Banks

Banks Earnings Deluge Banks Earnings Deluge Overweight (Downgrade Alert) Banks got earnings season off to a great start with heavyweight JPM (and the majority of the rest of the industry) reporting solid earnings. One of the key risks to our overweight banks call that we have been highlighting recently is the inverted yield curve infecting net interest margins (NIM), and JPM acknowledged a more “challenging interest rate backdrop” and that the economy had “slowed slightly”. Importantly, the previous drubbing in interest rates is stimulating credit demand and providing a volume offset across the board as highlighted by our in-house calculated aggregate Fed Senior Loan Officer survey indicators (middle & bottom panels). Bottom Line:  Stay overweight the compellingly valued S&P banks index, but keep the index on downgrade watch courtesy of NIM and manufacturing sector related risks. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC. ​​​​​​​

Highlights New structural recommendation: long GBP/USD. The substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. The most powerful equity play on a fading Brexit discount would be the U.K. homebuilders. Specifically, Persimmon still has a further 25 percent of upside. Take profits in long Euro Stoxx 50 versus Shanghai Composite. Within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Stay overweight banks versus industrials. Stay overweight the Euro Stoxx 50 versus the Nikkei 225. Fractal trade: long NZD/JPY. Feature Chart of the WeekThe Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades Carnival Says The Pound Is Cheap Carnival, the world’s largest cruise liner company, lists its shares on both the London and New York stock exchanges. But there is an apparent riddle: in London the shares trade on a forward PE of 8.8, while in New York they trade on 9.4. How can Carnival trade at different valuations on the two sides of the Atlantic when the market should instantly arbitrage the difference away? The answer to the riddle is that the London listing is quoted in pounds, the New York listing is quoted in dollars, while Carnival’s sales and profits are denominated in a mix of international currencies. Neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term.  Carnival is trading on a higher valuation in New York versus London because the market is expecting its mixed currency earnings to appreciate more in dollar terms than in pound terms. Put another way, the valuation differential is expecting the pound to appreciate versus the dollar to a ‘fair value’ of around $1.40 (Chart I-2). Likewise, BHP Billiton shares are trading on a higher valuation in their Sydney listing compared to their London listing. This valuation differential is expecting the pound to appreciate versus the Australian dollar to around A$2.00 (Chart I-3). Chart I-2Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Carnival Says The Pound Is Cheap Chart I-3BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap BHP Billiton Says The Pound Is Cheap In other words, the market believes that neither Brexit developments nor a potential Jeremy Corbyn led government will prevent the pound from rallying in the longer term. We tend to agree. The Wrong Way To Pick Stock Markets… And The Right Way Before continuing with the pound’s prospects, let’s wander into the wider investment landscape. One important lesson from dual-listed companies like Carnival and BHP Billiton is that a multinational’s valuation will appear attractive in a market where the currency is structurally cheap.1 This lesson has deep ramifications. Today, multinationals dominate all the major stock markets, meaning that the entire stock market will appear cheap if its currency is cheap. The stock market will also appear cheap if it is skewed towards lower-valued sectors. But sectors trade on a low valuation for a reason – poor long-term growth prospects. Through the past decade, Japanese banks seemed a relative bargain, trading on a forward PE of less than half of that on personal products companies (Chart I-4). Yet Japanese banks were not a relative bargain. Quite the contrary. Through the past decade Japanese personal products have outperformed the banks by 500 percent! (Chart I-5) Chart I-4Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Japanese Banks Seemed A Relative Bargain... Chart I-5...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain ...But Japanese Banks Were Not A Relative Bargain Hence, beware of picking stock markets on the basis of observations such as ‘European stocks are cheaper than U.S. stocks’. Given that a stock market valuation is the result of its currency valuation and its sector composition, assessing relative value across major stock markets is extremely difficult, if not impossible. To repeat, Carnival appears to be trading at a valuation discount in London versus New York, but the cheapness is illusory. Here’s the right way to pick major stock markets. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In this regard, large underweight sector skews also matter. For example, China and EM have a near-zero exposure to healthcare equities, so their performances tend to correlate negatively with that of the global healthcare sector – albeit the causality could run in either direction. Identify your preferred sectors and currencies, and then pick the regional and country stock markets that are skewed to these preferred sectors and currencies. In early May, we noticed that the extreme outperformance of technology versus healthcare was at a critical technical point at which there was a high probability of a trend reversal. This high conviction sector view implied overweight Europe versus China, as well as overweight Switzerland and underweight Netherlands within Europe (Chart I-6 and Chart I-7). Chart I-6When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland When Tech Underperforms Healthcare, China Underperforms Switzerland Chart I-7When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland When Tech Underperforms Healthcare, The Netherlands Underperforms Switzerland   Given that this sector trend reversal has played out exactly as anticipated, it is time to bank the profits:   Close long Euro Stoxx 50 versus Shanghai Composite. And within Europe, close the overweight to Switzerland and the underweight to the Netherlands. Right now, it is appropriate to overweight banks versus industrials. It is the pace of the bond yield’s decline that has weighed on bank performance this year. But if the sharpest decline in bond yields is behind us, as seems likely, then banks should fare better versus other cyclicals (Chart I-8). Chart I-8If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials If The Sharpest Decline In Bond Yields Is Over, Banks Will Outperform Industrials Once again, this sector view carries an equity market implication: stay overweight the Euro Stoxx 50 versus the Nikkei 225 (Chart I-9). Chart I-9Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen Euro Stoxx 50 Vs. Nikkei 225 = Global Banks In Euros Vs. Global Industrials In Yen The Pound Is A Long-Term Buy Back to the pound. The message from the dual listings of Carnival and BHP Billiton is that the pound is cheap, and this is neatly corroborated by the relationship between relative interest rates and the pound versus the euro and dollar. Based on the pre-Brexit relationship between relative real interest rates and the pound’s exchange rate, we can quantify the ‘Brexit discount’. Absent this discount, the pound would now be trading close to €1.30 and well north of $1.40 (Chart of the Week and Chart I-10). Chart I-10The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades The Pound Has Substantial Upside If The Brexit Discount Fades In the Brexit psychodrama, we do not claim to know exactly how the next few days or weeks will play out. In the short term, Brexit is a classic non-linear system, and non-linear systems are inherently unpredictable. However, in the longer term we expect the Brexit discount to fade in any sort of transitioned resolution that allows the U.K. to adapt to a new trading relationship with the world, or alternatively to stay in a relationship broadly similar to the current one. Whatever the eventual endpoint is, the key requirement to remove the Brexit discount is to avoid a cliff-edge. We expect the Brexit discount to fade in any sort of transitioned resolution. The stumbling block to a resolution is that the three key actors – the EU, the U.K. government, and the U.K. parliament – have conflicting red lines, so the Brexit ‘Venn diagram’ has had no overlap. The EU will not countenance a customs border that divides Ireland; the current U.K. government wants a Free Trade Agreement, which implies casting away Northern Ireland into the EU customs union; and the current U.K. parliament – unless its intentions suddenly change – wants the whole of the U.K., including Northern Ireland, to remain in the EU customs union.   Given that the EU will not budge its red line, the only way to a lasting resolution is for the government and parliament red lines to realign, This could happen via parliament being willing to sacrifice Northern Ireland, via a second referendum, or via a general election in which the government’s intentions and/or the composition of parliament changed. Given a long enough investment horizon – 2 years or more – it is likely that the government and parliament will realign their red lines to a Free Trade Agreement or to a customs union, one way or another. On this basis, the substantial Brexit discount in the pound makes it a long-term buy for investors who can tolerate near-term volatility. Accordingly, today we are initiating a new structural recommendation: long GBP/USD.  For equity investors, the most powerful play on a fading Brexit discount would be the U.K. homebuilders (Chart I-11). Specifically, if the pound reached $1.40, Persimmon still has a further 25 percent of upside. Chart I-11U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades U.K. Homebuilders Have Substantial Upside If The Brexit Discount Fades Fractal Trading System*  Based on its collapsed fractal structure, we anticipate a countertrend rally in NZD/JPY within the next 130 days. Accordingly, go long NZD/JPY setting a profit target of 3 percent and a symmetrical stop-loss. Chart I-12 NZD VS. JPY NZD VS. JPY For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions.   * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 There are also several companies with dual listings in the U.K. and the euro area. Unfortunately, these valuation differentials have been temporarily distorted by the risk of a no-deal Brexit, in which EU27 investors may have been forbidden from trading in the U.K. listed shares. Fractal Trading System Cyclical Recommendations Structural Recommendations Fractal Trades The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) The Pound Is A Long-Term Buy (And So Are Homebuilders) Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations  

Highlights The Chinese economy is still slowing, and there is not yet enough evidence from forward-looking economic data to suggest a turnaround is imminent. Deflation has returned to China’s industrial sector. Even though overall price deceleration has been relatively mild, it is further squeezing already deteriorating industrial profit growth. We do not expect deflation to spiral into a 2015/2016-style episode, which removes at least one risk to our growth outlook. At the same time, a mild deceleration in prices will not provide enough incentive for Chinese policymakers to hit the stimulus button.  The People’s Bank of China’s new interest rate-setting regime, the LPR, will not provide much in the way of stimulus over the next few months. But it has the potential to improve China’s monetary policy transmission mechanism over the coming year, increasing the odds that policymakers will succeed in stabilizing economic activity. Short-term downside risks to growth have not abated, and we remain tactically bearish on Chinese stocks. Cyclically, we continue to recommend an overweight stance, on the basis of an eventual reacceleration in economic activity. Feature Chart 1The Chinese Economy Is Still Slowing The Chinese Economy Is Still Slowing The Chinese Economy Is Still Slowing China’s economy is at a critical juncture: “Half-measured” stimulus so far has been able to keep the domestic economy in better shape than in the 2015-2016 down cycle, but overall economic activity has not bottomed (Chart 1). The Sino-America trade talk has resumed at the moment, but the two sides have yet to make any substantive progress towards a deal. In the meantime, the global economy has also reached a critical point where the degree of economic weakness has the potential to feed on itself, possibly triggering a recession.1  This underscores our tactically bearish stance towards Chinese stocks versus the global equity benchmark. Barring more forceful stimulus or resolution on the trade front, any external shock and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown. Hence, downside risks remain elevated for Chinese stocks over the next 3- to 6-months.    