia Freeland has indicated that parliament is not likely to be recalled for a vote unless there is progress down south. This leaves the Canadian ratification process at the mercy of progress in the U.S. – and ultimately Speaker Pelosi’s decision. The current government faces few hurdles in getting the bill passed (Chart 14). The next step is a final reading in the House where the bill will either be adopted or rejected. If it is approved, the bill will then proceed to the Senate where it will undergo a similar process. If the bill is passed in the same form in the House and Senate, it will become law. Chart 15...But Trudeau's Party Is At Risk Failure to ratify the deal before the election means it will be set aside and reintroduced in the next parliament. The Liberal Party is by no means guaranteed to win a majority in the election – our base case has Trudeau forming the next government, but the race is close (Chart 15). A Conservative-led parliament would be likely to pass the bill, but it would likely be delayed to 2021 at that point due to American politics. We suspect that Trudeau will eventually stop delaying and push for Canadian ratification. This would pressure Pelosi and the Democrats to go ahead and ratify, when they are otherwise inclined to reopen negotiations or otherwise delay until after November 2020. If this gambit succeeded, Trudeau would have forced total ratification prior to October 21, which would give him a badly needed boost in the election. He can always go through the frustration of re-ratifying the deal in his second term if the Democrats insist on changes, but not if he does not survive for a second term – so it is worth going forward at home and trying to pressure Pelosi into ratification in September or early October. Bottom Line: In light of Canada’s October election and the U.S. 2020 election cycle, USMCA faces a tight schedule. A delay into next year risks undermining the ratification effort, as we enter a period of hyper-partisan politics amid the 2020 presidential campaigns. This makes the third quarter a sweet spot for USMCA ratification. While we ultimately expect that it will make it through, each passing day raises the odds against it. GeoRisk Indicators Update: July 26, 2019 All ten GeoRisk indicators can be found in the Appendix, with full annotation. Below are the most noteworthy developments this month. U.K.: As expected, Boris Johnson sealed the Conservative party leadership contest. This was largely priced in by the markets and as such did not result in a big shift in our risk indicator. Johnson has stated that he is willing to exit the EU without a deal and it is undeniable that the odds of a no-deal Brexit have increased. Nevertheless, the odds of an election are also rising as Johnson may galvanize Brexit support under the Conservative Party even as Bremain forces are divided between the rising Liberal Democrats and a Labour Party hobbled by Jeremy Corbyn’s leadership. The odds that Johnson is willing to risk his newly cemented position on a snap election – having seen what happened in June 2017 – seem overstated to us, but we place the odds at about 21%. As for a no-deal exit, opinion polling still suggests that the median British voter prefers a soft exit or remaining in the EU. This imposes constraints on Johnson, as he may ultimately be forced to try to push through a plan similar to Theresa May’s, but rebranded with minimal EU concessions to make it more acceptable – or risk a no-confidence vote and potential loss of control. We maintain that GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. France: Our French indicator points toward a significant increase in political risk over the last month. President Macron’s government has recently unveiled the pension system overhaul that he promised during the 2017 campaign. The reform, which is due to take effect in 2025, encourages citizens to work longer, as their full pension will come at the age of 64 – two years later than under current regulations. French reform efforts have historically prompted significant social unrest. Both the 1995 Juppé Plan and the 2006 labor reforms were scrapped as a result of unrest, and the 2010 pension reform strikes forced the government to cut the most controversial parts of the bill. Labor unions have already called for strikes against the current bill in September. However, no pain, no gain. Unrest is a sign that ambitious reforms are being enacted, and Macron’s showdown with protesters thus far is no more dramatic than the unrest faced by the most significant European reform efforts. The 1984-85 U.K. miners’ strike led to over 10,000 arrested and significant violence, but resulted in the closures of most collieries, weakening of trade union power, and allowed the Thatcher government to consolidate its liberal economic program. German labor reforms in the early 2000s led to strikes, but marked a turning point in unemployment and GDP trends (Chart 16), and succeeded in increasing wages and pushing people back into the labor force (Chart 17). And the 2011 Spanish reforms under PM Rajoy led to the rise of Indignados, student protesters occupying public spaces, but ultimately helped kick-start Spain’s recovery. Investors should therefore not fear unrest, and we expect any related uncertainty to abate in the medium term. Chart 16Hartz IV Reforms Were Also Accompanied By Unrest... Chart 17...But Were Ultimately Favorable Note that Macron is doubling down on reforms after the experience of the Yellow Vest protests, just as his favorability has rebounded to pre-protest levels. While Macron’s approval is nearly the lowest compared to other French presidents at this point in their terms (Chart 18), he does not face an election until 2022, so he has the ability to trudge on in hopes that his reform efforts will bear fruit by that time. Spain: Our Spanish indicator is showing signs of increasing tensions as Prime Minister Pedro Sanchez attempts to form a government. After ousting Mariano Rajoy in a vote of no confidence in June 2018, Sanchez struggled to govern with an 84-seat minority in Congress. The Spanish Socialist Workers’ Party’s (PSOE) proposed budget plan was voted down in Congress in February, forcing Sanchez to call a snap election for April 28 in which PSOE secured 123 seats. The PSOE leader failed the first investiture vote on July 23 – and the rerun on July 25 – with less votes in his favor than his predecessor Mariano Rajoy received during the 2015-2016 government formation crisis (Chart 19). In the first investiture vote, Sanchez secured 124 votes out of the 176 he needed to be sworn in as prime minister. This led to a second round of voting in which Sanchez needed a simple majority, which he failed to do with 124 affirmative, 155 opposing votes, and 67 abstentions. Going forward, Sanchez has two months to obtain the confidence of Congress, otherwise the King may dissolve the government, leading to a snap election. The Spanish government is more fragmented today than at any point during the last 30 years (Chart 20). Even if Pedro Sanchez’s PSOE were to successfully negotiate a deal with Podemos and its partner parties, the coalition would still require support from nationalist parties such as Republican Left of Catalonia or Basque Nationalist Party to govern. These will likely require major concessions relating to the handling of Catalonian independence, which, if rejected by PSOE, will result in yet another gridlocked government. The next two months will see a significant increase in political risk, and we assign a non-negligible chance to another election in November, the fourth in four years. Turkey: Investors should avoid becoming complacent on the back of the stream of encouraging news following the Turkey-Russia missile defense system deal. Our indicator is signaling that the market is pricing a decrease in tensions, and President Trump has stated that sanctions will not be immediate. Nevertheless, we would be wary. Congress is taking a much tougher stance on the issue than President Trump: The U.S. administration already excluded Turkey from the F-35 stealth fighter jet program; Senators Scott (R) and Young (R) introduced a resolution calling for sanctions; Senator Menendez (D) stated that merely removing Turkey from the F-35 program would not be enough; The new Defense Secretary nominee Mark Esper said that he was disappointed with Turkey’s “drift from the West”; And U.S. Secretary of State Mike Pompeo expressed confidence that President Trump would impose sanctions. Under CAATSA, a law that targets companies doing business with Russia, the U.S. must impose sanctions on Turkey over the missile deal, but does not have a timeline to do so. The sanctions required are formidable, and the U.S. has already imposed sanctions on China for a similar violation. If President Trump is not going forward with sanctions now, he still could proceed later if Turkey does not improve U.S. relations in some other way. From Turkey’s side, Foreign Minister Mevlut Cavusoglu threatened retaliation if the U.S. were to impose sanctions. Turkey is also facing increasing tensions domestically. Erdogan suffered a stinging rebuke in the re-run of the Istanbul mayoral election. This defeat has left Erdogan even more insecure and unpredictable than before. On July 6, he fired central bank governor Murat Cetinkaya using a presidential decree, which calls the central bank’s independence into question. He may reshuffle his cabinet, which could make matters worse if the appointments are not market-friendly. As domestic tensions continue to escalate, and when the U.S. announces sanctions, we expect the lira to take yet another hit and add to Turkey’s economic woes. Diagram 3Brazil: Pension Reform Timeline Chart 21Brazil Faces A Fiscal Deficit Despite Pension Reform Brazil: Brazilian risks are likely to remain elevated as the country faces crunch-time over the controversial pension reform on which its fiscal sustainability depends. Although the Lower House voted overwhelmingly in support of the reform on July 11, the bill needs to make it through another Lower House vote slated for August 6. The bill will then proceed to at least two more rounds of voting in the Senate (by end-September at the earliest), with a three-fifths majority required in each round before being enshrined in Brazil’s constitution (Diagram 3). The whole process will likely be delayed by amendments and negotiations. The estimated savings of the bill in its current form are about 0.9 trillion reals, down from the 1.236 trillion reals originally targeted, which risks undermining the effort to close the fiscal deficit. Our colleagues at BCA’s Emerging Markets Strategy still forecast a primary fiscal deficit in four years’ time (Chart 21).5 Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Footnotes 1 For instance, the U.S.’s latest $2.2 billion arms package does not include F-16 fighter jets to Taiwan, and F-35s have entirely been ruled out. The Trump administration sent Paul Ryan, rather than a high-level cabinet member, to inaugurate the new office building of the American Institute in Taiwan for the 40th anniversary of the Taiwan Relations Act. At the same time, the Trump administration is threatening a more substantial upgrade of relations through more frequent arms sales, the Taiwan Travel Act (2018), and the Asia Reassurance Initiative Act (2018). 