The “D” Word Returns, But Won’t Spur Aggressive Further Easing Chart 2Industrial Price Deflation Returns Industrial Price Deflation Returns Industrial Price Deflation Returns Economic data over the past two months have provided mixed signals. Readings from both China’s National Bureau of Statistics (NBS) PMI and from the Caixin PMI show an improvement in the manufacturing sector. However, industrial deflation has returned to China: Three years after the country declared victory against a prolonged industrial destocking cycle, producer price inflation (PPI) relapsed into negative territory in July and declined further in August (Chart 2).   While prices are typically lagging indicators and reflect lingering effects from past economic conditions, there is not enough evidence in forward-looking economic data right now to suggest a turnaround in the economy is imminent.2  A deflationary PPI is not a trivial source of concern for Chinese policymakers. Last time growth in China’s PPI turned negative, it took policymakers four and a half years and an annualized 28% of GDP worth of credit expansion to pull the industrial sector out of its deflationary cycle. Chart 3Deflation Threatens Recovery In Industrial Profit Growth Deflation Threatens Recovery In Industrial Profit Growth Deflation Threatens Recovery In Industrial Profit Growth For investors, deflation has pernicious effects on profits, and we have received several client inquiries concerning the topic since PPI growth turned negative. The historical relationship suggests profit growth for both the A-share and investable markets is highly linked to fluctuations in producer prices (Chart 3), and China’s industrial sector profit growth has already been rapidly deteriorating over the past 12 months. The good news is that we do not expect the current episode of PPI deflation to become as protracted as it did in 2012-2016, or as severe as in 2015-2016. Two reasons underpin our view: Since early-2018, monetary policy has been much easier than during past deflationary episodes. Monetary policy in the past year and half has been much more accommodative than in the three years leading to the deep industrial deflationary cycle in 2015, particularly on the exchange rate front. The RMB was soft-pegged to a rising U.S. dollar before it was decoupled by the PBoC in August 2015, and was appreciating against its trading partners throughout most of 2012-2015. Bank lending rates were also kept at historically high levels during this period (Chart 4). This time, even though money and credit growth has not returned to the same pace as in 2015-2016, current ultra-loose monetary conditions should spur enough credit growth to keep prices from deflating aggressively. Chart 4Monetary Conditions Easier Than Last Cycle Monetary Conditions Easier Than Last Cycle Monetary Conditions Easier Than Last Cycle Inventory levels are low, and capacity levels do not appear to be overly excessive. After years of industrial consolidation, China’s industrial capacity does not appear to be particularly excessive compared to the past cycle. This is distinctively different from the prolonged contraction in PPI between 2012 and 2016, when China’s industrial inventories were coming off a five-year-long destocking cycle, and capacity utilization fell markedly (Chart 5). This is not the case today. Moreover, even though final demand has been weak, production has retrenched even more, drawing down inventories to the point where the pace of inventory destocking may have reached a cyclical bottom (Chart 6). A re-stocking of industrial goods should boost producers’ pricing power. Chart 5Capacity Is Not Excessively Underutilized Capacity Is Not Excessively Underutilized Capacity Is Not Excessively Underutilized Chart 6Inventory Destocking May Be Bottoming Out Inventory Destocking May Be Bottoming Out Inventory Destocking May Be Bottoming Out But the bad news (for investors), is that contained, or mild producer price deflation will not be reason alone to spur aggressive further easing from policymakers. This means that the re-emergence of price deflation, even mild and short-lived, will weigh on earnings and investor sentiment. Bottom Line: This episode of producer price deflation is unlikely to become as pernicious as occurred in the past, but policymakers are thus unlikely to act aggressively to counter it. While this removes some of the downside risks for Chinese stocks, even mild deflation will weigh on earnings growth (and thus sentiment) which underscores our tactically bearish stance on Chinese stocks. Demystifying China’s New Loan Prime Rate: Not The Stimulus You Are Looking For On August 20th, the PBoC launched a new loan prime rate (LPR) system, a revamped reference regime for setting bank loan interest rates3 (Chart 7). In September, the new LPR rate for one-year bank loans was lowered by five basis points. Since then, the market has been fixated on predicting whether the PBoC will cut the Medium-Lending Facility (MLF) rate next, which would be perceived as a change in China’s monetary stance. Chart 7China's New LPR: A Shadow 'Tax Cut' China's New LPR: A Shadow "Tax Cut" China's New LPR: A Shadow "Tax Cut" PBoC will increase its control of the pricing of credit, while tight financial regulations will restrict the size and speed of credit growth. The new LPR reform, in our view, is designed to force state-owned (and better-capitalized) commercial banks to hand out a “tax cut” to struggling small- and medium-sized enterprises (SMEs) by lowering bank lending rates. At the same time, it allows the PBoC to take back control of the pricing of credit from commercial banks, “killing two birds with one stone.” There are three main market implications from this approach: The new LPR is likely to gradually narrow the gap between corporate bond yields (i.e. “market rates”) and bank lending rates; A cut in the MLF rate in the near term should be interpreted as a “reward” to commercial banks rather than a stimulus for the economy; Most importantly, the new LPR system does not mean rapid credit expansion is in the cards. Quite the opposite, in the near term, banks may tighten their lending. The wide spread between the 3-month interbank repo rate and average bank lending rate illustrates the reason why the PBoC has introduced the LPR.4 This gap is also evident when comparing the yield of AAA-rated corporate bonds and the average bank lending rate (Chart 8). These gaps exist because Chinese commercial banks have largely manipulated the 1-year bank lending rate set by the PBoC when lending to their “preferred customers,” usually state-owned enterprises and real estate developers, by offering significantly discounted loan rates. Banks then charge substantial “risk premiums” on loans to the private sector, mostly SMEs, to make up for the narrower profit margins on loans to SOEs (Chart 9). Chart 8An Impaired Monetary Policy Transmission Mechanism An Impaired Monetary Policy Transmission Mechanism An Impaired Monetary Policy Transmission Mechanism Chart 9Evidence Of Asymmetrical Lending Practices Evidence Of Asymmetrical Lending Practices Evidence Of Asymmetrical Lending Practices The new LPR system is designed to minimize this discrepancy, since the new LPRs are more market based and are quoted based on the price of loans banks charge their prime clients. By design, the new LPR system should force the average bank lending rate closer to the rate companies borrow in the bond market. This means bank lending rates will be guided lower, including lending rates for SMEs. However, the new system will be implemented in phases, and the PBoC is likely to gradually guide LPRs lower to allow banks to readjust their pricing models.  The LPR rate is essentially the MLF rate plus bank profit margins (the added basis points above the MLF rate). The market will guide the top line lending rate, while the PBoC will have control over the floor rate (MLF) through open market operations. The fact that the PBoC is keeping the MLF rate unchanged while allowing the LPR to drop (albeit slightly) sends an explicit message: The PBoC is forcing banks to lower lending rates first before boosting their now-narrowed profit margins by lowering the MLF rate. In contrast to expectations of market participants that the LPR system will ease credit conditions, banks may actually tighten their lending in the coming months. While the PBoC will increase its control of the pricing of bank loans by the rate reform plan, the strengthening in financial regulations that has occurred over the past year will restrict the size and speed of credit growth. This combination has created more room for monetary easing without unleashing “animal spirits.” Borrowing costs to risky institutions have been higher since the Baoshang Bank takeover and are likely to remain elevated even if interest rates are lower (Chart 10). More importantly, mortgage and real estate developer loans together account for nearly 30% of total bank credit. Unless policymakers ease the brakes on lending restrictions to the property sector, bank lending growth is unlikely to pick up meaningfully (Chart 11). In fact, the PBoC has explicitly excluded mortgage and property-related lending from benefitting from the LPR rate cut.5 Barring a significant worsening in economic data, we do not expect the PBoC to lower mortgage lending and real estate-related loan rates in the coming months. Chart 10Tightened Financial Regulations Will Keep Cost Of Risky Lending High Tightened Financial Regulations Will Keep Cost Of Risky Lending High Tightened Financial Regulations Will Keep Cost Of Risky Lending High Chart 11Mortgage Rate Unlikely To Return To Its 2016 Low Mortgage Rate Unlikely To Return To Its 2016 Low Mortgage Rate Unlikely To Return To Its 2016 Low Finally, in the next two- to three-quarter mandatory implementation period, banks will be readjusting their pricing and credit risk-assessing models. During the transition, we expect more cautious sentiment among both lenders and borrowers. Hence, in the short term, bank loan growth may actually moderate. Bottom Line: The new LPR system may lower China’s banking sector profits in the short term. But in the next 6- to 12-months, we expect the PBoC to compensate commercial banks by keeping ample liquidity in the interbank system and by eventually lowering the MLF rate. The new LPR system may slow bank credit growth in the next few months, but after its full implementation (by the second quarter of 2020), it will have the potential to make PBoC’s policy more effective. Investment Conclusions We expect two phases of Chinese equity relative performance over the coming year: one phase of flat-to-potentially seriously down performance to last from now until sometime in the first quarter of 2020 when the economy bottoms, and then a phase of outperformance. Our expectation that the economy will bottom in Q1 2020 rests on the existing reflationary response by Chinese policymakers and an improved monetary transmission mechanism. Chart 12We Expect The Chinese Economy To Bottom In Q1 2020 We Expect The Chinese Economy To Bottom In Q1 2020 We Expect The Chinese Economy To Bottom In Q1 2020 Our expectation that the economy will bottom in the first quarter of 2020 continues to rest on the existing reflationary response by Chinese policymakers (Chart 12), and the fact that China’s new LPR system has the potential to improve what is currently a seriously impaired monetary transmission mechanism beyond the next two or three quarters. But the existing response of policymakers has been considerably more measured when compared to past economic cycles, meaning that equity investors are unlikely to be as forward-looking as they otherwise might be. Weak producer price deflation will weigh on investor sentiment, and it is unlikely to be weak enough to spur aggressive further easing. The potential for further escalation of the U.S.-China trade war also compellingly argues against an overweight stance in the near-term, even if we expect economic growth to subsequently improve. Consequently, we remain tactically bearish and cyclically bullish towards Chinese stocks: medium-term investors who are already positioned in favor of China-related assets should stay long, whereas investors who have not yet moved to an overweight stance should wait for a better buying opportunity to emerge over the coming few months.   Jing Sima China Strategist JingS@bcaresearch.com     Footnotes 1      Please see Global Investment Strategy Outlook “Fourth Quarter 2019 Strategy Outlook: A “Show Me” Market”, dated October 4, 2019, available at gis.bcaresearch.com 2      Please see China Investment Strategy Weekly Report “China Macro And Market Review”, dated October 2, 2019, available at cis.bcaresearch.com 3      Announcement of the People’s Bank of China on Improving Loan Prime Rate (LPR) Formation Mechanism, August 19, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3877490/index.html 4      PBC Official Answers Press Questions on Improving Loan Prime Rate (LPR) Formation Mechanism, August 20, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3877865/index.html 5      Announcement of the People’s Bank of China No.16, August 27, 2019, available at http://www.pbc.gov.cn/en/3688110/3688172/3881177/index.html Cyclical Investment Stance Equity Sector Recommendations

Highlights MARKET FORECASTS Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Investment Strategy: Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. We think both preconditions will be realized. Until then, risk assets could come under pressure. Global Asset Allocation: Investors should overweight stocks relative to bonds over a 12-month horizon, but maintain higher-than-normal cash positions in the near term as a hedge against downside risks. Equities: EM and European stocks will outperform once global growth bottoms out. Cyclical sectors, including financials, will also start to outperform defensives when the growth cycle turns. Bonds: Central banks will remain dovish, but yields will nevertheless rise modestly on the back of stronger global growth. Favor high-yield corporate credit over government bonds. Currencies: As a countercyclical currency, the U.S. dollar should peak later this year. Commodities: Oil and industrial metals prices will move higher. Gold prices have entered a holding pattern, but should shine again late next year or in 2021 when inflation finally breaks out. Feature Dear Client, In lieu of this report, I hosted a webcast on Monday, October 7th at 10:00 AM EDT, where I discussed the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist   I. Global Macro Outlook A Testing Phase For The Global Economy The global economy has reached a critical juncture. Growth has been slowing since early 2018, reaching what many would regard as “stall speed.” This is the point where economic weakness begins to feed on itself, potentially triggering a recession. Will the growth slowdown worsen? Our guess is that it won’t. Global financial conditions have eased significantly over the past four months, thanks in part to the dovish pivot by most central banks. Looser financial conditions usually bode well for global growth (Chart 1). Our global leading indicator has hooked up, mainly due to a marginal improvement in emerging markets’ data (Chart 2). Chart 1Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Chart 2Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows Global LEI Has Moved Off Its Lows     An important question is whether the weakness in the manufacturing sector will spread to the much larger services sector. There is some evidence that this is happening, with yesterday’s weaker-than-expected ISM non-manufacturing release being the latest example. Nevertheless, the deceleration in service sector activity has been limited so far (Chart 3). Even in Germany, with its large manufacturing base, the service sector PMI remains in expansionary territory. This is a key difference with the 2001/02 and 2008/09 periods, when service sector activity collapsed in lockstep with manufacturing activity. Chart 3AThe Service Sector Has Softened Less Than Manufacturing (I) The Service Sector Has Softened Less Than Manufacturing (I) The Service Sector Has Softened Less Than Manufacturing (I) Chart 3BThe Service Sector Has Softened Less Than Manufacturing (II) The Service Sector Has Softened Less Than Manufacturing (II) The Service Sector Has Softened Less Than Manufacturing (II) The Drive-By Slowdown If one were to ask most investors the reasons behind the manufacturing slowdown, they would probably cite the trade war or the Chinese deleveraging campaign. These are both valid reasons, but there is a less well-known culprit: autos. According to WardsAuto, global auto sales fell by over 5% in the first half of the year, by far the biggest decline since the Great Recession (Chart 4). Production dropped by even more. Chart 4Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Weakness In The Auto Sector Has Exacerbated The Manufacturing Downturn Chart 5U.S. Auto Demand Is Recovering U.S. Auto Demand Is Recovering U.S. Auto Demand Is Recovering   The weakness in the global auto sector reflects a variety of factors. New stringent emission requirements, expiring tax breaks, lagged effects from tighter auto loan lending standards, and trade tensions have all played a role. In addition, the decline in gasoline prices in 2015/16 probably brought forward some automobile purchases. This suggests that the 2015/16 global manufacturing downturn may have helped sow the seeds for the current one. The fact that automobile output is falling faster than sales is encouraging because it means that excess inventories are being worked off. U.S. auto loan lending standards have started to normalize, with banks reporting stronger demand for auto loans in the latest Senior Loan Officer Survey (Chart 5). In China, auto sales have troughed after having declined by as much as 14% earlier this year (Chart 6). The Chinese automobile ownership rate is a fifth of what it is in the U.S., a quarter of what it is in Japan, and a third of what it is in Korea (Chart 7). Given the low starting point, Chinese auto sales are likely to resume their secular uptrend. Chart 6Auto Sector In China Is Finding A Floor Auto Sector In China Is Finding A Floor Auto Sector In China Is Finding A Floor Chart 7China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright China: Structural Outlook For Autos Is Bright   The Trade War: Tracking Towards A Détente? Chart 8A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Manufacturing cycles typically last about three years – 18 months of slowing growth followed by 18 months of rising growth (Chart 8). To the extent that the global manufacturing PMI peaked in the first half of 2018, we should be nearing the end of the current downturn. Of course, much depends on policy developments. As we go to press, high-level negotiations between the U.S. and China have resumed. While it is impossible to predict the outcome of these talks, it does appear that both sides have an incentive to de-escalate the trade conflict. President Trump gets much better marks from voters on his management of the economy than on anything else, including his handling of trade negotiations with China (Chart 9). A protracted trade war would hurt U.S. growth, while weakening the stock market. Both would undermine Trump’s re-election prospects. Chart 9Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 10Who Will Win The 2020 Democratic Nomination? Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market China also wants to bolster growth. As difficult as it has been for the Chinese leadership to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would especially be the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more pliant to deal with on trade matters. Does the Chinese government really want to negotiate over environmental standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 10)? The Democrats’ initiative to impeach President Trump make a trade resolution somewhat more likely. First, it brings attention to Joe Biden’s (and his son’s) own dubious dealings in Ukraine, thus delivering a blow to China’s preferred U.S. presidential candidate. Second, it makes Trump more inclined to want to put the China spat behind him in order to focus his energies on domestic matters. More Chinese Stimulus? Strategically, China has a strong incentive to stimulate its economy in order to prop up growth and gain greater leverage in the trade negotiations. The Chinese credit impulse bottomed in late 2018. The impulse leads Chinese nominal manufacturing output and most other activity indicators by about nine months (Chart 11). So far, the magnitude of China’s credit/fiscal easing has come nowhere close to matching the stimulus that was unleashed on the economy both in 2015/16 and 2008/09. This is partly because the authorities are more worried about excessive debt levels today than they were back then, but it is also because the economy is in better shape. The shock from the trade war has not been nearly as bad as the Great Recession – recall that Chinese exports to the U.S. are only 2.7% of GDP in value-added terms. Unlike in 2015/16, when China lost over $1 trillion in external reserves, capital outflows have remained muted this time around (Chart 12). Chart 11Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chart 12China: No Major Capital Outflows China: No Major Capital Outflows China: No Major Capital Outflows Better-than-expected Chinese PMI data released earlier this week offers a glimmer of hope. Nevertheless, in light of the disappointing August activity numbers, China is likely to increase the pace of stimulus in the coming months. The authorities have already reduced bank reserve requirements. We expect them to cut policy rates further in the coming months. They will also front-load local government bond issuance, which should help boost infrastructure spending. European Growth Should Improve A pickup in global growth will help Europe later this year. Germany, with its trade-dependent economy, will benefit the most. Chart 13Spreads Have Come In Across Southern Europe Spreads Have Come In Across Southern Europe Spreads Have Come In Across Southern Europe Chart 14Faster Money Growth Bodes Well For GDP Growth In The Euro Area Faster Money Growth Bodes Well For GDP Growth In The Euro Area Faster Money Growth Bodes Well For GDP Growth In The Euro Area Falling sovereign spreads should also support Southern Europe (Chart 13). The Italian 10-year spread with German bunds has narrowed by almost a full percentage point since mid-August, taking the Italian 10-year yield down to 0.83%. Greek 10-year bonds are now yielding less than U.S. Treasurys (the Greek manufacturing PMI is currently the strongest in the world). With the ECB back in the market buying sovereign and corporate debt, borrowing rates should remain low. Euro area money growth, which leads GDP growth, has already picked up (Chart 14). Bank lending to the private sector should continue to accelerate. A modest serving of fiscal stimulus will also help. The European Commission estimates that the fiscal thrust in the euro area will increase by 0.5% of GDP in 2019 (Chart 15). Assuming, conservatively, a fiscal multiplier of one, this would boost euro area growth by half a percentage point. Owing to lags between changes in fiscal policy and their impact on the real economy, most of the gains to GDP growth will occur over the remainder of this year and in 2020. Chart 15Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Chart 17Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Chart 16U.K.: Brexit Uncertainty Is Weighing On Growth U.K.: Brexit Uncertainty Is Weighing On Growth U.K.: Brexit Uncertainty Is Weighing On Growth In the U.K., Brexit uncertainty continues to weigh on growth. U.K. business investment has been especially hard hit (Chart 16). Prime Minister Boris Johnson remains insistent that he will take the U.K. out of the EU with or without a deal at the end of October. We would downplay his bluster. The Supreme Court has already denied his attempt to shutter parliament. The public is having second thoughts about the desirability of Brexit (Chart 17). While we do not have a strong view on the exact plot twists in the Brexit saga, we maintain that the odds of a no-deal Brexit are low. This is good news for U.K. growth and the pound. Japan: Own Goal Recent Japanese data releases have not been encouraging: Machine tool orders declined by 37% year-over-year in August. Exports contracted by over 8%, with imports recording a drop of 12%. The September PMI print exposed further deterioration in manufacturing, with the index falling to 48.9 from 49.3 in August. In addition, industrial production contracted by more than expected in August, falling by 1% month-over-month, and close to 5% year-over-year. The ongoing uncertainty surrounding the U.S.-China trade negotiations, as well as Japan’s own tensions with neighboring South Korea, have also weighed on the Japanese economy. Japanese industrial activity will improve later this year as global growth rebounds. But the government has not helped growth prospects by raising the consumption tax on October 1st. While various offsets will blunt the full effect of the tax hike, it still amounts to unwarranted tightening in fiscal policy. Nominal GDP has barely increased since the early 1990s. What Japan needs are policies that boost nominal income. Such reflationary policies may be the only way to stabilize debt-to-GDP without pushing the economy back into a deflationary spiral.1  The U.S.: Hanging Tough Chart 18U.S. Has A Smaller Share Of Manufacturing Than Most Other Developed Economies Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market The U.S. economy has fared relatively well during the latest global economic downturn, partly because manufacturing represents a smaller share of GDP than in most other economies (Chart 18). According to the Atlanta Fed GDPNow model, real GDP is on track to rise at a trend-like pace of 1.8% in the third quarter (Chart 19). Personal consumption is set to increase by 2.5%, after having grown by 4.6% in the second quarter. Consumer spending should stay robust, supported by rising wage growth. The personal savings rate also remains elevated, which should help cushion households from any adverse shocks (Chart 20).   