2 The risk is that history repeats itself. In 2007, then President George W. Bush sent the free-trade agreement with Colombia to Congress prior to securing Pelosi’s approval. She halted the fast-track timeline and the standoff lasted nearly five years. 3 Please see Gary Clyde Hufbauer, “USMCA Needs Democratic Votes: Will They Come Around?” Peterson Institute For International Economics, May 15, 2019, available at piie.com. 4 Bill C-100, as it is known, has already received its second reading in the House of Commons and has been referred to the Standing Committee on International Trade. 5 Please see BCA Research’s Emerging Markets Strategy Weekly Report titled “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. Appendix Geopolitical Calendar
Highlights Global inflation will slow further, allowing central banks to ease policy. Liquidity indicators will have more upside as monetary policy will remain accommodative. Widening fiscal deficits, easing Chinese credit trends and rising U.S. consumer real income levels, all will allow improved liquidity to boost global growth in the second half of 2019. Important indicators are already flashing an increase in global growth. Yields have upside; keep a below-benchmark duration within bond portfolios. Commodity plays will perform well. The 12-month outlook for stocks remains positive, but they will churn over the coming six months. Equities will nonetheless outperform bonds. Favor cyclicals over defensives and international equities over the U.S. Feature Treasury yields are stuck near 2%, yet the S&P 500 is flirting with all-time highs. Investors are worried about global growth, still hoping that central banks will step in. The fears are well-placed: manufacturing has not stabilized, Asian trade is contracting, and the U.S. real estate sector is in the doldrums. Other concerns include the threat of U.S. President Donald Trump re-igniting the trade war and the U.S. corporate sector’s growing debt load. The positive news is that global inflation will remain low for the next 12 months or so. Without prices accelerating upward, global policymakers will continue to ease monetary and fiscal conditions. Consequently, nascent improvements in global liquidity conditions will blossom and growth will rebound in the second half of the year. Increased growth creates a paradox. At current levels, it is bearish for bonds and bullish for commodities. However, stock valuations will be undermined by higher bond yields, especially because earnings should experience additional downside this year. Consequently, the S&P 500 will churn sideways for the coming three to six months before taking off. In the meantime, stocks should outperform bonds. Blessed By Low Inflation The best news for the global economy is that inflation will stay low. Our U.S. Bond Investment Strategy colleagues recently showed that when the private sector does not quickly build large debt loads, rising inflation prompts all the post-war recessions.1 Today, the private sector’s debt vulnerability is limited. Nonfinancial private-sector leverage has only expanded by 2.1 percentage points of GDP since its trough four years ago (Chart I-1). In particular, after a drop from 134% to 106%, the household sector's debt-to-disposable income ratio has flat-lined for the past three years. Meanwhile, household debt-servicing costs as a percentage of after-tax income are at multi-generational lows. Even in the corporate sector, excesses are smaller than they appear. Despite accumulating US$5 trillion in credit since 2009, the nonfinancial corporate sector’s debt-to-asset ratio remains below its historical average of 22.4%. This sector is also generating free cash flows equal to 2.1% of GDP. Prior to recessions, the corporate sector consumed cash instead of generating it.2 Chart I-1No Excessive Debt Built-Up In The U.S. In this context, we are optimists because inflation is set to slow, leaving policymakers around the world a window to maintain generous monetary conditions and support growth. At the global level, we currently see a paucity of inflation. Among advanced economies, average core inflation is only 1.5%. Moreover, only 15% of these nations are experiencing rates of underlying inflation above the critical 2% level (Chart I-2). Chart I-2Global Inflation Will Stay Tame Going forward, risks are skewed toward a deceleration in prices. Inflation is the most lagging economic variable. Thus, the recent global economic slowdown will continue to exert downward pressure on prices. Singapore, a country highly dependent on trade, is an excellent barometer for global cyclical sectors. In the second quarter of 2019, Singapore’s annual GDP growth declined to 0.1%, its lowest level since the Great Financial Crisis. Historically, this has presaged a marked deceleration in global core CPI (Chart I-2, bottom panel). The weakness in global inflation also will translate into lower U.S. underlying inflation. U.S. import prices (excluding oil) are contracting by 1.4% on an annual basis. Despite U.S. tariffs, import prices from China are also shrinking by 1.5%, the deepest retrenchment since the deflationary scare of 2016. This will weigh on the price of U.S. goods. U.S. activity suggests imported disinflation will spill over into overall core CPI. Since 2009, the changes in the ISM manufacturing index and the annual performance of transport stocks relative to utilities have led core inflation (Chart I-3). Based on these relationships, core CPI should slow markedly. Pipeline inflation measures suggest this is a fait accompli. Core crude producer prices are melting, signaling lower inflation excluding food and energy. Chart I-3Deflationary Forces In The U.S. As Well Finally, there is only a slim chance that inflation will exceed 2.5% in the coming year, according to the St. Louis Fed’s Price Pressure Measure (Chart I-4, top panel). Import prices point toward lower goods prices, while core service CPI is quickly slowing and medical care CPI remains close to 2%, which is near record lows (Chart I-4, second panel). Meanwhile, shelter CPI shows little upward momentum (Chart I-4, third panel). Finally, the rebound in productivity growth to 2.4% is also limiting the inflationary impact of rising wages: unit labor costs are contracting at a 0.8% annual rate, despite a 3.1% year-over-year expansion in average hourly earnings (Chart I-4, bottom panel). Chart I-4Details Of U.S. CPI Evidence, therefore, points to inflation slowing down in advanced economies, even in the more robust U.S. Opening The Liquidity Spigots The lack of inflation allows central banks to ease policy in response to the slowdown in global growth. The Fed is set to trim rates by 25 basis points next week and again later this year. The ECB just telegraphed a rate cut and potentially a resumption of its QE program for September. The Reserve Bank of Australia has chopped rates twice this year, and the Reserve Bank of New Zealand, one time. Meanwhile, the People’s Bank of China has slashed the reserve requirement ratio (RRR) by 3.5% in the past 15 months. The Fed’s interest rate cuts are crucial for U.S. growth and emerging market liquidity conditions. Money moved into EM economies as interest rate markets priced in ever-deeper U.S. rate cuts after the Federal Open Market Committee’s dovish pivot this winter. As a result, EM currencies stabilized, allowing EM central banks to ease policy to support their sagging domestic economies. The Bank of India, the Bank of Indonesia, the Bank of Korea, the South African Reserve Bank, the Bank of Russia, Bank Negara Malaysia, and the Turkish Central Bank have all cut rates. Central banks in Brazil and Mexico are expected to follow suit. Global policy easing should solidify an improvement in many global liquidity indicators and thus, support global growth in the next year: M2 growth in the U.S. bottomed last November. Concurrently, the growth of money of zero maturity in excess of credit has improved since late last year. This sends a positive signal for BCA’s Global Nowcast, BCA’s Global LEIs, and global and Asian export prices (Chart I-5). Chart I-5More Excess Money, More Activity Our U.S. Financial Liquidity Index continues to accelerate, corroborating the message about global growth conditions from our excess-money indicator (Chart I-6). Chart I-6Improving Global Liquidity Conditions Emerging Markets’ M1 is turning up, albeit at a depressed level. This improvement will likely morph into a recovery as EM and DM central banks ease policy. EM M1 has excellent leading properties on EM activity and profits. Gold, a traditional reflation gauge, has broken out as real rates remain depressed. Finally, TED spreads, both on a spot and a three-month forward basis, have tumbled to near all-time lows (Chart I-7). Plentiful global liquidity narrows these spreads. Moreover, their tightness indicates that there is minimal stress in the financial system. Also, TED spreads were more elevated and getting wider before previous recessions, during the euro area crisis and even during the 2015-16 slowdown. Chart I-7No Stress In TED Spreads Low inflation allows monetary authorities to nurture an improvement in liquidity, which would raise the odds that the cycle