Chart 19U.S. Growth Has Softened, But Is Still Close To Trend Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Residential investment finally looks as though it is turning the corner. Housing starts, building permits, and home sales have all picked up. Given the tight relationship between mortgage rates and homebuilding, construction activity should accelerate over the next few quarters (Chart 21). Low inventory and vacancy rates, rising household formation, and reasonable affordability all bode well for the housing market (Chart 22). Chart 20The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth The Savings Rate Has (A Lot Of) Room To Drop, Judging From The Historical Relationship With Wealth Chart 21U.S. Housing Will Rebound U.S. Housing Will Rebound U.S. Housing Will Rebound Chart 22U.S. Housing: On A Solid Foundation U.S. Housing: On A Solid Foundation U.S. Housing: On A Solid Foundation Chart 23U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels U.S. Capex Plans Have Come Off Their Highs, But Are Nowhere Close to Recessionary Levels In contrast to residential investment, business capex continues to be weighed down by the manufacturing recession, a strong dollar, and trade policy uncertainty. Core durable goods orders declined in August. Capex intention surveys have also weakened, although they remain well above recessionary levels (Chart 23). The ISM manufacturing index hit its lowest level since July 2009 in September. The internals of the report were not quite as bad as the headline. The new orders-to-inventories component, which leads the ISM by two months, moved back into positive territory. The weak ISM print also stands in contrast to the more upbeat Markit U.S. manufacturing PMI, which rose to its highest level since April. Statistically, the Markit PMI does a better job of tracking official measures of U.S. manufacturing output, factory orders, and employment than the ISM. Taking everything together, the U.S. economy is likely to see modestly stronger growth later this year, as the global manufacturing recession comes to an end, while strong consumer spending and an improving housing market bolster domestic demand. II. Financial Markets Global Asset Allocation Markets have entered a “show me” phase. Better economic data and meaningful progress on the trade negotiations will be necessary for stocks to move sustainably higher. As such, investors should maintain larger-than-normal cash positions for the time being to guard against downside risks. Chart 24Stocks Will Outperform Bonds If Growth Recovers Stocks Will Outperform Bonds If Growth Recovers Stocks Will Outperform Bonds If Growth Recovers Fortunately, any pullback in risk asset prices is likely to be temporary. If trade tensions subside and global growth rebounds later this year, as we expect, stocks and spread product should handily outperform government bonds over a 12-month horizon (Chart 24). Admittedly, there are plenty of things that could upend this sanguine 12-month recommendation: Global growth could continue to deteriorate; the trade war could intensify; supply-side shocks could cause oil prices to spike up again; the U.K. could end up leaving the EU in a “hard Brexit” scenario; and last but not least, Elizabeth Warren or some other far-left candidate could end up becoming the next U.S. president. The key question for investors today is whether these risks have been fully discounted in financial markets. We think they have. Chart 25 shows our estimates for the global equity risk premium (ERP), calculated as the difference between the earnings yield and the real bond yield. Our calculations suggest that stocks still look quite cheap compared to bonds. Chart 25AEquity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Chart 25BEquity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) One might protest that the ERP is high only because today’s ultra-low bond yields are reflecting very poor growth prospects. There is some truth to that claim, but not as much as one might think. While trend GDP growth has fallen in the U.S. over the past decade, bond yields have declined by even more. The gap between U.S. potential nominal GDP growth, as estimated by the Congressional Budget Office, and the 10-year Treasury yield is close to two percentage points, the highest since 1979 (Chart 26). Chart 26Bond Yields Have Fallen More Than Trend Nominal GDP Growth Bond Yields Have Fallen More Than Trend Nominal GDP Growth Bond Yields Have Fallen More Than Trend Nominal GDP Growth At the global level, trend GDP growth has barely changed since 1980, largely because faster-growing emerging markets now make up a larger share of the global economy (Chart 27). For large multinational companies, global growth, rather than domestic growth, is the more relevant measure of economic momentum. Gauging Future Equity Returns A high ERP simply says that equities are attractive relative to bonds. To gauge the prospective return to stocks in absolute terms, one should look at the absolute level of valuations. Chart 27The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM chart 27 The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM The Trend In Global Growth Has Remained Steady Thanks To Faster-Growing EM Chart 28S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector S&P 500: All Of The Increase In Margins Has Occurred In The IT Sector As we argued in a recent report entitled “TINA To The Rescue?,”2 the earnings yield can be used as a proxy for the expected real total return on equities. Empirically, the evidence seems to bear this out: Since 1950, the earnings yield on U.S. equities has averaged 6.7%, compared to a real total return of 7.2%. Today, the trailing and forward PE ratio for U.S. stocks stand at 21.1 and 17.4, respectively. Using a simple average of the two as a guide for future returns, U.S. stocks should deliver a long-term real total return of 5.2%. While this is below its historic average, it is still a fairly decent return. One might complain that this calculation overstates prospective equity returns because the U.S. earnings yield is temporarily inflated by abnormally high profit margins. The problem with this argument is that virtually all of the increase in S&P 500 margins has occurred in just one sector: technology. Outside of the tech sector, S&P 500 margins are not far from their historic average (Chart 28). If high IT margins reflect structural changes in the global economy – such as the emergence of “winner take all” companies that benefit from powerful network effects and monopolistic pricing power – they could remain elevated for the foreseeable future.   Regional And Sector Equity Allocation The earnings yield is roughly two percentage points higher outside the U.S., suggesting that non-U.S. stocks will best their U.S. peers over the long haul. In the developed market space, Germany, Spain, and the U.K. appear especially cheap. In the EM realm, China, Korea, and Russia stand out as being very attractively priced (Chart 29). At the sector level, cyclical stocks look more appealing than defensives (Chart 30). Chart 29U.S. Stocks Appear Expensive Compared To Their Peers Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 31Economic Growth Drives Stocks Over A 12-Month Horizon Economic Growth Drives Stocks Over A 12-Month Horizon Economic Growth Drives Stocks Over A 12-Month Horizon Chart 30Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Chart 32EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves Valuations are useful mainly as a guide to long-term returns. Over a horizon of say, 12 months, cyclical factors – i.e., what happens to growth, interest rates, and exchange rates – matter more (Chart 31). Fortunately, our cyclical views generally line up with our valuation assessment. Stronger global growth, a weaker dollar, and rising commodity prices should benefit cyclical stocks relative to defensives. To the extent that EM and European stock markets have more of a cyclical sector skew than U.S. stocks, the former should end up outperforming (Chart 32). We would put financials on our list of sectors to upgrade by year end once global growth begins to reaccelerate. Falling bond yields have hurt bank profits (Chart 33). The drag on net interest margins should recede as yields start rising. European banks, which currently trade at only 7.6 times forward earnings, 0.6 times book value, and sport a hefty dividend yield of 6.3%, could fare particularly well (Chart 34). Chart 33AHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (I) Chart 33BHigher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) Higher Bond Yields And Steeper Yield Curves Will Benefit Financials (II) As Chart 35 illustrates, a bet on financials is similar to a bet on value stocks. Growth has trounced value over the past 12 years, but a bit of respite for value is in order over the next 12-to-18 months. Chart 34European Banks Are Attractive European Banks Are Attractive European Banks Are Attractive Chart 35Is Value Turning The Corner? Is Value Turning The Corner? Is Value Turning The Corner?   Fixed Income Chart 36AYields Should Rise On Stronger Growth (I) Yields Should Rise On Stronger Growth (I) Yields Should Rise On Stronger Growth (I) Dovish central banks and, for the time being, still-subdued inflation will help keep government bond yields in check over the next 12 months. Nevertheless, yields will still rise from currently depressed levels on the back of stronger global growth (Chart 36).     Chart 36BYields Should Rise On Stronger Growth (II) Yields Should Rise On Stronger Growth (II) Yields Should Rise On Stronger Growth (II) Bond yields tend to rise or fall depending on whether central banks adjust rates by more or less than is anticipated (Chart 37). Investors currently expect the Fed to cut rates by another 80 basis points over the next 12 months. While we think the Fed will bring down rates by 25 basis points on October 30th, we do not anticipate any further cuts beyond then. The cumulative 75 basis points in cuts during this easing cycle will be equivalent to the amount of easing delivered during the two mid-cycle slowdowns in the 1990s (1995/96 and 1998). All told, the U.S. 10-year Treasury yield is likely to move back into the low 2% range by the middle of 2020. Chart 37AStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (I) Chart 36BStronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields (II) Chart 38U.S. Government Bond Yields Are More Procyclical Than Yields Abroad U.S. Government Bond Yields Are More Procyclical Than Yields Abroad U.S. Government Bond Yields Are More Procyclical Than Yields Abroad Unlike U.S. equities, which tend to have a low beta compared to stocks abroad, U.S. bonds possess a high beta. This means that U.S. Treasury yields usually rise more than yields abroad when global bond yields, in aggregate, are increasing, and fall more than yields abroad when global bond yields are decreasing (Chart 38).  Moreover, U.S. Treasurys currently yield less than other bond markets once currency-hedging costs are taken into account (Table 1). If U.S. yields were to rise more than those abroad over the next 12-to-18 months, this would further detract from Treasury returns. As a result, investors should underweight Treasurys within a global government bond portfolio. Stronger global growth should keep corporate credit spreads at bay. Lending standards for U.S. commercial and industrial loans have moved back into easing territory, which is usually bullish for corporate credit (Chart 39). According to our U.S. bond strategists, high-yield corporate spreads, and to a lesser extent, Baa-rated investment-grade spreads, are still wider than is justified by the economic fundamentals (Chart 40).3 Better-rated investment-grade bonds, in contrast, offer less relative value. Table 1Bond Markets Across The Developed World Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 39Easier Lending Standards Bode Well For Corporate Credit Easier Lending Standards Bode Well For Corporate Credit Easier Lending Standards Bode Well For Corporate Credit Chart 40U.S. Corporates: Focus On Baa And High-Yield Credit U.S. Corporates: Focus On Baa And High-Yield Credit U.S. Corporates: Focus On Baa And High-Yield Credit     Looking beyond the next 18 months, there is a high probability that inflation will start to move materially higher. The unemployment rate across the G7 has fallen to a multi-decade low (Chart 41). The share of developed economies that have reached full employment has hit a new cycle high (Chart 42). For all the talk about how the Phillips curve is dead, wage growth has remained tightly correlated with labor market slack (Chart 43). Chart 41Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Chart 42Developed Markets: Full Employment Reaching New Cycle Highs Developed Markets: Full Employment Reaching New Cycle Highs Developed Markets: Full Employment Reaching New Cycle Highs Chart 43The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well The Phillips Curve Is Alive And Well As wages continue to rise, prices will start to move up, potentially setting off a wage-price spiral. The Fed, and eventually other central banks, will have to start raising rates at that point. Once interest rates move into restrictive territory, equities will fall and credit spreads will widen. A global recession could ensue in 2022. Currencies And Commodities Chart 44The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The U.S. dollar is a countercyclical currency, meaning that it tends to move in the opposite direction of the global business cycle (Chart 44). We do not have a strong near-term view on the direction of the dollar at the moment, but expect the greenback to begin to weaken by year end as global