should soon bottom. Global Growth Indicators In addition to a supportive liquidity environment, important developments point toward a meaningful global growth pick in the second half of the year. At first glance, data continues to deteriorate. Aggregate capital goods orders in the U.S., Japan, and Germany are contracting at a 7.3% annual pace, the flash PMI numbers released this week were poor and the U.S. LEI shrunk last month on a sequential basis and only increased 1.6% year-on-year. However, these data points miss crucial undercurrents. Governments normally loosen fiscal policy – as measured by the changes in cyclically-adjusted primary balances – after a recession has begun. This time, governments are already expanding deficits. In the euro area, the fiscal thrust is moving from -0.3% of GDP to 0.4% of GDP, a 0.7% of GDP boost to growth compared to last year. In China, fiscal deficits are deepening. In response to large tax cuts and expanding subsidies to various sectors, Beijing’s official budget hole has grown from 3.7% of GDP in 2017 to 4.9% this year. Broader measures, which include provincial and local governments, and off-balance-sheet entities, recorded a deficit of 11% this year. In Japan, the government is implementing fiscal offsets as large, if not larger, than the upcoming VAT increase. Even in the U.S., fiscal policy will probably ease. The Congressional Budget Office tabulates a fiscal drag of 0.5% of GDP in 2020 because of the 2011 Budget Control Act. However, the national debt was set to hit its ceiling soon. In response, the GOP and the Democrats have agreed to a proposed funding measure that will ultimately boost spending by US$50 billion more than the previously tabulated fiscal retrenchment (Chart I-8). Chinese credit policy is also increasingly supportive of global growth. Adjustments to the RRR normally take approximately 12 months to affect China’s adjusted total social financing (TSF) (Chart I-9, top panel). Changes to the RRR also lead global industrial activity, albeit more loosely, by 18 months (Chart I-9, second panel). This last relationship exists because soon after the TSF expands, Chinese economic agents use the proceeds to invest or spend on durable goods. This process boosts Chinese imports and lifts global economic activity (Chart I-9, bottom panel). Moreover, as we argued last month, we expect China’s reflationary efforts to continue for the rest of the year.3 Chart I-9The Impact Of The Chinese Stimulus Is Only Starting To Be Felt China’s stimulus is showing early signs of working, despite regulatory constraints on the banking sector. Construction and installation spending by Chinese real estate firms troughed in June 2018 and are growing at a 5.4% annual pace. The growth of equipment purchases is a stunning 22%, near its highest yearly rate in three years. Additionally, China’s intake of steel and cement is surging. These developments normally materialize ahead of rebounds in the PMI or the Li-Keqiang index. Even the outlook for China’s auto sales may be improving. Vehicle sales in China fell by 15.8% in May. In June, they remained soft despite heavy discounts by auto manufacturers. However, vehicle inventories are falling, indicating that auto production is poised to pick up. Importantly, real income levels for U.S. consumers are on the rise. Real average hourly earnings are growing by 1.8% year-on-year, the highest in this cycle. This is a dividend from the recent uptick in productivity (Chart I-10). Mounting productivity both puts a lid on inflation and enhances real incomes. Chart I-10Productivity Is The Name Of The Game Additional developments warrant optimism over global growth: The performance of EM carry trades funded in yen is rebounding. Historically, this has been a reliable leading indicator of global industrial activity (Chart I-11, top panel). As carry traders buy EM currencies and sell the yen, they borrow funds from an economy replete with excess liquidity and savings (Japan) and inject them where they are needed to finance investment and consumption (the EM). In the process, they bid up EM currencies and inject liquidity in those countries, supporting growth conditions globally. Chart I-11Positive Signs For Growth The annual performance of the sectors most sensitive to global growth conditions – global semi, industrials and materials stocks – is bottoming relative to the broader market. Normally, this happens ahead of troughs in BCA’s Global Nowcast (Chart I-11, middle panel). European luxury stocks are performing strongly, which also usually precedes rebounds in global economic activity (Chart I-11, bottom panel). Shipping costs are moving up. The Baltic Dry Index, a measure of the cost of shipping commodities, has surged by 270% since February 2019 to its highest level since 2013. Some have argued this gauge overstates the economy’s potential strength. However, the Harpex index, a measure of the cost of shipping containers, has risen by 30% in the same period. This concurrence of moves suggests that the Baltic Dry is probably correct about the direction of growth, but might be overstating the size of the rebound. Our composite momentum indicator for ethylene and propylene – two chemicals that enter into the production of pretty much everything that makes the modern economy work – is forming a bullish price divergence (Chart I-12). The price of these chemicals normally rises when global growth accelerates. Chart I-12Chemical Technicals Point To A Rebound Bottom Line: Global growth should be buoyed by several indicators, specifically a low inflation environment, an easing in both monetary and fiscal policy, a positive outlook for already improving global liquidity conditions, a healthy U.S. consumer, and the lagged impact of China’s stimulus. Investment Implications: Strong Crosscurrents For Stocks Bonds At this juncture, bonds may be the easier asset class to call; a below-benchmark duration is appropriate for fixed-income portfolios. Pessimism towards global growth is most evident in the prices of safe-haven assets. According to the CFTC, asset managers’ net-long positions in all forms of listed Treasurys contracts are hovering near all-time highs. This makes bonds vulnerable to positive economic surprises. The long-term interest rate component of the ZEW survey corroborates this message. Expectations for global long-term interest rates are near record lows. If a recession is avoided, then readings this low offer a powerful contrarian signal for bonds (Chart I-13). Chart I-13Bonds: A Contrarian Bet A potential uptick in growth would confirm this bond-bearish setup. The improvement in Chinese TSF and the strength in European luxury goods makers point towards higher yields (Chart I-14). Bond prices would also suffer if the average price of ethylene and propylene can heed the bullish signal from its momentum oscillator. Moreover, in the post-war era, on average Treasury yields typically bottomed 12 months ahead of inflation. Chart I-14Cyclical Dynamics Point To Higher Yields Given that bonds are expensive, there is a greater likelihood that positioning and cyclical forces will push up yields. Our bond valuation model shows that Treasurys are expensive and various estimates of global term premia have never been this negative. This reflects the belief that policy rates will stay low forever. However, if global growth picks up, then the Fed is highly unlikely to cut rates over the coming 12 months by the 90 basis points currently discounted by the OIS curve. Moreover, stimulating at this point in the cycle increases the risk of generating inflation down the road. Accelerating inflation would ultimately force global central banks to boost rates in the next three to five years by much more than expected, warranting higher term premia around the world. Therefore, we expect inflation expectations and term premia – but not real rates – to drive up yields, at least until global central banks abandon their dovish biases. Commodities Commodities and related assets are attractive. A measure of growth sentiment based on futures positioning in stocks, oil, copper, the Australian dollar and the Canadian dollar relative to bets on Treasury of all maturities and the dollar index shows that investors have not moved into commodity plays (Chart I-15). Moreover, traders who manage money on behalf of clients are also massively short copper, one of the most growth-sensitive commodities (Chart I-16). Chart I-15Investors Are Not Positioned For A Rebound In Growth Chart I-16Copper Is An Attractive Bet For A Growth Rebound The six-month outlook is particularly positive for the Australian dollar. The RBA has already moved aggressively to ease policy and the purging of excesses in the Australian economy is well advanced. Property borrowing for investments has collapsed by 35%, housing activity has contracted by 22%, and building permits have fallen by 20%. However, the Australian labor market remains robust and early indicators of real estate activity in major cities are stabilizing. External forces are also positive for the AUD. Strong steel prices, which have contributed to the rally in iron ore, coupled with quickly growing Australian LNG exports, will boost the terms of trade for the AUD. Moreover, the rebound in Chinese TSF, which we expect to gather momentum, creates another tailwind (Chart I-17, top panel). What’s more, rising ethylene and propylene prices, as well as rallying stock prices of European luxury goods makers, are strong supports for commodity currencies (Chart I-17, second and third panel). Chart I-17The AUD Looks Increasingly Interesting Silver is another attractive play. Last month, we argued that easy global policy would create an important support for gold.4 Since then, silver has broken out of a downward sloping trend line in place since 2016. Unlike gold, silver is still trading near very depressed levels (Chart I-18). Moreover, according to net speculative positions, gold is overbought on a tactical basis and ripe for a pullback, whereas silver is not nearly as popular with speculators. Our optimistic stance on global growth is congruent with an outperformance of silver relative to gold. Silver has more industrial uses than gold and the gold-to-silver ratio generally falls when manufacturing activity perks up. Chart