growth starts to rebound. EUR/USD should increase to around 1.13 by mid-2020. GBP/USD will rise to 1.29. USD/CNY will move back to 7. USD/JPY is likely to be flat, reflecting the yen’s defensive nature and the drag on Japanese growth from the consumption tax hike. The trade-weighted dollar will continue to depreciate until late-2021, after which time a more aggressive Fed and a slowdown in global growth will cause the dollar to rally anew. During the period in which the dollar is weakening, commodity prices will move higher (Chart 45). Chart 45Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities BCA’s commodity strategists are particularly bullish on oil over a 12-month horizon (Chart 46). They see Brent crude prices rising to $70/bbl by the end of this year and averaging $74/bbl in 2020 based on the expectation that stronger global growth and production discipline will drive down oil inventory levels. OPEC spare capacity – the difference between what the cartel is capable of producing and what it is actually producing – is currently below its historic average (Chart 47). Crude oil reserves have also been trending lower within the OECD. Saudi Arabia’s own reserves have fallen by over 40% since peaking in 2015 (Chart 48). Chart 46Supply Deficit To Continue Supply Deficit To Continue Supply Deficit To Continue Chart 47Limited Availability Of Spare Capacity To Offset Outages Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Chart 48Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Key Strategic Petroleum Reserves Higher oil prices should benefit currencies such as the Canadian dollar, Norwegian krone, Russian ruble and Colombian peso. Finally, a few words on gold. We closed our long gold trade on August 29th for a 20-week gain of 20.5%. We still see gold as an excellent long-term hedge against higher inflation. In the near term, however, rising bond yields may take the wind out of gold’s sails, even if a weaker dollar does help bullion at the margin. We will reinitiate our long gold position towards the end of next year or in 2021 once inflation begins to break out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “Are High Debt Levels Deflationary Or Inflationary?” dated February 15, 2019. 2Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 3Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed,” dated September 17, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Fourth Quarter 2019 Strategy Outlook: A "Show Me" Market Tactical Trades Strategic Recommendations Closed Trades

Highlights The global manufacturing cycle is likely to bottom soon, and consumption and services remain robust. The risk of recession over the next 12 months is low. This suggests that equities will continue to outperform bonds. But the risks to this optimistic scenario are rising. A denting of consumer confidence and worsening of geopolitical tensions could hurt risk assets. We hedge this by overweighting cash. China remains reluctant for now to use aggressive monetary easing. Until it does, the less cyclical U.S. equity market should outperform. We may shift into EM and European equities when China ramps up stimulus and the manufacturing cycle clearly bottoms. To hedge against this upside risk, we go tactically overweight Financials, and reiterate our overweight on Industrials and neutral on Australia. Bond yields should continue their rebound. We recommend an underweight on duration and favor TIPS. Credit should outperform on the cyclical horizon, but high corporate debt is a risk – we recommend a neutral position. Recommendations Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Feature Overview Hedges All Around This is a particularly uncertain time for the global economy – and so a tricky one for asset allocators. Will manufacturing activity bottom soon, or will it drag down the services sector and consumption with it? Will bond yields continue their strong rebound? Is the Fed done cutting rates? Will China now ramp up monetary stimulus? Will Iran escalate a confrontation with Saudi Arabia? What will President Trump tweet about next? This is the sort of environment in which portfolio construction comes into its own. We have our view on all these questions, but our level of conviction is somewhat lower than usual. The way for investors to react is to plan asset allocation in such a way that a portfolio is robust in all the most probable scenarios. We expect the global manufacturing cycle to bottom soon. The Global Leading Economic Indicator is already picking up, and the Global PMI shows some signs of bottoming (Chart 1). The shortest-term lead indicator, the Citigroup Economic Surprise Index, has recently jumped in every region except Europe (Chart 2). (See also What Our Clients Are Asking on page 7 for some more esoteric indicators of cycle bottoms.) The bottoming-out is due to easier financial conditions over the past nine months, a stabilization in Chinese growth, and simply time – the down-leg in manufacturing cycles typically last 18 months, and this one peaked in H1 2018. Chart 1First Signs Of Bottoming First Signs Of Bottoming First Signs Of Bottoming Chart 2Surprisingly Strong Surprises Surprisingly Strong Surprises Surprisingly Strong Surprises     At the same time, government bond yields should have further to rise. The Fed may cut rates once more but, given the resilient U.S. economy, no more than that. This is less than the 59 basis points of cuts over the next 12 months priced in by the Fed Fund futures. The recent pick-up in economic surprises suggests that the 10-year U.S. Treasury yield should return at least to where it was six months ago, 2.3-2.4% (Chart 3). This might be delayed, however, if there is an increase in political tensions, for example a break-up of the U.S./China trade talks (Chart 4). Chart 3Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Chart 4...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk This implies that equities are likely to continue to outperform bonds over the next few quarters, and so we remain overweight global equities and underweight global bonds on the 12-month investment horizon. However, the risks to this rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II, usually about 18 months in advance (Chart 5). The 3-month/10-year curve inverted in the middle of this year. We also worry that the weakness in the manufacturing sector may dent consumer confidence. There are some signs of this in Europe and Japan – but none significant yet in the U.S. (Chart 6). Accordingly last month, as a hedge against an economic downturn, we went overweight cash, which we see as a more attractive hedge, from a risk/reward point-of-view, than bonds. Chart 5Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Chart 6Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence     We also remain overweight U.S. equities, which are lower-beta and have fewer structural headwinds than equities in other regions. However, we continue to look for an entry point into the more cyclical equity markets which would also be beneficiaries of bolder China stimulus. China’s monetary easing remains more tepid than in previous stimulus episodes. It has probably been enough to stabilize domestic activity (Chart 7) but not to trigger a rally in industrial commodity prices, EM assets, and euro area equities, as it did in 2016. A pick-up in global PMIs and signs of stronger Chinese credit growth would clearly help EM and Europe (Chart 8) but we need higher conviction that these things are indeed happening before making that move. In the meantime, we are hedging the upside risk by raising the global Financials sector tactically to overweight, since it would likely do well if euro area stocks started to outperform. Earlier this year, we raised the Industrials sector to overweight and Australian equities to neutral, also to hedge against the upside risk from more aggressive Chinese stimulus. Chart 7Chinese Stimulus Has Merely Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chart 8Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets     Chart 9Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions The biggest geopolitical risk to our sanguine scenario is the situation in the Middle East, after the attacks on Saudi oil refineries. Every recession in the past 50 years has been preceded by a 100% year-on-year spike in the crude oil price (though note that Brent would need to rise to over $100 a barrel by year-end, from $61 today, for that to eventuate (Chart 9)). A short-term oil shortage is not the problem since strategic reserves are ample. But the attack demonstrates the vulnerability of the Saudi installations. And a reprisal attack on Iran could lead it to block the Strait of Hormuz, through which more than 20% of global oil passes. We have an overweight on the Energy sector, partly as a hedge against these risks. BCA’s oil strategists expected Brent crude to rise to $70 this year, and average $74 in 2020, even before the recent attack. They argue that the risk premium in the oil price (the residual in Chart 10) is too low, given not only tensions with Iran, but also other potential supply disruptions in Iraq, Libya, Venezuela and elsewhere.   Chart 10Is The Oil Risk Premium Too Low? Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com     What Our Clients Are Asking Which Leading Indicators Should Investors Watch To Time The Rebound In Global Growth? Chart 11Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth During 2019, the global growth decline was a key driver of the bond rally and the outperformance of defensive assets. Thus, timing when this decline will reverse will be crucial, since it would also result in a change of leadership from defensive to cyclical assets. But how can this be done? Below we list three of our favorite indicators that have provided reliable leading signals on the global economy in the past: Carry-trade performance: The performance of EM currencies with very high carry versus the yen tends to be a leading indicator for global growth (Chart 11, panel 1). In general, carry trades distribute liquidity from countries where funds are plentiful but rates of return are low (like Japan), to places with savings shortfalls and high risk, but where prospective returns are high. Positive performance of these currencies tends to signal a positive shift in global liquidity, which usually fuels global growth. Swedish inventory cycle: The Swedish new-orders-to-inventories ratio is a leading indicator of the global manufacturing cycle (panel 2). Why? Sweden is a small open economy that is very sensitive to global growth dynamics. Moreover, Swedish exports are weighted towards intermediate goods, which sit early in the global supply chain. This makes the Swedish inventory cycle a good early barometer of the health of the global manufacturing cycle. G3 monetary trends: G3 excess money supply – measured as the difference between money supply growth and loan growth – is a leading indicator of global industrial production (panel 3). As base money and deposits become more plentiful in the banking system relative to the pool of existing loans, the liquidity position of commercial banks improves. This provides banks with the necessary fuel to generate more loan growth, a development which eventually provides a boon to economic activity. Importantly, all these leading indicators are sending a positive signal on the global economy. This confirms our view that rates should go up as global growth strengthens. Therefore, investors should remain overweight equities and underweight bonds in their portfolios.   Is It Time To Buy Euro Area Banks? In a Special Report on euro area banks in December 2018, we noted that “Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected”.1 Our recommendation back then was that “long-term investors should avoid banks in the region, but investors with a more tactical mandate and much nimbler style could use the valuation indicators to ‘time’ their entry into and exit out of banks as a short-term trade.” Since then, banks have continued to underperform the overall market by over 10%, further pushing down relative valuation metrics. Currently, both relative P/B and relative dividend yield are at extreme levels that have historically heralded at least a short-term bounce. The euro area PMI is still below 50, but there are signs that the euro area economy could rebound later this year, which should be positive for banks’ relative earnings. Already, forward EPS growth has been stabilizing relative to the broad market (Chart 12, panel 4). In addition, two of the key concerns back in December 2018 were Italian government debt and the unwinding of QE. Now Italian debt is no longer in crisis and the ECB has relaunched QE. As such, investors with a tactical mandate and a nimble style should buy (overweight) banks in the euro area. Long-term investors should still avoid such a short-term trade because structural issues remain. Chart 12Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks   Is The Gold Rally Over? Spot gold prices have increased 17% year-to-date, on the back of global growth weakness, dovish central banks, and rising political tensions. Should investors now pare back their gold exposure? Common sense would suggest they should. However, these are not ordinary times. In the short term, gold prices might suffer from some profit-taking due to overbought technicals and excessively positive sentiment (Chart 13, panel 1). Moreover, gold prices have moved this year due to increased market expectations of central bank easing (panel 2). We expect that markets will be disappointed going forward by only limited rate cuts, which could put downward pressure on gold. On the other hand, with approximately 27%, or $14.9 trillion, of global debt with negative yields at the moment, investors will continue to shift to the next best asset – zero-yielding gold (panel 3). This is clear from the rise in holdings of gold over the past few years by both central banks and investors (panels 4 & 5). We expect this trend to persist as investors continue their search to avoid negative yields and focus on capital preservation. Geopolitical tensions have intensified since the beginning of the year: ongoing yet inconclusive trade negotiations between the U.S. and China, implementation of further tariffs, Brexit uncertainty, and the recent military attacks in the Middle East (panel 6). This environment should also continue to push gold prices higher. We continue to recommend gold as a hedge against inflation – which we see picking up over the next 12 months – as well as against any further deterioration in global growth and the geopolitical situation. Chart 13Gold: Sell Or Hold? Gold: Sell Or Hold? Gold: Sell Or Hold? Risks to the rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II. How Low Can Rates Go? The zero lower bound is a thing of the past. Last month, Denmark’s central bank cut rates to -0.75%, and 10-year government bonds in Switzerland hit a historic low for any major country, -1.12%. In the next recession, how much further could interest rates theoretically fall? For individuals, cash rates might be limited by the cost of storing paper currency, which has a zero yield (unless governments find a way to ban cash or charge an annual fee on it). A bank safety deposit box costs about $300 a year, and a professional-quality safe big enough to store $1 million (which would be a pile of $100 bills 31 x 55 cms, weighing 10 kg) costs $2,000 with installation costs. Amortize the latter over 10 years, and the cost of storing $1 million is about 0.2%-0.3% a year. Swiss franc bills – maximum denomination CHF1,000 – would cost less to store. But storage costs for physical gold are around 2% a year. Since rates have fallen below this, there must be other constraints. Individuals would find storing money in cash possibly dangerous and certainly very inconvenient (imagine having to transport the cash to a bank to pay a tax bill). And the cost for a rich individual or company of storing, say, $1 billion (weighing 10 tonnes) would be much higher. Given the history in even low-rate countries (Chart 14, panel 1), we suspect around -1% is the level at which cashholders would seek alternatives to bank deposits of government bills. Chart 14How Low Can They Go? How Low Can They Go? How Low Can They Go? Chart 15Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below   At the long end, the yield curve does not typically invert much when short-term rates are zero or negative (Chart 15). The biggest 3-month/10-year inversion was in Switzerland earlier this year, -0.05%. This points then to the absolute lowest level for 10-year bonds anywhere, even in the middle of a nasty recession, at around -1.1%. That is a worry for asset allocators. It means that the maximum mathematical upside for Swiss government bonds from their current level (-0.8%) is 3% while it is 5% for German bonds (currently -0.5%). This is not much of a hedge. Only the U.S. looks better: if the 10-year Treasury yield falls to 0%, the total return is 18%.   Global Economy Chart 16U.S. Growth Remains Solid U.S. Growth Remains Solid U.S. Growth Remains Solid Overview: Industrial-sector growth globally has been weak, with the manufacturing PMI in most countries falling below 50. But consumption and services almost everywhere have remained resilient, even in the manufacturing-heavy euro area. And there are tentative signs of a bottoming-out in manufacturing. However, a full-scale rebound will depend on further monetary stimulus in China, where the authorities still seem cautious about rolling out easing on the scale of what was done in 2016. U.S.: U.S. manufacturing has now followed the rest of the world into contraction, with the ISM manufacturing index slipping below 50 in August (Chart 16, panel 2). However, consumption and services are holding up well. Employment continues to expand (albeit at a slightly slower pace than last year, perhaps because of a lack of jobseekers), there is no sign of a rise in layoffs, and consumer confidence remains close to a historical high (though it slipped slightly in September). Housing has recovered after last year’s slowdown, and the recent congressional budgetary agreement means fiscal policy will be mildly expansionary over the coming 12 months. Only capex (panel 5) has slowed, as companies postpone investment decisions due to uncertainty surrounding the trade war. The consensus expects U.S. real GDP growth of 2.2% this year, above most estimates of trend growth. Euro Area: Given its higher concentration in manufacturing, European growth is weaker than in the U.S. The manufacturing PMI has been below 50 since February, and fell further to 45.6 in August. Industrial production is shrinking by 2% year-on-year. Italy has experienced two negative quarters of growth, and Germany may also enter a technical recession in Q3 (GDP shrank by 0.1% in Q2). However, there are some tentative signs that manufacturing is bottoming: the ZEW survey in September, for example, surprised on the upside. And, like the U.S., consumption remains strong. Even in manufacturing-heavy Germany, employment continues to grow, and retail sales in July were up 4.4% year-on-year. In the U.K., however, uncertainty surrounding Brexit has damaged business investment, though employment has been strong.2 Chart 17First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? Japan: Consumption has already slipped, even before the consumption tax hike scheduled in October. Retail sales in July fell 2% year-on-year, due to negative wage growth and consumer sentiment falling to a five-year low. Manufacturing continues to suffer from China’s slowdown and the strong yen (up 6% over the past 12 months), with exports falling 6% and industrial production down 2% year-on-year over the past three months. The effect of the consumption tax hike may be cushioned by government measures (lowering taxes on autos and making high-school education free, for example). And a pickup in Chinese growth would boost exports. But there are scant signs yet of a bottoming in activity. Emerging Markets: China’s growth appears to have stabilized, with both manufacturing and non-manufacturing PMIs above 50 (Chart 17, panel 3). But confidence remains fragile, with retail sales growth slowing to a 20-year low and car sales down 7% in August, despite the introduction of cars compliant with new emissions standards. The authorities have responded with further easing measures (including a further cut in the reserve requirement in September) but seem reluctant to launch a full-scale monetary stimulus, similar to what they did in 2016. Elsewhere in EM, growth has slowed in countries with structural issues (latest year-on-year real GDP growth in Argentina is -5.7%, in Turkey -1.5% and in Mexico -0.8%) but remains fairly resilient elsewhere (India 5%, Indonesia 5%, Poland 4.2%, Colombia 3.4%). Interest Rates: Central banks almost everywhere have turned dovish, with the Fed cutting rates for a second time, the ECB restarting asset purchases, and the Bank of Japan signaling it will ease in October. But further monetary accommodation will probably be less than the market expects. The Fed signaled that its cuts were just a mid-cycle correction and that further easing is unlikely. And the ECB and BoJ have little ammunition left. With signs of growth bottoming, and the market understanding that central banks’ dovish turn is reaching its end, long-term rates, which have already risen in the U.S. from 1.45% to 1.72% in September, are likely to move higher. Investors should also carefully watch U.S. inflation, which is showing signs of underlying strength, with core CPI inflation rising 2.4% year-on-year in August (and as much as 3.4% annualized over the past three months).   Global Equities Chart 18Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Still Cautious, But Adding An Upside Hedge: Global equities registered a small loss of 8 basis points in Q3 (Chart 18) despite all the headline risks from geopolitics and weakening economic data. Overall, our defensive country allocation worked well in Q3, since DM equities outperformed EM by 4.5%, and the U.S. outperformed the euro area by 2.8%. Our sector positioning did not do as well since underweights in Utilities and Consumer Staples and overweights in Industrials, Energy and Health Care all went in the wrong direction, even though the underweight in Materials did help to offset the loss. During the quarter, however, both sector and country rotations were evident within the global equity universe, in line with the wild swings in bond yields. September saw some reversals in DM/EM, U.S./euro area and cyclical/defensives. Going forward, BCA’s House View remains that global economic growth will begin to recover over the coming months, albeit a little later than we previously expected. As such, our defensive country allocation remains appropriate. We did put euro area and EM equities on upgrade watch in April,3 but the delay in the global recovery also implies that it is still not the time to trigger this call. With our view that bond yields have hit bottom,4 we are making one adjustment in our global sector allocation by upgrading Financials to overweight from neutral. We are financing this by cutting in half the double overweight in Health Care to overweight (see next page for more details). This adjustment also acts as a hedge against two possible outcomes: 1) that the euro area outperforms the U.S., and 2) that Elizabeth Warren wins in the upcoming U.S. presidential election.5   Upgrade Global Financials To Overweight From Neutral Chart 19Upgrade Global Financials Upgrade Global Financials Upgrade Global Financials The relative performance of global Financials to the overall equity market has been hugely affected by the movements in global bond yields (Chart 19, panel 1). As bond yields made a sharp reversal in September, so did the relative performance of Financials, even though it is barely evident on the chart given how much Financials have underperformed the broad market over recent years. It’s not clear how sustainable the sharp reversal in bond yields will be, but BCA’s House View is that bond yields will move higher over the next 9-12 months. As such, we are upgrading Financials to overweight from neutral, for the following additional reasons: Valuations are extremely attractive as shown in panel 2. More importantly, the relative valuation is now at an extreme level that historically heralded a bounce in Financials’ relative performance. Loan quality has improved. The U.S. non-performing loan (NPL) ratio is nearing the lows reached before the Global Financial Crisis (GFC). Even in Spain and Italy, NPL ratios have fallen significantly, though they remain higher than they were prior to the GFC (panel 3). U.S. consumption has been strong, housing has rebounded, and demand for loans is getting stronger (panel 4), in line with data such as the Citi Economic Surprise Index, suggesting that economic data may have hit bottom. To finance this upgrade, we cut the double overweight of Health Care to overweight, as a hedge against Elizabeth Warren winning next year’s U.S. presidential election and tightening rules on drug pricing. Government Bonds Maintain Slight Underweight On Duration. Our below-benchmark duration call was severely challenged by the global bond markets in the first two months of the third quarter. The U.S. 10-year Treasury yield hit 1.43% on September 3 in response to the weaker-than-expected ISM manufacturing index in the U.S., 57 bps lower than the level at the end of previous quarter, and just a touch higher than the historical low of 1.32% reached on July 6, 2016. The rebound in bond yields since September 5, however, was driven not only by the ebb and flow in the U.S./China trade policy dynamics, but also by the positive surprises in economic data releases, as shown in Chart 20. BCA’s Global Duration Indicator, constructed by our Global Fixed Income Strategy team using various leading economic indicators, is also pointing to higher yields globally going forward. Investors should maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Global inflation expectations have also rebounded after continuing their downtrend in the first two months of the quarter. This largely reflects the acceleration in August in realized inflation measures such as core CPI, core PCE, and average hourly earnings. In addition, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. The oil price jumped initially by 20% following the attack on the Saudi Arabian oil production facilities. While it’s not clear how the geopolitical tensions will evolve in