I-18Silver To Shine Brighter Than Gold Equities The window to own stocks remains open. Stocks have more upside on a 9- to 12-month basis, but are set to churn over the coming three to six months. The risk of sharp but temporary corrections is elevated. Stocks rarely enter a bear market if a recession is far away. Stock prices perform well in the 12 months prior to the last half-year before a recession begins (Table I-1). If we expect growth to pick up over the next 6 to 12 months and policy to remain easy, then a recession will not occur before late 2021/early 2022. The improvement in our global liquidity indicators also supports a period of strong equity performance ahead (Chart I-19). Moreover, the 2-year/fed funds rate yield curve is inverted. Since the 1980s, after such inversions, the median 12-month return for the S&P 500 has been 14%. Stripping out recessionary episodes, the median returns would have been 18.6%, 13.1%, and 9.9%, over 12, 6 and 3 months, respectively (Table I-2). Chart I-19Liquidity Will Put A Floor Under Stock Prices Technically, stocks are also on a strong footing. The equal-weight S&P 500 has broken out, indicating robust breadth. Our composite sentiment indicator for U.S. equities is not flagging any euphoria among market participants (Chart I-20). BCA’s Monetary, Technical and Intermediate Indicators show one should own stocks. Chart I-20BCA's Indicators Favor Stocks Nevertheless, important negatives for stocks also exist. The rally in equities has been fueled by hope, as our U.S. Equity Strategy team has highlighted. Since December 2018, the rally has been driven by multiples expansion (Chart I-21). Meanwhile, Section II’s debate shows that Anastasios’s earnings models all point to low earnings growth later this year. The weakness in core crude producer price inflation will weigh on margins and corporate profits (Chart I-22). It will therefore become increasingly difficult to justify widening P/E ratios. Furthermore, the S&P 500 has moved well ahead of the performance implied by earnings estimates revisions (Chart I-23).5 Chart I-21Multiples Inflation Chart I-22Profits Still Face Near-Term Hurdles Chart I-23EPS Revisions And Stock Prices Have Dissociated From a valuation perspective, the S&P’s price-to-book, price-to-sales, or cyclically adjusted P/E ratio, all are demanding by historical standards, but justifiable if Treasurys only offer a 2% yield. This rally based on hope is vulnerable to our expectations of higher yields. Only once earnings rebound, which will pull down multiples in a benign fashion, can stocks resume their uptrend. U.S. stocks will probably churn for the rest of the year. The media made much of the S&P 500 hitting new highs in September last year and this month, but the U.S. benchmark is only 3.5% above its January 2018 peak. U.S. stocks have been very volatile, but have gone nowhere for 18 months; this pattern should hold. We are overweight stocks relative to bonds given that we recommend maintaining a below-benchmark duration for fixed-income portfolios. At 1.9%, the S&P 500 dividend yield is in line with the yield to maturity of 10-year Treasurys, while the wide equity risk premium suggests that stocks are a bargain compared to bonds. Also, the stock-to-bond ratio performs well when global industrial activity rebounds (Chart I-24). Chart I-24If Growth Helps Chemical Prices, It Will Help Stocks Outperform Bonds... Cyclical stocks will likely outperform defensive equities on rebounding global growth. The bullish configuration in the price of chemicals is consistent with a period of outperformance for cyclical equities (Chart I-25). Cyclicals also perform well when yields are moving higher, especially when central banks remain accommodative. A positive view on commodities fits within this pattern. Chart I-25...And Cyclicals Outperform Defensives European stocks are better placed than their U.S. counterparts in the coming six to nine months. European stocks outperform U.S. ones when the Chinese TSF moves up (Chart I-26), reflecting their higher sensitivity to the global business cycle. Additionally, European equities are trading at a large discount. The forward P/E and price-to-book of an equally weighted average of European stocks stand at 14.4 and 2.1 respectively, versus 20.7 and 4.1 for the U.S. Chart I-26Look Into Upgrading Europe At The Expense Of The U.S. Loan volumes will benefit from the large easing in European financial conditions resulting from the 166-basis-point drop in peripheral yields this year, with BTP yields falling to a near three years low following the ECB’s dovish tilt. This will remove some of the negative impact of soft net interest margins on bank profits. European banks could be an attractive trade. Finally, global auto stocks are trading at their lowest levels relative to the global equity benchmark since the beginning of the 2000s (Chart I-27). Moreover, global auto stocks trade at 44% discount to the broad market on a 12-month forward P/E basis, the largest handicap since 2009. This sector should perform well in the next year based on purged global auto inventories, robust consumer real income, falling interest rates and rebounding global growth. Chart I-27Autos Are A Contrarian Play Mathieu Savary Vice President The Bank Credit Analyst July 25, 2019 Next Report: August 29, 2019 II. What Goes On Between Those Walls? BCA’s Diverging Views In The Open BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.6 The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). Chart II-1 (ANASTASIOS)The 1998 Episode Revisited With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4 Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S. Chart II-7illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel). Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production. These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth. Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart II-14 (PETER)The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Chart II-15 (ANASTASIOS)Gravitational Pull Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Chart II-19 (ARTHUR)China And EM Profits Are Contracting Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6 Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-21 (ANASTASIOS)Buy Hypermarkets This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Chart II-22 (ANASTASIOS)Stick With Managed Health Care Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (II) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (I) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade. Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst Summary Of Views And Recommendations The Bulls… …And The Bears III. Indicators And Reference Charts The S&P 500 has limited cyclical downside for now, however, the short-term outlook is more troublesome. U.S. stocks are hovering near all-time highs, but they are not showing much conviction. Positive catalysts have moved into the rearview mirror now that a flurry of central banks have also cut rates, that it is certain that the Fed will cut rates next week, and that the ECB will follow in September. A volatile churning pattern will likely prevail over the coming three months. Our Revealed Preference Indicator (RPI) points to short-term risks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuation and policy, investors should lean against the market trend. A pick-up in global growth is needed to help earnings, which would cheapen valuations enough to clear the short-term clouds hanging over the stock market. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it is slightly deteriorating in Europe. The WTP indicator tracks flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips, creating a floor under stock prices in the process. Our Monetary Indicator continues to move deeper into stimulative territory, supporting our cyclically constructive equity view. Global central banks are easing policy in unison, creating very accommodative liquidity conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory. However, it is not elevated enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator continues to move further above its 9-month moving average. These dynamics confirm that equities have more cyclical upside and that dips should be bought. According to our model, 10-year Treasurys are now as expensive as at any point over the past five years. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Various rate-of-change measures for bond prices are flashing extremely overbought conditions as well. Additionally, duration surveys, positioning data, and sentiment measures are all showing that investors expect nothing but low yields. Considering this technical backdrop, BCA’s economic view implies that yields are likely to have bottomed earlier this month. On a PPP basis, the U.S. dollar remains very expensive. Additionally, our Composite Technical Indicator has formed a negative divergence with prices. The dollar’s recent strength could set it up for a substantial decline. If the dollar’s Technical Indicator falls below zero, the momentum-continuation behavior of the greenback will kick in. The USD would suffer markedly were this to happen. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1 Please see U.S. Bond Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence,” dated April 23, 2019, available at usbs.bcaresearch.com 2 The biggest concern with debt sustainability is the distribution of the debt. Aggregate ratios are currently flattered by the low debt loads and high cash holdings as well as cash generation power of the tech sector. Nonetheless, the low level of aggregate debt accumulation by the entire private sector, including households, points to a limited cyclical vulnerability to the economy created by leverage. However, this also means that a more-severe-than-usual default wave is likely to materialize outside the tech sector once a recession emerges. 3 Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 4 Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 5 Please see U.S. Equity Strategy Weekly Report, “Divorced From Reality,” dated July 15, 2019, available at uses.bcaresearch.com 6 To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 7 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 8 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 9 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 10 France is a good proxy for the euro area. 11 Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:
Highlights Q2/2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -19bps in the second quarter of the year. Winners & Losers: Our below-benchmark overall duration stance expressed through country underweights in the U.S. (-25bps) and Italy (-10bps) hurt Q2 returns. This dwarfed the gains from U.S. corporate bond overweights (+14bps) and selective sovereign bond overweights in Germany, Australia and the U.K. Scenario Analysis For Next Six Months: We are adding credit exposure to our model portfolio, increasing spread product allocations in U.S. high-yield and European corporates. In our Base Case scenario, the Fed is likely to deliver some “insurance” rate cuts in the next few months, but by less than the markets are currently discounting, while global growth momentum will stabilize. The resulting price action will favor relative returns from spread product versus government debt. Feature The first half of 2019 produced a surprising result across the global fixed income universe – practically everything delivered a positive total return. From U.S. Treasuries to Italian BTPs to U.S. investment grade industrial corporates to emerging market hard currency sovereigns, all the year-to-date returns are colored green on your Bloomberg screen. Those returns have occurred despite all the uncertainties that investors have had to navigate during the past three months, from shock Trump tariff tweets to persistent weakness in global manufacturing data to swift dovish turns by global central bankers (rate cuts in Australia and New Zealand, the Fed hinting at easing and the ECB signaling a potential restart of asset purchases). In this report, we review the performance of the BCA Global Fixed Income Strategy (GFIS) model bond portfolio during the eventful second quarter of 2019. We also present our updated scenario analysis, and total return projections, for the portfolio over the next six months. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. Q2/2019 Model Portfolio Performance Breakdown: Credit Overweights Help Limit Damage From Below-Benchmark Duration Chart of the WeekBelow-Benchmark Duration Overwhelms Credit Overweights In Q2/19 The total return for the GFIS model portfolio (hedged into U.S. dollars) in the second quarter was 2.8%, underperforming the custom benchmark index by -19bps (Chart of the Week).1 The bulk of the underperformance came from the government bond side of the portfolio (-33bps) - a function of our below-benchmark duration tilt and underweight stance on sovereign bonds, both occurring against a backdrop of rapidly falling bond yields (Table 1). Partially offsetting that was the outperformance from our recommended overweights in U.S. corporate debt, which helped the spread product side of our model portfolio outperform the benchmark by +14bps. Table 1GFIS Model Bond Portfolio Q2/2019 Overall Return Attribution The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. The main individual sectors of the portfolio that drove the excess returns were the following: Biggest outperformers Overweight U.S. investment grade industrials (+5bps) Overweight U.S. high-yield Ba-rated (+4bps) Overweight U.S. high-yield B-rated (+4bps) Overweight U.S. investment grade financials (+2bps) Overweight German government bonds with maturity of 7-10 years (+2bps) Biggest underperformers Underweight U.S. government bonds with maturity beyond 10+ years (-10bps) Underweight Italy government bonds with maturity beyond 10+ years (-6bps) Underweight Japanese government bonds with maturity beyond 10+ years (-6bps) Underweight U.S. government bonds with maturity of 1-3 years (-5bps) Underweight U.S. government bonds with maturity of 3-8 years (-5bps) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q2/2019. The returns are hedged into U.S. dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q2/2019 (red for underweight, blue for overweight, gray for neutral).2 Ideally, we would look to see more blue bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Our underweight tilts on European Peripheral sovereign debt were our biggest “miss” in the quarter, as Spanish and Italian yields plunged after the ECB signaled future rate cuts and a potential return to bond purchases in order to boost flailing European growth. We had been viewing Spain and Italy as growth-focused credit stories rather than yield plays, leaving us to maintain a cautious stand on both markets given worsening economic momentum (but with an imbedded “long Spain/short Italy” tilt by having a smaller relative underweight in Spain). In terms of our best “hits” in the quarter, our overweight stance on U.S. investment grade corporates and Australian government bonds performed relatively well. We also avoided a big “miss” by upgrading emerging market U.S. dollar-denominated sovereign debt to neutral from underweight on April 30.3 We also avoided a bigger hit to the portfolio through tactical adjustments made in late May, when we added back some interest rate duration to the portfolio given the increasing uncertainties from slowing global growth and rising U.S. trade policy hawkishness.4 We also reduced our U.S. corporate bond overweights at the same time, but the additional duration exposure was the more important factor – without those changes, the portfolio would have lagged the benchmark index by another -8bps in Q2. In terms of our best “hits” in the quarter, our overweight stance on U.S. investment grade corporates and Australian government bonds performed relatively well. Bottom Line: Our recommended model bond portfolio underperformed the custom benchmark index in the second quarter of the year, with the drag on performance from underweight exposure to U.S. Treasuries and Italian BTPs overwhelming the gains from credit overweights in the U.S. Future Drivers Of Portfolio Returns Looking ahead, the performance of the model bond portfolio will be driven by two main factors: our below-benchmark duration bias and our overweight stance on global corporate debt versus government bonds. In terms of the specific high-level weightings in the model portfolio, we currently have a moderate overweight, equal to three percentage points, on spread product versus government debt (Chart 5). This reflects a more constructive view on future global growth, with early leading economic indicators starting to bottom out to the benefit of growth-sensitive assets like corporate debt. That faster growth backdrop will also benefit our below-benchmark duration stance through a rebound in government bond yields. This should happen only slowly, however, as global central bankers are likely to keep their newly-dovish policy bias in place for some time until there are more decisive signs of accelerating growth AND inflation. Chart 6Overall Portfolio Duration: Below-Benchmark We are maintaining our below-benchmark duration tilt (0.5 years short of the custom benchmark), but we recognize that the underperformance from duration seen in the first half of 2019 will only be clawed back slowly over the next six months (Chart 6). As for country allocation, we continue to favor regions where looser monetary policy is most likely (core Europe, Australia, Japan and the U.K.). We are staying underweight the U.S., however, as the market’s expectations for the Fed are too dovish, with -82bps of rate cuts now discounted over the next twelve months. We are also keeping our underweight stance on Italian government bonds, which we now see as overvalued after the recent rally. We are maintaining our below-benchmark duration tilt (0.5 years short of the custom benchmark), but we recognize that the underperformance from duration seen in the first half of 2019 will only be clawed back slowly over the next six months We are, however, making some adjustments to the portfolio allocations to reflect our expectation of less negative news on global growth and easier monetary policies from global central bankers facing uncertainty alongside too-low inflation expectations: Increasing the overweight to U.S. high-yield corporates, boosting the allocation to Ba-rated and B-rated credit tiers by one percentage point each. This is funded by reducing our U.S. Treasury allocation by two percentage points. Upgrading euro area corporates to overweight, increasing the allocation to both investment grade and high-yield by one percentage point each. This is funded by reducing our German government bond allocation by two percentage points. Upgrading U.K. investment grade corporates to neutral, funded by reducing U.K. Gilt exposure by 0.5 percentage points. Upgrading Spanish government bonds to neutral, funded by reducing German exposure by 0.3 percentage points. These changes will boost the overall spread product allocation to 50% of the portfolio (an overweight of seven percentage points versus the benchmark index). This will also boost the overall yield of the portfolio to 3.2%, +6bps greater than that of the benchmark. That relative yield advantage looks even better in U.S. dollar terms, with currency hedging adding an additional +16bps to the relative portfolio yield given the current powerful carry advantage of the greenback (Chart 7). Chart 7Portfolio Yield: Small Positive Carry Chart 8Portfolio Risk Budget Usage: Cautious Even though we have decent-sized overall tilts on global duration and spread product allocation, our estimated tracking error (excess volatility of the portfolio versus its benchmark) remains low (Chart 8). We remain comfortable with a portfolio tracking error of 38bps, well below our self-imposed 100bps ceiling, as the internal weightings in the portfolio are helping keep overall portfolio volatility at a modest level. Scenario Analysis & Return Forecasts In April 2018, we introduced a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors.5 For credit, returns are estimated as a function of changes in the U.S. dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-U.S. yield changes are estimated using historical betas to changes in U.S. Treasury yields (Table 2B). This framework allows us to conduct scenario analysis of projected returns for each asset class in the model bond portfolio by making assumptions on those individual risk factors. In Tables 3A & 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, are all driven by what we believe will be the most important driver of market returns over the rest of 2019 – the momentum of global growth and the path of U.S. monetary policy. Our Base Case: the Fed delivers -50bps of easing by the end of 2019, the U.S. dollar depreciates by -3%, oil prices rise by +10%, the VIX index hovers around 15, and there is a mild bear-steepening of the U.S. Treasury curve. This is a scenario where the Fed delivers a rate cut in July and one more “insurance cut” before year-end, while signaling that no other easing beyond that. The model bond portfolio is expected to beat the benchmark index by +57bps in this case. Global Growth Rebounds: the Fed stays on hold to year-end, the U.S. dollar is flat, oil prices increase +10%, the VIX index falls to 12 and there is a mild bear-flattening of the U.S. Treasury curve. This is a scenario where improving economic data outside the U.S. diminishes the fears of a U.S. recession, allowing the Fed to stand pat and keep rates unchanged as financial market volatility stays muted. The model bond portfolio is expected to outperform the benchmark by +50bps here. Global Downturn Intensifies: the Fed cuts the funds rate by -75bps by year-end, the U.S. dollar falls by -5%, oil prices decline -15%, the VIX index increases to 30 and there is a bull steepening of the U.S. Treasury curve. This is a scenario where U.S./global growth momentum continues to fade, prompting the Fed to deliver a series of curve-steepening rate cuts to try and stabilize elevated financial market volatility amid increasing recession risks. The model portfolio will severely underperform the benchmark by -41bps with this outcome. The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the U.S. dollar and the VIX index) are different than what was presented in our last model bond portfolio review in mid-April (Chart 9). Then, we were contemplating scenarios involving the Fed keeping rates stable and even potentially looking for an opportunity to deliver another rate hike by year-end. Now, given the Fed’s clear dovish shift after the downshift in global growth momentum, two of our three main scenarios involve rate cuts in the U.S. The only scenario where Treasury yields can fall further, however, is if the global economic downturn deepens – a scenario we view as more of a tail risk rather than a higher-probability possibility (Chart 10). Chart 9Risk Factors Assumptions For The Scenario Analysis Chart 10U.S. Treasury Yield Assumptions For The Scenario Analysis In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are most confident that credit returns will exceed those of sovereign debt over the next six months. Bottom Line: We are adding credit exposure to our model portfolio, increasing spread product allocation in U.S. high-yield and European corporates. In our Base Case scenario, the Fed is likely to deliver some “insurance” rate cuts in the next few months, but by less than the markets are currently discounting, while global growth momentum will stabilize. The resulting price action will favor spread product over government bonds, helping boost the returns of our model portfolio. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 2 Note that sectors where we made changes to our recommended weightings during Q2/2019 will have multiple colors in the respective bars in Chart 4. 3 Please see BCA Global Fixed Income Strategy Weekly Report, “It’s Time To Break Out The Fine China”, dated April 30, 2019, available at gfis.bcaresearch.com. 4 Please see BCA Global Fixed Income Strategy Weekly Report, “The Message From Low Bond Yields”, dated May 28, 2019, available at gfis.bcaresearch.com. 5 Please see BCA Global Fixed Income Strategy Weekly Report, “GFIS Model Bond Portfolio Q1/2018 Performance Review: A Rough Start”, dated April 10th 2018, available at gfis.bcareseach.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns
GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of June 28, 2019. The quant model has upgraded Sweden to the second largest overweight (from a slight underweight) mainly due to sharp improvement in the liquidity indicator. This is financed by reductions in the overweight of Germany, Italy and the downgrade of Switzerland to a slight underweight (from overweight), as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI world benchmark by 39 bps in June, largely driven by 104 bps of outperformance from Level 2 model, offset by 10 bps of underperformance from Level 1. Directionally, six out of the 12 choices generated positive alpha. The largest contributions to the outperformance in June came from the overweight in Italy and the underweight in Japan. Since going live, the overall model has outperformed by 238 bps, with 511 bps of outperformance by the Level 2 model, offset by 2 bps of underperformance from Level 1. Table 2Performance (Total Returns In USD %) Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA 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 Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of June 28, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model increased its cyclical exposure by overweighting Materials on the backdrop of improvement in its momentum component. The model is therefore overweight two cyclical and two defensive sectors – Industrials, Materials, Consumer Staples and Utilities. The valuation component remains muted across all sectors. The growth component continues to favor defensive sectors so far, as an improvement in global growth hard data has not yet materialized. 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 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com
Highlights So What? Economic stimulus will encourage key nations to pursue their self-interest – keeping geopolitical risk high. Why? The U.S. is still experiencing extraordinary strategic tensions with China and Iran … simultaneously. The Trump-Xi summit at the G20 is unlikely to change the fact that the United States is threatening China with total tariffs and a technology embargo. The U.S. conflict with Iran will be hard to keep under wraps. Expect more fireworks and oil volatility, with a large risk of hostilities as long as the U.S. maintains stringent oil sanctions. All of our GeoRisk indicators are falling except for those of Germany, Turkey and Brazil. This suggests the market is too complacent. Maintain tactical safe-haven positioning. Feature “That’s some catch, that Catch-22,” he observed. “It’s the best there is,” Doc Daneeka agreed. -Joseph Heller, Catch-22 (1961) One would have to be crazy to go to war. Yet a nation has no interest in filling its military’s ranks with lunatics. This is the original “Catch-22,” a conundrum in which the only way to do what is individually rational (avoid war) is to insist on what is collectively irrational (abandon your country). Or the only way to defend your country is to sacrifice yourself. This is the paradox that U.S. President Donald Trump faces having doubled down on his aggressive foreign policy this year: if he backs away from trade war to remove an economic headwind that could hurt his reelection chances, he sacrifices the immense leverage he has built up on behalf of the United States in its strategic rivalry with China. “Surrender” would be a cogent criticism of him on the campaign trail: a weak deal will cast him as a pluto-populist, rather than a real populist – one who pandered to China to give a sop to Wall Street and the farm lobby just like previous presidents, yet left America vulnerable for the long run. Similarly, if President Trump stops enforcing sanctions against Iranian oil exports to reduce the threat of a conflict-induced oil price shock that disrupts his economy, then he reduces the United States’s ability to contain Iran’s nuclear and strategic advances in the wake of the 2015 nuclear deal that he canceled. The low appetite for American involvement in the region will be on full display for the world to see. Iran will have stared down the Great Satan – and won. In both cases, Trump can back down. Or he can try to change the subject. But with weak polling and yet a strong economy, the point is to direct voters’ attention to foreign policy. He could lose touch with his political base at the very moment that the Democrats reconnect with their own. This is not a good recipe for reelection. More important – for investors – why would he admit defeat just as the Federal Reserve is shifting to countenance the interest rate cuts that he insists are necessary to increase his economic ability to drive a hard bargain with China? Why would he throw in the towel as the stock market soars? And if Trump concludes a China deal, and the market rises higher, will he not be emboldened to put more economic pressure on Mexico over border security … or even on Europe over trade? The paradox facing investors is that the shift toward more accommodative monetary policy (and in some cases fiscal policy) extends the business cycle and encourages political leaders to pursue their interests more intently. China is less likely to cave to Trump’s demands as it stimulates. The EU does not need to fear a U.K. crash Brexit if its economy rebounds. This increases rather than decreases the odds of geopolitical risks materializing as negative catalysts for the market. Similarly, if geopolitical risk falls then the need for stimulus falls and the market will be disappointed. The result is still more volatility – at least in the near term. The G20 And 2020 As we go to press the Democratic Party’s primary election debates are underway. The progressive wave on display highlights the overarching takeaway of the debates: the U.S. election is now an active political (and geopolitical) risk to the equity market. A truly positive surprise at the G20 would be a joint statement by Trump and Xi plus some tariff rollback. Whenever Trump’s odds of losing rise, the U.S. domestic economy faces higher odds of extreme policy discontinuity and uncertainty come 2021, with the potential for a populist-progressive agenda – a negative for financials, energy, and probably health care and tech. Yet whenever Trump’s odds of winning rise, the world faces higher odds of an unconstrained Trump second term focusing on foreign and trade policy – a potentially extreme increase in global policy uncertainty – without the fiscal and deregulatory positives of his first term. We still view Trump as the favored candidate in this race (at 55% chance of reelection), given that U.S. underlying domestic demand is holding up and the labor market has not been confirmed to be crumbling beneath the consumer’s feet. Still Chart 1 highlights that Trump’s shift to more aggressive foreign and trade policy this spring has not won him any additional support – his approval rating has been flat since then. And his polling is weak enough in general that we do not assign him as high of odds of reelection as would normally be afforded to a sitting president on the back of a resilient economy. This raises the question of whether the G20 will mark a turning point. Will Trump attempt to deescalate his foreign conflicts? Yes, and this is a tactical opportunity. But we see no final resolution at hand. With China, Trump’s only reason to sign a weak deal would be to stem a stock market collapse. With Iran, Trump is no longer in the driver’s seat but could be forced to react to Iranian provocations. Bottom Line: Trump’s polling has not improved – highlighting the election risk – but weak polling amid a growing economy and monetary easing is not a recipe for capitulating to foreign powers. The Trump-Xi Summit On China the consensus on the G20 has shifted toward expecting an extension of talks and another temporary tariff truce. If a new timetable is agreed, it may be a short-term boon for equities. But we will view it as unconvincing unless it is accompanied with a substantial softening on Huawei or a Trump-Xi joint statement outlining an agreement in principle along with some commitment of U.S. tariff rollback. Otherwise the structural dynamic is the same: Trump is coercing China with economic warfare amid a secular increase in U.S.-China animosity that is a headwind for trade and investment. Table 1 shows that throughout the modern history of U.S.-China presidential-level summits, the Great Recession marked a turning point: since then, bilateral relations have almost always deteriorated in the months after a summit, even if the optics around the summit were positive. Table 1U.S.-China Leaders Summits: A Chronology The last summit in Buenos Aires was no exception, given that the positive aura was ultimately followed by a tariff hike and technology-company blacklistings. Of course, the market rallied for five months in between. Why should this time be the same? First, the structural factors undermining Sino-American trust are worse, not better, with Trump’s latest threats to tech companies. Second, Trump will ultimately resent any decision to extend the negotiations. China’s economy is rebounding, which in the coming months will deprive Trump of much of the leverage he had in H2 2018 and H1 2019. He will be in a weaker position if they convene in three months to try to finalize a deal. Tariff rollback will be more difficult in that context given that China will be in better shape and that tariffs serve as the guarantee that any structural concessions will be implemented. Bottom Line: Our broader view regarding the “end game” of the talks – on the 2020 election horizon – remains that China has no reason to implement structural changes speedily for the United States until Trump can prove his resilience through reelection. Yet President Trump will suffer on the campaign trail if he accepts a deal that lacks structural concessions. Hence we expect further escalation from where we are today, knowing full well that the G20 could produce a temporary period of improvement just as occurred on December 1, 2018. The Iran Showdown Is Far From Over Disapproval of Trump’s handling of China and Iran is lower than his disapproval rating on trade policy and foreign policy overall, suggesting that despite the lack of a benefit to his polling, he does still have leeway to pursue his aggressive policies to a point. A breakdown of these opinions according to key voting blocs – a proxy for Trump’s ability to generate support in Midwestern swing states – illustrates that his political base is approving on the whole (Chart 2). Yet the conflict with Iran threatens Trump with a hard constraint – an oil price shock – that is fundamentally a threat to his reelection. Hence his decision, as we expected, to back away from the brink of war last week (he supposedly canceled air strikes on radar and missile installations at the last minute on June 21). He appears to be trying to control the damage that his policy has already done to the 2015 U.S.-Iran equilibrium. Trump has insisted he does not want war, has ruled out large deployments of boots on the ground, and has suggested twice this week that his only focus in trying to get Iran back into negotiations is nuclear weapons. This implies a watering down of negotiation demands to downplay Iran’s militant proxies in the region – it is a retreat from Secretary of State Mike Pompeo’s more sweeping 12 demands on Iran and a sign of Trump’s unwillingness to get embroiled in a regional conflict with a highly likely adverse economic blowback. The Iran confrontation is not over yet – policy-induced oil price volatility will continue. This retreat lacks substance if Trump does not at least secretly relax enforcement of the oil sanctions. Trump’s latest sanctions and reported cyberattacks are a sideshow in the context of an attempted oil embargo that could destabilize Iran’s entire economy (Charts 3 and 4). Similarly, Iran’s downing of a U.S. drone pales in comparison to the tanker attacks in Hormuz that threatened global oil shipments. What matters to investors is the oil: whether Iran is given breathing space or whether it is forced to escalate the conflict to try to win that breathing space. Chart 4Iran’s Rial Depreciated Sharply The latest data suggest that Iran’s exports have fallen to 300,000 barrels per day, a roughly 90% drop from 2018, when Trump walked away from the Iran deal. If this remains the case in the wake of the brinkmanship last week then it is clear that Iran is backed into a corner and could continue to snarl and snap at the U.S. and its regional allies, though it may pause after the tanker attacks. Chart 5More Oil Volatility To Come Tehran also has an incentive to dial up its nuclear program and activate its regional militant proxies in order to build up leverage for any future negotiation. It can continue to refuse entering into negotiations with Trump in order to embarrass him – and it can wait until Trump’s approach is validated by reelection before changing this stance. After all, judging by the first Democratic primary debate, biding time is the best strategy – the Democratic candidates want to restore the 2015 deal and a new Democratic administration would have to plead with Iran, even to get terms less demanding than those in 2015. Other players can also trigger an escalation even if Presidents Trump and Rouhani decide to take a breather in their conflict (which they have not clearly decided to do). The Houthi rebels based in Yemen have launched another missile at Abha airport in Saudi Arabia since Trump’s near-attack on Iran, an action that is provocative, easily replicable, and not necessarily directly under Tehran’s control. Meanwhile OPEC is still dragging its feet on oil production to compensate for the Iranian losses, implying that the cartel will react to price rises rather than preempt them. The Saudis could use production or other means to stoke conflict. Bottom Line: Given our view on the trade war, which dampens global oil demand, we expect still more policy-induced volatility (Chart 5). We do not see oil as a one-way bet … at least not until China’s shift to greater stimulus becomes unmistakable. North Korea: The Hiccup Is Over Chart 6China Ostensibly Enforces North Korean Sanctions The single clearest reason to expect progress between the U.S. and China at the G20 is the fact that North Korea is getting back onto the diplomatic track. North Korea has consistently been shown to be part of the Trump-Xi negotiations, unlike Taiwan, the South China Sea, Xinjiang, and other points of disagreement. General Secretary Xi Jinping took his first trip to the North on June 20 – the first for a Chinese leader since 2005 – and emphasized the need for historic change, denuclearization, and economic development. Xi is pushing Kim to open up and reform the economy in exchange for a lasting peace process – an approach that is consistent with China’s past policy but also potentially complementary with Trump’s offer of industrialization in exchange for denuclearization. President Trump and Kim Jong Un have exchanged “beautiful” letters this month and re-entered into backchannel discussions. Trump’s visit to South Korea after the G20 will enable him and President Moon Jae-In to coordinate for a possible third summit between Trump and Kim. Progress on North Korea fits our view that the failed summit in Hanoi was merely a setback and that the diplomatic track is robust. Trump’s display of a credible military threat along with Chinese sanctions enforcement (Chart 6) has set in motion a significant process on the peninsula that we largely expect to succeed and go farther than the consensus expects. It is a long-term positive for the Korean peninsula’s economy. It is also a positive factor in the U.S.-China engagement based on China’s interest in ultimately avoiding war and removing U.S. troops from the peninsula. From an investment point of view, an end to a brief hiatus in U.S.-North Korean diplomacy is a very poor substitute for concrete signs of U.S.-China progress on the tech front or opening market access. There has been nothing substantial on these key issues since Trump hiked the tariff rate in May. As a result, it is perfectly possible for the G20 to be a “success” on North Korea but, like the Buenos Aires summit on December 1, for markets to sell the news (Chart 7). Chart 7The Last Trade Truce Didn't Stop The Selloff Chart 8China Needs A Final Deal To Solve This Problem Bottom Line: North Korea is not a basis in itself for tariff rollback, but only as part of a much more extensive U.S.-China agreement. And a final agreement is needed to improve China’s key trade indicators on a lasting basis, such as new export orders and manufacturing employment, which are suffering amid the trade war. We expect economic policy uncertainty to remain elevated given our pessimistic view of U.S.-China trade relations (Chart 8). What About Japan, The G20 Host? Japan faces underrated domestic political risk as Prime Minister Abe Shinzo approaches a critical period in his long premiership, after which he will almost certainly be rendered a “lame duck,” likely by the time of the 2020 Tokyo Olympics. The question is when will this process begin and what will the market impact be? If Abe loses his supermajority in the July House of Councillors election, then it could begin as early as next month. This is a real risk – because a two-thirds majority is always a tall order – but it is not extreme. Abe’s polling is historically remarkable (Chart 9). The Liberal Democratic Party and its coalition partner Komeito are also holding strong and remain miles away from competing parties (Chart 10). The economy is also holding up relatively well – real wages and incomes have improved under Abe’s watch (Chart 11). However, the recent global manufacturing slowdown and this year’s impending hike to the consumption tax in October from 8% to 10% are killing consumer confidence. Chart 10Japan's Ruling Coalition Is Strong The collapse in consumer confidence is a contrary indicator to the political opinion polling. The mixed picture suggests that after the election Abe could still backtrack on the tax hike, although it would require driving through surprise legislation. He can pull this off in light of global trade tensions and his main objective of passing a popular referendum to revise the constitution and remilitarize the country. Chart 11Japanese Wages Up, But Consumer Confidence Diving We would not be surprised if Japan secured a trade deal with the U.S. prior to China. Because Abe and the United States need to enhance their alliance, we continue to downplay the risk of a U.S.-Japan trade war. Bloomberg recently reported that President Trump was threatening to downgrade the U.S.-Japan alliance, with a particular grievance over the ever-controversial issue of the relocation of troops on Okinawa. We view this as a transparent Trumpian negotiating tactic that has no applicability – indeed, American military and diplomatic officials quickly rejected the report. We do see a non-trivial risk that Trump’s rhetoric or actions will hurt Japanese equities at some point this year, either as Trump approaches his desired August deadline for a Japan trade deal or if negotiations drag on until closer to his decision about Section 232 tariffs on auto imports on November 14. But our base case is that there will be either no punitive measures or only a short time span before Abe succeeds in negotiating them away. We would not be surprised if the Japanese secured a deal prior to any China deal as a way for the Trump administration to try to pressure China and prove that it can get deals done. This can be done because it could be a thinly modified bilateral renegotiation of the Trans-Pacific Partnership, which had the U.S. and Japan at its center. Bottom Line: Given the combination of the upper house election, the tax hike and its possible consequences, a looming constitutional referendum which poses risks to Abe, and the ongoing external threat of trade war and China tensions, we continue to see risk-off sentiment driving Japanese and global investors to hold then yen. We maintain our long JPY/USD recommendation. The risk to this view is that Bank of Japan chief Haruhiko Kuroda follows other central banks and makes a surprisingly dovish move, but this is not warranted at the moment and is not the base case of our Foreign Exchange Strategy. GeoRisk Indicators Update: June 28, 2019 Our GeoRisk indicators are sending a highly complacent message given the above views on China and Iran. All of our risk measures, other than our German, Turkish, and Brazilian indicators, are signaling a decrease geopolitical tensions. Investors should nonetheless remain cautious: Our German indicator, which has proven to be a good measure of U.S.-EU trade tensions, has increased over the first half of June (Chart 12). We expect Germany to continue to be subject to risk because of Trump’s desire to pivot to European trade negotiations in the wake of any China deal. The auto tariff decision was pushed off until November. We assign a 45% subjective probability to auto tariffs on the EU if Trump seals a final China deal. The reason it is not our base case is because of a lack of congressional, corporate, or public support for a trade war with Europe as opposed to China or Mexico, which touch on larger issues of national interest (security, immigration). There is perhaps a 10% probability that Trump could impose car tariffs prior to securing a China deal. Chart 12U.S.-EU Trade Tensions Hit Germany Chart 13German Greens Overtaking Christian Democrats! Germany is also an outlier because it is experiencing an increase in domestic political uncertainty. Social Democrat leader Andrea Nahles’ resignation on June 2 opened the door to a leadership contest among the SPD’s membership. This will begin next week and conclude on October 26, or possibly in December. The result will have consequences for the survivability of Merkel’s Grand Coalition – in case the SPD drops out of it entirely. Both Merkel and her party have been losing support in recent months – for the first time in history the Greens have gained the leading position in the polls (Chart 13). If the coalition falls apart and Merkel cannot put another one together with the Greens and Free Democrats, she may be forced to resign ahead of her scheduled 2021 exit date. The implication of the events with Trump and Merkel is that Germany faces higher political risk this year, particularly in Q4 if tariff threats and coalition strains coincide. Meanwhile, Brazilian pension reform has been delayed due to an inevitable breakdown in the ability to pass major legislation without providing adequate pork barrel spending. As for the rest of Europe, since European Central Bank President Mario Draghi’s dovish signal on June 18, all of our European risk indicators have dropped off. Markets rallied on the news of the ECB’s preparedness to launch another round of bond-buying monetary stimulus if needed, easing tensions in the region. Italian bond spreads plummeted, for instance. The Korean and Taiwanese GeoRisk indicators, our proxies for the U.S.-China trade war, are indicating a decrease in risk as the two sides moved to contain the spike in tensions in May. While Treasury Secretary Steve Mnuchin notes that the deal was 90% complete in May before the breakdown, there is little evidence yet that any of the sticking points have been removed over the past two weeks. These indicators can continue to improve on the back of any short-term trade truce at the G20. The Russian risk indicator has been hovering in the same range for the past two months. We expect this to break out on the back of increasing mutual threats between the U.S. and Russia. The U.S. has recently agreed to send an additional 1000 rotating troops to Poland, a move that Russia obviously deems aggressive. The Russian upper chamber has also unanimously supported President Putin’s decree to suspend the Intermediate Nuclear Forces treaty, in the wake of the U.S. decision to do so. This would open the door to developing and deploying 500-5500 km range land-based and ballistic missiles. According to the deputy foreign minister, any U.S. missile deployment in Europe will lead to a crisis on the level of the Cuban Missile Crisis. Russia has also sided with Iran in the latest U.S.-Iran tension escalation, denouncing U.S. plans to send an additional 1000 troops to the Middle East and claiming that the shot-down U.S. drone was indeed in Iranian airspace. We anticipate the Russian risk indicator to go up as we expect Russia to retaliate in some way to Poland and to take actions to encourage the U.S. to get entangled deeper into the Iranian imbroglio, which is ultimately a drain on the U.S. and a useful distraction that Russia can exploit. In Turkey, both domestic and foreign tensions are rising. First, the re-run of the Istanbul mayoral election delivered a big defeat for Turkey’s President Erdogan on his home turf. Opposition representative Ekrem Imamoglu defeated former Prime Minister Binali Yildirim for a second time this year on June 23 – increasing his margin of victory to 9.2% from 0.2% in March. This was a stinging rebuke to Erdogan and his entire political system. It also reinforces the fact that Erdogan’s Justice and Development Party (AKP) is not as popular as Erdogan himself, frequently falling short of the 50% line in the popular vote for elections not associated directly with Erdogan (Chart 14). This trend combined with his personal rebuke in the power base of Istanbul will leave him even more insecure and unpredictable. Second, the G20 summit is the last occasion for Erdogan and Trump to meet personally before the July 31 deadline on Erdogan’s planned purchase of S-400 missile defenses from Russia. Erdogan has a chance to delay the purchase as he contemplates cabinet and policy changes in the wake of this major domestic defeat. Yet if Erdogan does not back down or delay, the U.S. will remove Turkey from the F-35 Joint Strike Fighter program, and may also impose sanctions over this purchase and possibly also Iranian trade. The result will hit the lira and add to Turkey’s economic woes. Geopolitically, it will create a wedge within NATO that Russia could exploit, creating more opportunities for market-negative surprises in this area. Finally, we expect our U.K. risk indicator to perk up, as the odds of a no-deal Brexit are rising. Boris Johnson will likely assume Conservative Party leadership and the party is moving closer to attempting a no-deal exit. We assign a 21% probability to this kind of Brexit, up from our previous estimate of 14%. It is more likely that Johnson will get a deal similar to Theresa May’s deal passed or that he will be forced to extend negotiations beyond October. Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Section III: Geopolitical Calendar