the Middle East, a conservative assumption of a flat oil price until the end of the year still points to much higher inflation expectations, supporting our preference for inflation-linked bonds over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds (Chart 21). Chart 20Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Chart 21Favor Inflation Linkers Favor Linkers Favor Linkers We continue to look for an entry point into more cyclical markets which would benefit from a bolder Chinese stimulus. Corporate Bonds Since we turned cyclically overweight on credit within a fixed-income portfolio, investment-grade bonds and high-yield bonds have produced 220 and 73 basis points, respectively, of excess return over duration-matched government bonds. We remain bullish on the outlook for credit over the next 12 months, as we expect global growth to accelerate before the end of the year. Historically, improving global growth has resulted in sustained outperformance of credit over government bonds. Moreover, default rates should remain subdued over the next year given that lending standards continue to ease (Chart 22, panel 1). How long will we remain overweight credit? High levels of leverage, declining interest coverage ratios, and the high share of Baa-rated debt in the U.S. corporate debt market continue to make credit a risky proposition on a structural basis. However, with inflation expectations still very low, the Fed has a strong incentive to keep monetary policy easy. This dovish monetary policy should keep interest costs at bay, helping credit outperform over the next year. That said, we believe that there are some credit categories that are more attractive than others. Specifically, we recommend investors favor Baa-rated and high yield securities, given that there is still room for further credit compression in these credit buckets (panel 2 and panel 3). On the other hand, investors should stay away from the highest credit categories, as they no longer offer value (panel 4). Chart 22Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value   Commodities Chart 23No Supply Shock In The Oil Market Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around Energy (Overweight): September’s drone attack on Saudi crude facilities sent oil prices soaring as much as 20% in the days following, before falling back to pre-attack levels. Initial estimates estimated the supply disruption at 5.7 million barrels a day – approximately 5.5% of global supply – making it the largest crude supply outage in history. However, assuming the Saudis can return 70% of the lost output back online as they claim, OPEC’s spare capacity, approximately 1.8 million barrels a day, should be able to balance the market and cover the remaining lost production.6,7 In the longer-term, a pick-up in global oil demand, as economic growth rebounds, plus supply tightness should keep oil price elevated, with Brent reaching $70 this year and averaging $74 in 2020 (Chart 23, panels 1 & 2). Industrial Metals (Neutral): A combination of half-hearted year-to-date stimulus by Chinese authorities and a stronger USD in the second and third quarters of 2019 have driven industrial metals spot prices lower. However, the Chinese government announced additional stimulus in September, with further bond issuance to finance infrastructure projects and an easing of monetary policy (panel 3). This should give some upside for industrial metal prices over the coming six-to-12 months. Precious Metals (Neutral): We remain positive on gold, despite its strong performance year-to-date, since we see it as a good hedge against recession, inflation, and geopolitical risks. We discuss gold in detail in the What Our Clients Are Asking section on page 9. Silver also looks attractive in the short term. The nature of the use of silver has changed over the past two decades, from being mostly a base metal for industrial fabrication to becoming more of a precious metal viewed as a safe haven. The correlation between gold and silver prices has increased since the Global Financial Crisis from an average of 0.5 pre-crisis to 0.8 post-crisis (panels 4 & 5). Global growth and political uncertainty should support silver prices in the coming months. Currencies U.S. Dollar: The trade-weighted dollar has appreciated by 2.5% since we turned neutral in April. We expect that the steep drop in yields will continue to ease financial conditions and help global growth in the last quarter of the year. Given that the dollar is a counter-cyclical currency, an environment where global growth rallies have historically been negative for the greenback. Euro: Since we turned bullish in April, EUR/USD has depreciated by 2.7%. Overall, we continue to be positive on EUR/USD on a cyclical timeframe. After the ECB cut rates by 10 basis points and announced further rounds of quantitative easing, there is not much room left for the euro area to keep easing relative to the U.S. (Chart 24, panel 1). Moreover, improving expectations of profit growth in the euro area vis-à-vis the U.S. will drive money flows towards Europe, pushing EUR/USD up in the process (panel 2). Emerging Market Currencies: We remain bearish on emerging market currencies for the time being. That being said, they remain on upgrade watch for the end of the year. There are multiple signs that global growth is turning up, a consequence of the easy financial conditions caused by some of the lowest bond yields on record. Moreover, the marginal propensity to spend (proxied by M1 growth relative to M2 growth) in China, the main engine of EM growth, continues to point to further appreciation in emerging market currencies (panel 3). Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro     Alternatives Chart 25Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Return Enhancers: Over the past 12 months, we have recommended investors pare back on private equity and increase allocations to hedge funds – macro hedge funds in particular. This was due to our judgement that we are late in the economic cycle. While we expect growth to pick up over the coming months, this is not yet clear in the data (Chart 25, panel 1). This uncertain macro outlook will prove tough for private equity funds, especially given an environment of rising multiples and increasing competition for deals. We continue to see global macro hedge funds as the best hedge ahead of the next recession and would advise investors to allocate funds now, given the time it takes to move allocations in the illiquid space. Inflation Hedges: In the current environment, TIPS are likely a better inflation hedge than illiquid alternative assets. Our May 2019 Special Report 8 showed that TIPS produce a particularly attractive risk-adjusted return during times when inflation is rising, but still fairly low (below 2.3%). TIPS should do well, therefore, in the environment we expect over the next few months, where the Fed remains dovish, cutting rates perhaps once more, while condoning a moderate acceleration of inflation (panel 2). Volatility Dampeners: Structured products – mostly Mortgage-Backed Securities (MBS) – have had an excellent record of reducing portfolio volatility (panel 3). Despite that, we do not recommend more than a neutral allocation to MBS currently due to a less-than-attractive valuation picture. Despite Treasury yields falling by more than 100 basis points this year and refinancing activity picking up, nominal MBS spreads remained near their all-time lows. However, as Treasury yields bottom, we expect refinancing to slow, putting downward pressure on spreads. Risks To Our View The most likely upside risk comes from the Fed being too dovish and falling behind the curve. Underlying inflation pressures in the U.S. remain strong (with core CPI up 3.4% annualized over the past three months). After two rate cuts, the Fed Funds rate is now comfortably below the neutral rate: 0.1% in real terms compared to a Laubach-Williams r* of 0.8% (Chart 26). Tightness in the money markets have pushed the Fed to start expanding its balance sheet again. If manufacturing growth accelerates next year, and wages and profits begin to rise, a stock market melt-up, similar to that in 1999, would be possible. Eventually, though, the Fed would need to raise rates (perhaps sharply) to kill inflation, which could usher in the next recession. There are a broader range of possible downside risks. As argued throughout this Quarterly, there are various possible triggers of recession: failure of China to stimulate, and a loss of confidence by consumers, in particular. Some models of recession put the risk over the next 12 months as high as 30% (Chart 27). Structurally, the biggest risk is probably the high level of corporate debt in the U.S. (Chart 28). A breakdown in the junk bond market, as seen briefly last December, could lead to companies failing to refinance the large amount of debt maturing over the next 18 months. Geopolitical risks also remain elevated and are, by nature, hard to forecast. The outcome of Brexit remains highly uncertain – though we see low risk of a no-deal exit. We expect trade talks between the U.S. and China to drag on, without a comprehensive deal, while a clear breakdown would be negative. Impeachment of President Trump is probably not a significant market event, but might hurt market sentiment briefly (particularly if it makes the election of Elizabeth Warren more likely). The Iran/Saudi conflict could escalate. Risk premiums may need to rise to take into account these threats. Chart 26Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Chart 27What Risk Of Recession? What Risk Of Recession? What Risk Of Recession? Chart 28Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk?   Footnotes 1Please see Global Asset Allocation Special Report, titled "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated 20 September 2019, available at fes.bcaresearch.com. 3Please see Global Asset Allocation Quarterly, titled "Quarterly - April 2019" dated April 1, 2019, available at gaa.bcaresearch.com. 4Please see Global Investment Strategy Weekly Report, titled "Bond Yields Have Hit Bottom," dated September 6, 2019, available at gis.bcaresearch.com. 5Please see Global Investment Strategy Weekly Report, titled "Elizabeth Warren And The Markets," dated September 13, 2019, available at gis.bcaresearch.com. 6Dmitry Zhdannikov and Alex Lawler “Exclusive: Saudi oil output to return faster than first thought - sources,” Reuters, dated Sepetmber 17, 2019. 7Please see Geopolitical Strategy Special Alert titled, “Attacks On Critical Infrastructure In KSA Raises Questions About U.S. Response,” dated September 16, 2019, available at gps.bcaresearch.com. 8Please see Global Asset Allocation Special Report, titled “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019, available at gaa.bcaresearch.com GAA Asset Allocation

Energy Stocks Are Heading North Energy stocks are heading north Energy stocks are heading north Banks Clamoring For Higher Rates And A More Hawkish Fed Banks clamoring for higher rates and a more hawkish Fed Banks clamoring for higher rates and a more hawkish Fed Homebuilding Stocks Are Catching Up To Housing Starts Homebuilding stocks are catching up to housing starts. Homebuilding stocks are catching up to housing starts. Will Global Trade Get “Fed-Exed”? Will Global Trade Get "Fed-Exed"? Will Global Trade Get "Fed-Exed"? Do Not Try To Bottom Fish… ... in cyclicals vs. defensives. ... in cyclicals vs. defensives. ... In Cyclicals Vs. Defensives ... in cyclicals vs. defensives. ... in cyclicals vs. defensives. ​​​​​​​

Staying Patient With Banks Staying Patient With Banks Overweight – Downgrade Alert Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market, and we continue to recommend an above benchmark allocation in the S&P banks index. This is a global phenomenon as even the ultimate global value group, Eurozone bank equities, bottomed out on August 15 alongside their U.S. peers. The latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher, likely as a delayed consequence of the dramatic fall in interest rates since last November (bottom panel). Encouragingly, bank officers also reported that they were willing extenders of credit. Our in-house calculated overall gauge of loan tightening standards fell compared with last quarter, signaling that at the margin it is easier to get a loan (middle panel). Bottom Line: Continue to overweight the S&P banks index, but keep it on the downgrade watch list, acknowledging the yield curve and manufacturing related risks. Please see the following Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC. ​​​​​​​

Highlights Portfolio Strategy Small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys, and if the Fed goes ahead and cuts interest rates in half in the coming year as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. The budding recovery in the 10-year UST yield, a rising Citi Economic Surprise Index (CESI) into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Healthy credit growth, still pristine credit quality and early signs of a recovery in the price of credit all signal that an overweight stance is warranted in the S&P banks index.  Recent Changes Last Wednesday we removed the S&P software index from the high-conviction overweight list for a 10% gain. Last Wednesday we removed the large cap size bias from the high-conviction list for a 9% gain. Table 1 The Great Rotation The Great Rotation Feature The SPX built on recent gains last week, but failed to surpass the July highs. Beneath the surface, some big sector shifts are taking place, but it is still early to declare a definitive change in trend. Dormant value stocks have awaken and are riding a high at the expense of growth and momentum names, on the back of a selloff in the bond market (Chart 1). Similarly, small cap stocks have a pulse, and started to outshine large caps. Even in a red SPX day, small cap indexes managed to close in the black (Chart 1). As a reminder with regard to our portfolio, last Wednesday we obeyed our S&P software stop and removed it from the high-conviction call list for a 10% gain, and simultaneously booked gains in the tactical large cap bias and removed it from the high-conviction call list (Chart 1). In both cases our shorter-term confidence was taken down a notch, and we intend to obey our cyclical trailing stops in both positions in order to protect gains for our portfolio (for additional details please refer to the Daily Sector Insights available here and here). Following up from last week’s ISM-related analysis, we turn our attention to the labor market that is beginning to reveal some minor cracks. While the ISM debate has centered around the steep divergences between services and manufacturing on the headline number and the new orders subcomponents, the labor components have gone nearly unnoticed. Chart 1Healthy Rotation Healthy Rotation Healthy Rotation Worrisomely on the employment front, the surveys are in agreement (second panel, Chart 2), warning that the labor market will have trouble standing on its own two feet. This is a bearish backdrop for the broad equity market (third panel, Chart 2). Tack on the latest NFIB survey, and the news gets grimmer. Chart 3 shows that an equally-weighted index of small business job openings and hiring plans is quickly losing momentum. Given that roughly 2/3 of job creation originates in small and medium businesses, non-farm payroll growth will likely continue to lose steam in the coming months (Chart 3). Chart 2Labor Market… Labor Market… Labor Market… Chart 3…Yellow Flags …Yellow Flags …Yellow Flags This week, we update an early cyclical sector and one of its key subcomponents. Finally, the still sinking stock-to-bond ratio corroborates the ISM and NFIB surveys’ messages. Crudely put, the longer that bonds outperform stocks, the higher the chances that employment will suffer a severe setback (Chart 4). Chart 4Last Man Standing Last Man Standing Last Man Standing Granted, the labor market is a lagging indicator and typically one of the last, if not the last, shoes to drop on the eve of recession. With regard to recession, a simple thought experiment is in order. If we assume the bond market’s forecast for another 100bps of fed funds rate (FFR) cuts in the coming year as accurate, then the FFR will fall to 1.25%. This Fed policy easing will represent a 44% fall in the FFR on a year-over-year basis. Since the late 1960s recession there have not been any mid-cycle slowdowns that the Fed has engineered by clipping the FFR in half (Chart 5). Put differently, when the Fed is compelled to cut interest rates so deeply in every iteration we examined a recession followed suit. Chart 5When The Fed Funds Rate Gets Halved, Recession Is The Reason When The Fed Funds Rate Gets Halved, Recession Is The Reason When The Fed Funds Rate Gets Halved, Recession Is The Reason In sum, small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys and if the Fed goes ahead and cuts interest rates in half in the coming year, as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. This week, we update an early cyclical sector and one of its key subcomponents. Stick With Financials… The 45bps rise in the 10-year U.S. Treasury (UST) yield over the past two weeks has breathed life back into the S&P financials sector, and for the time being we are sticking with an overweight recommendation. While it remains to be seen how sustainable the rise in yields will be, BCA's long-held view remains that the 10-year UST yield will sell off on a cyclical 9-12 time month horizon. If this is the case then financials stocks will lead the nascent sector rotation that commenced in late-August and outperform the SPX in the coming months (top panel, Chart 6). Foreign flows had put a solid bid under U.S. bonds and artificially suppressed yields and this is at the margin reversing. In addition, the market was hoping for a 50bps rate cut from the Fed in the September meeting further weighing on the UST yield, but now the odds of that happening are nil. Finally, the Citi Economic Surprise Index (CESI) has also come out of hibernation and spiked in positive territory, evidence that economic data estimates had hit rock bottom. This slingshot recovery in the CESI is tonic for financials stocks (bottom panel, Chart 6). On the earnings front, our profit growth model has kissed off the zero line. While financials sector EPS cannot grow indefinitely at a 30%/annum clip, the turn in our three-factor macro model is a positive development (second panel, Chart 7). Chart 6Moving In Lockstep With Rates Moving In Lockstep With Rates Moving In Lockstep With Rates Chart 7Unwarranted Extreme Bearishness Unwarranted Extreme Bearishness Unwarranted Extreme Bearishness Importantly, it stands in marked contrast to the sell side community. Analysts have been feverishly cutting EPS estimates for the sector, and now net earnings revisions have sunk to a level last hit during the great recession (middle panel, Chart 7). Similarly, relative 12-month and five-year forward profit growth forecasts are overly pessimistic. The upshot is that this lowered profit bar will be easy to surpass. With regard to shareholder friendly activities, while the overall share buyback frenzy has taken a breather, financials sector equity retirement is alive and kicking and on track to register the largest annual buyback since the short history of the data (second panel, Chart 8). If there is any sector with pent up buyback demand it is the financials sector that has been a net equity issuer until very recently still wrestling with equity dilution in the aftermath of the GFC. Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Dividend growth has been steady and in expansionary territory and the dividend payout ratio is far from waving any yellow flags. Moreover, financials yield 2.07% or 25bps higher than the 10-year UST yield and 17bps higher than the SPX, which is attractive for yield seeking investors (Chart 8). Moving on to relative valuations beyond the enticing relative dividend yield, relative price-to-book, relative forward P/E and our bombed out composite relative valuation indicator that collapsed to all-time lows suggest that financials are a screaming buy. Technicals remain oversold and also suggest that an overweight stance is warranted (Chart 9). Chart 8Pent-Up Demand For Shareholder Friendly Activities Pent-Up Demand For Shareholder Friendly Activities Pent-Up Demand For Shareholder Friendly Activities Chart 9Undervalued And Unloved Undervalued And Unloved Undervalued And Unloved Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Bottom Line: Stay overweight the S&P financials sector, that is compellingly valued, under-owned, and with promising profit prospects. … And Banks For A While Longer Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market, and we continue to recommend an above benchmark allocation in the S&P banks index. This is a global phenomenon as even the ultimate global value group, Eurozone bank equities, bottomed out on August 15 alongside their U.S. peers. While the broad financials index is levered to interest rate movements, banks – that comprise roughly 42% of the S&P financials sector – are hyper-sensitive to changes in the risk-free asset. Thus, the recent jack up in interest rates represents a profit-augmenting opportunity for this early cyclical subgroup (Chart 10) Beyond the rising price of credit, credit growth is another key industry profit driver. Our bank loan models have crested, but are still expanding at a healthy clip (second and bottom panels, Chart 11). As long as they manage to remain above the zero line, they will prove a boon to bank earnings. Specifically on the consumer front, sky high consumer confidence coupled with rising wage inflation signal that consumer credit growth prospects remain upbeat (Chart 11). Chart 10Rising Rates=Buy Banks Rising Rates=Buy Banks Rising Rates=Buy Banks Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher, likely as a delayed consequence of the dramatic fall in interest rates since last November (bottom panel, Chart 12). Chart 11Loan Growth… Loan Growth… Loan Growth… Chart 12…Prospects Are Firming …Prospects Are Firming …Prospects Are Firming Encouragingly, bank officers also reported that they were willing extenders of credit. Our in-house calculated overall gauge of loan tightening standards fell compared with last quarter, signaling that at the margin it is easier to get a loan (middle panel, Chart 12). Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index.  Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine (Chart 13). The upshot is that this credit quality backdrop combined with a jump in bank return-on-equity to low double digits, should serve as catalysts to unlock excellent value (third & bottom panel, Chart 13). Nevertheless, there are two risks worth close monitoring. First, parts of the yield curve inverted last December and more recently the 10/2 yield curve slope inverted warning that the path of least resistance is lower for bank net interest margins (NIMs, middle panel, Chart 14). Chart 13Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Chart 14Two Risks To monitor Two Risks To monitor Two Risks To monitor Second, the ISM manufacturing survey fell below the boom/bust line in August for the first time since the late-2015/early-2016 manufacturing recession (bottom panel, Chart 14). Given that C&I loans are the largest loan category on the asset side of bank balance sheets, the current manufacturing recession may hurt bank profitability in two distinct ways. Not only C&I credit quality will worsen as the risk of defaults rises, but also C&I loan growth may take the back seat and weigh on bank profit growth prospects. Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index.  Bottom Line: Continue to overweight the S&P banks index, but keep it on the downgrade watch list, acknowledging the yield curve-related potential decline in NIMs and manufacturing recession-related C&I loan growth risks. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Bifurcated Equity Markets Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM Bifurcated Markets In EM Bifurcated Markets In EM   How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD bca.ems_wr_2019_09_05_s1_c3 bca.ems_wr_2019_09_05_s1_c3 Chart I-4EM And DM Commodity Currencies EM And DM Commodity Currencies EM And DM Commodity Currencies   Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks U.S. High-Beta Stocks U.S. High-Beta Stocks DM bond yields.  Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Korean Exports: No Recovery Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chinese Imports To Remain Weak Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German Manufacturing Confidence German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio bca.ems_wr_2019_09_05_s1_c9 bca.ems_wr_2019_09_05_s1_c9 Chart I-10Global Cyclicals Versus Defensives Global Cyclicals Versus Defensives Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 U.S. High-Beta Stocks Versus S&P 500 U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds EM Stocks Have Massively Underperformed U.S. Bonds EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile Continue Receiving Rates In Korea And Chile Continue Receiving Rates In Korea And Chile   We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Short EM Banks / Long EM Consumer Staples Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight EM Credit / Overweight U.S. Investment-Grade Corporates Underweight EM Credit / Overweight U.S. Investment-Grade Corporates   Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling  further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating The Economy Is Deteriorating The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth Narrow Money Points To Negative Growth Narrow Money Points To Negative Growth   An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve A Message From The Inverted Yield Curve A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot Fiscal Policy Has Tightened A Lot Fiscal Policy Has Tightened A Lot   Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Local Bond Yields And Relative Stocks: Mexico Versus EM Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse Consumer Staples Have A Large Weight In Mexican Bourse Consumer Staples Have A Large Weight In Mexican Bourse   We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Investors Are Long MXN Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade Take Profits On Long MXN / Short ZAR Trade Take Profits On Long MXN / Short ZAR Trade   Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations