Banks

Highlights Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The key and necessary condition for a new secular EM bull market to emerge is the end of abundant financing. The latter is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. The cyclical EM outlook hinges on China’s business cycle. The slowdown in China is broad-based and will deepen. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. Feature As we head into 2019, the past decade is shaping up to be a lost one for emerging markets (EM) assets. In particular: EM stocks have underperformed DM markets substantially since the end of 2010 (Chart I-1). In absolute terms, EM share prices are at the same level as they were in early 2010. Chart I-1EM Equities Have Been Underperforming DM For Eight Years EM Equities Have Been Underperforming DM For Eight Years EM Equities Have Been Underperforming DM For Eight Years EM currencies have depreciated substantially since 2011, and the EM local currency bond index (GBI-EM) on a total-return basis has produced zero return in U.S. dollar terms since 2010 (Chart I-2). Chart I-2A Lost Decade For Investors In EM Local Currency Bonds? A Lost Decade For Investors In EM Local Currency Bonds? A Lost Decade For Investors In EM Local Currency Bonds? Finally, EM sovereign and corporate high-yield bonds have not outperformed U.S. high-yield corporate bonds on an excess-return basis. Will 2019 witness a major reversal of such dismal EM performance? And if so, will it be a structural or cyclical bottom? The roots underneath this lost decade for EM stem neither from trade wars nor from Federal Reserve tightening. Therefore, a structural bottom in EM financial markets is contingent neither on the end of Fed tightening nor the resolution of current trade tussles. We address the issues of Fed tightening and trade wars below. A Lost Decade: Causes And Remedies What led to a lost decade for EM was cheap and plentiful financing. When the price of money is low and financing is abundant, companies and households typically rush to borrow and spend unwisely. Capital is misallocated and, consequently, productivity and real income growth disappoint – and debtors’ ability to service their debts worsens. This is exactly what has happened in EM, as easy money splashed all over developing economies since early 2009. There have been three major sources of financing for EM: Source 1: Chinese Banks Chinese banks have expanded their balance sheets by RMB 198 trillion to RMB 262 trillion (or the equivalent of $28.8 trillion) over the past 10 years (Chart I-3, top panel). When commercial banks expand their balance sheets by lending to or buying an asset from non-banks, they create deposits (money). Consistently, the broad money supply has expanded by RMB 175 trillion to RMB 234 trillion (or the equivalent of $25.5 trillion). Chart I-3Enormous Boom In Chinese Banks' Assets And Money Supply Enormous Boom In Chinese Banks' Assets And Money Supply Enormous Boom In Chinese Banks' Assets And Money Supply Notably, the People’s Bank of China (PBoC) has increased commercial banks’ excess reserves by RMB 1.5 trillion to RMB 2.8 trillion (or the equivalent of $0.22 trillion) (Chart I-3, bottom panel). Hence, the meaningful portion of money supply expansion has been due to the money multiplier – money created by mainland banks – not a provision of excess reserves by the PBoC (Chart I-4). Chart I-4Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Attribution Of Rise In Money Supply To Excess Reserves And Money Multiplier Not only has such enormous money creation by commercial banks generated purchasing power domestically, but it has also boosted Chinese companies’ and households’ purchases of foreign goods and services. The Middle Kingdom’s imports of goods and services have grown to $2.5 trillion compared with $3.2 trillion for the U.S. (Chart I-5). China’s spending has boosted growth considerably in many Asian, Latin American, African, Middle Eastern, and even select advanced economies. Chart I-5Imports Of Goods And Services: China And The U.S. Imports Of Goods And Services: China And The U.S. Imports Of Goods And Services: China And The U.S. Source 2: DM Central Banks’ QE By conducting quantitative easing, the central banks of several advanced economies have crowded out investors from fixed-income markets, incentivizing them to search for yield in EM. The Fed, the Bank of England, the European Central Bank and the Bank of Japan have in aggregate expanded their balance sheets by $10 trillion (Chart I-6). Chart I-6Quantitative Easing In DM Quantitative Easing In DM Quantitative Easing In DM This has led to massive inflows of foreign portfolio capital into EM, and reflated asset prices well beyond what was warranted by their fundamentals. Specifically, since January 2009, foreign investors have poured $1.5 trillion on a net basis into the largest 15 developing countries excluding China, Taiwan and Korea (Chart I-7, top panel). For China, net foreign portfolio inflows amounted to $560 billion since January 2009 (Chart I-7, bottom panel). Chart I-7Cumulative Foreign Portfolio Inflows Into EM And China Cumulative Foreign Portfolio Inflows Into EM And China Cumulative Foreign Portfolio Inflows Into EM And China Source 3: EM Ex-China Banks EM ex-China began expanding their balance sheets aggressively in early 2009, originating new money (local currency) and thereby creating purchasing power. This was especially the case between 2009 and 2011. Since that time, money creation by EM ex-China banks has decelerated substantially due to periodic capital outflows triggering currency weakness and higher borrowing costs. Out of these three sources, China’s money/credit cycles remain the primary driver of EM. The mainland’s imports from developing economies serves as the main nexus between China and the rest of EM. Essentially, Chinese money and credit drive imports, influencing growth and corporate profits in the EM universe (Chart I-8). Chart I-8China's Credit Cycle Leads Its Imports China's Credit Cycle Leads Its Imports China's Credit Cycle Leads Its Imports In turn, EM business cycle upturns attract international capital. Meanwhile, credit creation by local banks in EM ex-China – primarily in economies with high inflation or current account deficits – is a residual factor. In these countries, domestic credit creation is contingent on a healthy balance of payments and a stable exchange rate. The latter two, in turn, transpire when exports to China and international portfolio capital inflows are improving. The outcome of easy financing is over-borrowing and capital misallocation. The upshot of the latter is usually lower efficiency and productivity growth. Not surprisingly, productivity growth in both China and EM ex-China has decelerated considerably since 2009 (Chart I-9). EM return on assets has dropped a lot in the past 10 years and is now on par with levels last seen during the 2008 global recession (Chart I-10). Chart I-9Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Falling Productivity Growth In EM And China =... Chart I-10... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital ... = Low Profit Margins And Low Return On Capital Accordingly, the ability to service debt by EM companies has deteriorated considerably in the past decade – the ratios of cash flows from operations to both interest expenses and net debt have dropped (Chart I-11). Chart I-11EM: Deteriorating Ability To Service Debt EM: Deteriorating Ability To Service Debt EM: Deteriorating Ability To Service Debt These observations offer unambiguous confirmation that money has been spent inefficiently – i.e., misallocated. Credit booms and capital misallocations warrant a period of corporate restructuring and banking sector recapitalization. Without this, a new cycle cannot emerge. A secular bull market in equities and exchange rates arises when productivity growth and hence income-per-capita growth accelerates, and return on capital begins to climb. This is not yet the case for most developing economies. The end of cheap and abundant financing is imperative to compel corporate restructuring, bank recapitalization as well as structural reforms. These are necessary conditions to create the foundation for a new secular bull market. Ironically, the best remedy for an addiction to easy money is a period of tight money. For example, U.S. share prices would not be as high as they currently are if the U.S. did not go through the Lehman crisis. This 10-year bull market in U.S. equities was born from the ashes of the Lehman crisis. Vanished financing and the private sector’s tight budgets in 2008-‘09 compelled corporate restructuring as well as a focus on efficiency and return on equity. Has EM financing become scarce and tight? Cyclically, China’s money creation and credit flows have slowed, pointing to a cyclical downturn in EM share prices and commodities (please see below for a more detailed discussion). International portfolio flows to EM have also subsided since early this year. There has been selective corporate restructuring post the 2015 commodities downturn, including in the global/EM mining and energy sectors, China steel and coal industries as well as among Russian and Brazilian companies. However, there are many economies and industries where corporate restructuring, bank recapitalization and structural reforms have not been undertaken. Yet from a structural perspective, China’s money and credit growth remain elevated and excesses have not been purged. Besides, international portfolio flows to EM have had periodic “stop-and-gos” but have not yet retrenched meaningfully (refer to Chart I-7 on page 4). Consequently, structural overhauls and corporate restructuring in China/EM have by and large not yet occurred – in turn negating the start of a new secular bull market. Bottom Line: Conditions for a structural bull market in EM/China are not yet present. EM/China: A Cyclical Bottom Is Not In Place From a cyclical perspective, China is an important driving force for the majority of EM economies, and its deepening growth slowdown will continue to weigh on EM growth and global trade. In fact, odds are that global trade will contract in the first half of 2019: In China, tightening of both monetary policy as well as bank and non-bank regulation from late 2016 has led to a deceleration in money and credit growth. The latter has, with a time, lag depressed growth since early this year. Policymakers have undertaken some stimulus since the middle of this year, but it has so far been limited. Stimulus also works with a time lag. Besides, even though the broad money impulse has improved, the credit and fiscal spending impulse remains in a downtrend (Chart I-12). Therefore, there are presently mixed signals from money and credit. Chart I-12China's Stimulus Leads EM And Commodities China's Stimulus Leads EM And Commodities China's Stimulus Leads EM And Commodities As illustrated in Chart I-12, the bottoms in the money and combined credit and fiscal spending impulses, in July 2015, preceded the bottom in EM and commodities by six months and their peak led the top in financial markets by about 15 months in January 2018. Besides, in 2012-‘13, the rise in the money and credit impulses did not do much to help EM stocks or industrial commodities prices. Hence, even if the money as well as credit and fiscal impulses bottom today, it could take several more months before the selloff in EM financial markets and commodities prices abates. Additionally, the ongoing regulatory tightening of banks and non-bank financial institutions will hinder these institutions' willingness and ability to extend credit, despite lower interest rates. We discussed in a recent report that both the effectiveness of the monetary transmission mechanism and the time lag between policy easing and a bottom in the business cycle are contingent on the money multiplier (creditors' willingness to lend, and borrowers' readiness to borrow) and the velocity of money (the marginal propensity to spend among households and companies). Growth in capital spending in general and construction in particular have ground to a halt (Chart I-13). Chart I-13China: Weak Capital Spending China: Weak Capital Spending China: Weak Capital Spending Not only has capital spending decelerated but household consumption has also slowed since early this year, as demonstrated in the top panel of Chart I-14. Chart I-14China: A Broad-Based Slowdown China: A Broad-Based Slowdown China: A Broad-Based Slowdown Finally, mainland imports are the main channel in terms of how China’s growth slowdown transmits to the rest of the world. Not surprisingly, EM share prices and industrial metals prices correlate extremely well with the import component of Chinese manufacturing PMI (Chart I-15). Chart I-15China's Imports And EM And Commodities China's Imports And EM And Commodities China's Imports And EM And Commodities Bottom Line: The slowdown in China is broad-based, and our proxies for marginal propensity to spend by households and companies both point to further weakness (Chart I-14, middle and bottom panels). Constraints And Chinese Policymakers’ Dilemma Given the ongoing slowdown in the economy, why are Chinese policymakers not rushing to the rescue with another round of massive stimulus? First, policymakers in China realize that the stimulus measures of 2009-‘10, 2012-‘13 and 2015-‘16 led to massive misallocations of capital and fostered both inefficiencies and speculative excesses in many parts of the economy – the property markets being among the main culprits. Indeed, policymakers recognize that easy money does not foster productivity growth, which is critical to the long-term prosperity of any nation. For China to grow and prosper in the long run, the economy’s addiction to easy financing should be curtailed. Second, policymakers are currently facing a dilemma. The real economy is saddled with enormous debt and is slowing. This warrants lower interest rates – probably justifying bringing down short-term rates close to zero. Yet, despite enforcing capital controls, it seems the exchange rate has been correlated with China’s interest rate differential with the U.S. since early 2010 (Chart I-16). Given the ongoing growth slowdown and declining return on capital in China, there are rising pressures for capital to exit the country. Notably, the PBoC’s foreign exchange reserves of $3 trillion are only equivalent to 10-14% of broad money supply (i.e., all deposits in the banking system) (Chart I-17). Chart I-16Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chinese Currency And Interest Rates Chart I-17China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits China: Foreign Currency Reserves Are Very Low Compared To Money Supply/Deposits The current interest rate differential is only 33 basis points. If the PBoC guides short-term rates lower and the Fed stays on hold or hikes a few more times, the spread will drop to zero or turn negative. Based on the past nine-year correlation, the narrowing interest rate spread suggests yuan depreciation. This will weigh on EM and probably even global risk assets. In a scenario where policymakers prioritize defending the yuan’s value, they may not be able to reduce borrowing costs and assist indebted companies and households. As a result, the downtrend in the real economy would likely worsen. Consequently, EM and global growth-sensitive assets will drop further. Given the constraints Chinese policymakers are facing, reducing interest rates and allowing the yuan to depreciate further is the least-bad outcome. Yet this will rattle Asian and EM currencies and risk assets. What About The Fed And Trade Wars? The Fed and EM: Fed policy and U.S. interest rates are relevant to EM, but they are of secondary importance. The primary driver of EM economies are their own domestic fundamentals as well as global trade – not just U.S. growth. Historically, the correlation between EM risk assets and the fed funds rate has been mixed, albeit more positive than negative (Chart I-18). On this chart, we have shaded the five periods over the past 38 years when EM stocks rallied despite a rising fed funds rate. Chart I-18The Fed And EM Share Prices: A Historical Perspective The Fed And EM Share Prices: A Historical Perspective The Fed And EM Share Prices: A Historical Perspective There were only two episodes when EMs crashed amid rising U.S. interest rates: the 1982 Latin American debt crisis and the 1994 Mexican Tequila crisis. Yet it is vital to emphasize that these crises occurred because of poor EM fundamentals – elevated foreign currency debt levels, negative terms-of-trade shocks, large current account deficits and pegged exchange rates. Dire EM fundamentals also prevailed before the Asian/EM crises of 1997-1998. However, these late-1990s crises occurred without much in the way of Fed tightening or rising U.S. bond yields. Trade Wars: China’s current growth slowdown has not originated from a decline in its exports. In fact, Chinese aggregate exports and those to the U.S. have been growing at a double-digit pace, largely due to the front running ahead of U.S. import tariffs. More importantly, China’s exports to the U.S. and EU account for 3.8% and 3.2% of its GDP, respectively (Chart I-19). Total exports amount to 20% of GDP, with almost two-thirds of that being shipments to developing economies. This compares with capital spending that makes up 42% of GDP and household consumption of 38% of GDP. Hence, capital expenditures and household spending are significantly larger than shipments to the U.S. Chart I-19Structure Of Chinese Economy Structure Of Chinese Economy Structure Of Chinese Economy There is little doubt that the U.S.-China confrontation has affected consumer and business sentiment in China. Nevertheless, the slowdown in China has - until recently - stemmed from domestic demand, not exports. Investment Recommendations It is difficult to forecast whether the current EM down leg will end with a bang or a whimper. Whatever it is, the near-term path of least resistance for EM is to the downside. “A bang” scenario – where financial conditions tighten substantially and for an extended period – would likely compel corporate and bank restructuring as well as structural reforms. Therefore, it is more likely to mark a structural bottom in EM financial markets. “A whimper” scenario would probably entail only moderate tightening in financial conditions. Thereby, it would not foster meaningful corporate restructuring and structural reforms. Hence, such a scenario might not mark a secular bottom in EM stocks and currencies. In turn, the EM cyclical outlook hinges on China’s business cycle. If and when Chinese policymakers reflate aggressively, the mainland business cycle will revive, producing a cyclical rally in EM risk assets. At the moment, Chinese policymakers are behind the curve. With respect to investment strategy, we continue to recommend: Downside risks to EM assets remain substantial. Stay put. EM stocks, credit and currencies will underperform their DM counterparts in the first half of 2019. The slowdown in China/EM will likely lead to global trade contraction. The latter is negative for global cyclicals yet bullish for the U.S. dollar. For dedicated EM equity portfolios, our overweights are: Brazil, Mexico, Chile, Colombia, Russia, central Europe, Korea and Thailand. Our underweights are: South Africa, Peru, Indonesia, India, the Philippines and Hong Kong stocks. We are neutral on the remaining bourses. In the currency space, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR and KRW. The latter is a play on RMB depreciation. The full list of our recommendation across EM equity, fixed-income, currency and credit markets is available on pages 14-15. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The Reserve Bank of Australia (RBA) may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band.  Reflation in China could also embolden the RBA to tighten monetary policy – though the odds of a more aggressive stimulus package will decline as long as China’s overall economy remains stable and the U.S. maintains its tariff ceasefire. The Labor Party is favored to win the federal election, which is most likely to occur in May. This is a low-conviction view, as polls are tight and economic improvement will help the ruling Liberal-National Coalition. Feature 2018 has been a challenging year for global financial markets, as investors have had to deal with greater economic uncertainty, less dovish central banks and more volatile asset prices. One country that has bucked the trend to some degree is Australia. The nation has famously avoided a recession since 1991 and last saw a tightening of monetary policy in 2010. While the recession streak is unlikely to be broken in 2019, there are growing risks that the era of interest rate tranquility will soon end. In this Special Report, jointly published with our colleagues at BCA Geopolitical Strategy, we update our views on Australia for 2019 – a year when the investment backdrop has the potential to become far more interesting, and volatile, due to election year uncertainty and a potential shift to a more hawkish bias for monetary policy. The Bond Outlook: What To Watch To Turn Bearish BCA Global Fixed Income Strategy has maintained an overweight stance on Australian government bonds since the end of 2017. That high-conviction view stemmed from our expectation that the Reserve Bank of Australia (RBA) would keep policy rates on hold for longer due to sluggish economic growth and underwhelming inflation. This recommendation has performed well, with Australian government bonds returning 2.4% (currency-hedged into U.S. dollars) in 2018 year-to-date, beating the Bloomberg Barclays Global Treasury index by 190bps. The benchmark 10-year Australian government is now yielding 36bps below the equivalent 10-year U.S. Treasury yield, the tightest spread since 1980 (Chart 1). Chart 1Australian Bonds Have Outperformed Australian Bonds Have Outperformed Australian Bonds Have Outperformed Looking ahead, we still have a positive opinion on Australian debt relative to its global peers over the next six months. The RBA is unlikely to make any adjustments to the Cash Rate - which remains at a highly-accommodative level of 1.5% - without seeing some signs of accelerating inflation in both the Q4 2018 and Q1 2019 CPI reports. This is especially true given the political uncertainty with another federal election due by May 18,1 which could change the outlook for fiscal policy (as we discuss later in this report) and impact the RBA’s economic projections. In our view, the RBA will only be able to seriously consider an interest rate hike, warranting a downgrade of our recommended overweight stance, if all three of the following conditions occur: Australia’s underemployment rate falls below 8% China’s economy shows convincing evidence of reacceleration, especially in commodity-intensive industries like construction Core CPI inflation rises back to at least the midpoint of the RBA’s 2-3% target band We will now discuss each of these in turn. Underemployment Australia is a fairly open economy with a large export sector, but consumer spending is still the largest share of GDP (60%) so it matters most for growth. On that front, real consumption has grown in a narrow and uninspiring range between 2-3% over the past five years. Anemic wages and disposable incomes have been the problem, with the growth of both (in nominal terms) struggling to grow faster than low realized inflation, which now sits below the RBA’s inflation target range of 2-3% (Chart 2). Households have been forced to deploy a greater share of that modest income growth just to maintain spending, with the savings rate plunging from 8% at the end of 2014 to 1% this year and consumer debt piling up. Chart 2An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending An Income-Fueled Pickup In Consumer Spending The dynamics may be changing in a more positive direction, however. Growth rates of nominal wage (+2.3%) and disposable income (+3.1%) have accelerated this year to a pace faster than inflation. With real incomes perking up, the year-over-year growth rate of real consumer spending growth accelerated to 3% in Q3/2018, driving real GDP growth to similar levels. A sustained pickup in wage growth is necessary before the RBA would even contemplate a rate hike. For that to occur, there must be decisive evidence of a tightening Australian labor market and increased resource utilization. While the headline unemployment rate of 5.0% is below the OECD’s estimate of the full employment NAIRU for Australia (5.3%), broader measures of labor market slack are still at elevated levels. Specifically, the “underemployment” rate, which includes workers who are working fewer hours than they would like or at jobs below their skill levels, is still at an elevated 8.3% (Chart 3). That is down from the peak of just below 9% seen in early 2017, but well above the 2012 trough near 7% (when wage growth was close to 4%).  Chart 3UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages UNDERemployment Rate Matters More For Australian Wages Australian wage growth tends to correlate more with the underemployment rate than the traditional unemployment rate (middle panel). This suggests that the recent blip higher in wage growth could be the beginning of a new trend, given that it has occurred alongside the recent drop in underemployment. Already, underemployment is back below the levels that prevailed when the RBA did its last interest rate cut back in 2016 (bottom panel).  A further dip lower in the underemployment rate to below the 8% threshold would likely confirm that wage growth has more upside. That outcome would give the RBA greater confidence that consumer spending will gain more strength even with a low savings rate, and that CPI inflation will return back into the target range – both outcomes that would justify some removal of the RBA’s highly stimulative monetary accommodation. China Stimulus The main connection from China’s economy to Australia is through Chinese demand for Australian exports. There is also an indirect, but very important, link between Chinese demand boosting industrial commodity prices. The latter boosts Australian growth through positive terms-of-trade effects and increased capital spending in commodity-related sectors like mining. Iron ore is the most important of those commodities, representing 18% of total Australian goods exports, with 85% of those iron ore exports going to China. Australian export growth has decelerated during 2018 from the very robust 15% year-over-year pace to a still solid 10% rate. This has mirrored the trends seen in many other economies, where exports have slowed alongside diminished demand from China. If Chinese authorities change their current policy trajectory, and embrace more aggressive fiscal and credit stimulus, then they will reaccelerate the country’s flagging demand, which should benefit Australian exporters. If the increase in spending occurs in commodity-intensive parts of China’s economy, like construction, then Australia can also benefit from a terms-of-trade impact if commodity prices rise. However, BCA’s Geopolitical Strategy and China Investment Strategy remain skeptical that China will launch a major economic stimulus package along the lines of what occurred in 2015-16. That surge not only boosted Chinese GDP and import demand but also triggered a boost to global industrial commodity prices that benefitted many commodity exporters, including Australia. In recent months, there has been a pickup in overall Chinese import growth, as well as some acceleration of higher frequency growth indicators like the Li Keqiang index (Chart 4). Australian exports to China have not picked up though, and Chinese iron ore imports are contracting. Part of that is due to the elevated levels of Chinese iron ore inventories. More likely, there is little demand for additional iron ore given China’s reform agenda and the struggles of its construction sector (which accounts for roughly 35% of Chinese steel demand). Chart 4China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? China Stimulus Not Helping Australia...Yet? Our colleagues at BCA China Investment Strategy2 have noted that both weakening sales and tighter funding sources for real estate developers point to declining growth in property starts and construction. This will be negative for construction-related commodity markets and construction-related machinery. This is coming at a time when the Chinese government is trying specifically to address over-indebted industries like construction. As for the U.S.-China trade truce, a permanent de-escalation of tensions – which has not yet occurred – could provide a boost to Australian export demand, as with other export-focused countries. But the negative impact of bilateral U.S.-China tariffs on the global economy is much smaller than that of China’s attempt to limit indebtedness. Moreover, a trade truce will remove China’s primary incentive to adopt more aggressive stimulus. Nevertheless, from the RBA’s perspective, any boost to China’s construction-related activity would have a big impact on Australia’s economy and would strengthen the case for a rate hike in 2019.  Core Inflation Australia’s headline CPI inflation has struggled to hit even the bottom end of the RBA’s 2-3% target band since 2015, reaching only 1.9% in Q3 of this year (Chart 5). The story is even worse for inflation excluding food and energy, with core CPI inflation now only at 1.2% after having drifted lower in two consecutive quarters. Both market-based and survey-based measures of inflation expectations are also hovering near 2%. Chart 5Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target Australian Inflation Well Below RBA Target When breaking down the CPI into tradeables (i.e. more globally-focused) and non-tradeables (i.e. more domestically-focused), the two types of inflation have not been accelerating at the same time since the 2009-11 period. Since then, faster tradeables inflation has occurred alongside slowing non-tradeables inflation, and vice versa.  While volatility on the tradeables side should be expected given the correlation to swings in commodity prices and the Australian dollar, the weakness in non-tradeables is more directly related to the spare capacity in the domestic economy. Therefore, if wage growth continues to pick up as the labor market tightens, then non-tradeables inflation should follow suit and boost Australian CPI inflation back towards the RBA target range. The implication for the RBA is that a move in core CPI inflation back towards 2.5% (the midpoint of the RBA band), occurring after an acceleration in wage growth as described above, would give the central bank confidence that a higher Cash Rate is required. Bottom Line: The RBA has kept interest rates on hold for over two years, but may consider a rate hike in 2019 if additional tightening of labor markets leads to higher wage inflation, which would help lift core inflation back to the midpoint of the RBA’s 2-3% target band. A more aggressive fiscal and monetary stimulus package in China, while not our base case, would also embolden the RBA to tighten monetary policy. Risks From Australian Banks? Throughout 2018, the Australian financial industry has had to endure the slings and arrows of a government inquiry into its questionable business practices and misconduct. Revelations of bribery, fraud, the charging of fees for no service and from the accounts of deceased people, as well as board-level deception of regulators, have roiled Australia's financial sector since the explosive inquiry began in February. The final report of the Australian Financial Services Royal Commission will be published in February, but the impact is already being felt throughout the industry. Bank CEOs have been publically shamed, while other senior financial sector executives have been forced from their jobs. The chairman of National Australia Bank stated before the inquiry that customers’ trust in lenders had been “pretty well eroded to zero”, and that it could take as long as a decade to successfully overhaul the culture within the banks. The biggest impacts from the Commission will come through hits to banks’ earnings and funding costs, as well as the potential impact on lending standards for new loans. Australian banks will be less profitable because of fines, customer refunds, setting aside provisions for potential misconduct penalties and the government wanting increased competition. If banks also choose to be more conservative with the marking of loans, then higher loan-loss provisions could be an additional drag on bank earnings. Already, Australian bank stocks have severely underperformed the overall domestic market, and there has been some slowing of domestic credit growth (Chart 6). There are also signs of bank funding stresses from contracting bank deposit growth (second panel) and wider offshore funding costs like relatively elevated LIBOR-OIS spreads (bottom panel). Considering how heavily Australian banks rely on offshore funding, any squeeze in those markets could severely influence the availability of credit within the Australian economy. Chart 6Australian Banks Under Some Stress... Australian Banks Under Some Stress... Australian Banks Under Some Stress... Looking ahead, if banks do tighten up their lending standards in response to the criticism and findings of the Commission, that will be from a starting point of very accommodative levels. In other words, getting a loan will likely still be “easy”, rather than “incredibly easy”. The reason is that Australian bank balance sheets remain in excellent condition. Credit crunches begin when banks are undercapitalized and are forced to retrench new loan activity as losses on existing loans pile up. That is not the case in Australia, where the major banks have Tier 1 capital ratios in the 10-12% range and non-performing loans are a tiny share of total lending. In our view, a true credit crunch would likely only occur after the Australian housing bubble bursts and the economy enters a severe downturn. That outcome would most likely be triggered by monetary policy tightening via multiple RBA rate hikes. Importantly, some of the steam has already been taken out of Australian house prices thanks to changes in regulations on new lending (Chart 7), potentially reducing some of the immediate risks to growth from a sharp plunge in home values.  Chart 7...But No Credit Crunch Expected ...But No Credit Crunch Expected ...But No Credit Crunch Expected Bottom Line: In 2019, the Australian government and its key financial regulators will have to work together to enforce responsible lending without triggering a catastrophic property market unwind. RBA policymakers are less likely to hike rates given their desire to maintain financial stability in the aftermath of the Commission – or at least until the inflation story forces their hand, as outlined in this report. The Federal Election: Polling Slightly Favors Labor Scandals in the financial sector are of utmost importance to the other major factor that could make 2019 a year of significant change in Australia: the federal election that looms most likely in the spring. Parliament is balanced on a knife’s edge, with the Australian Liberal Party’s loss of former Prime Minister Malcolm Turnbull’s parliamentary seat in a Sydney by-election on October 20. The ruling Liberal-National Coalition no longer has a majority and must rely on independent MPs to survive any no-confidence vote. This precarious situation suggests that the election could come even sooner than May and that the slightest twist in the campaign could deliver at least a small majority to either of the top two parties. Indeed, at this early stage, a high-conviction view on the election outcome is not warranted. After all, the 2016 election was decided in the Coalition’s favor only after a shift in opinion in the final month! Chart 8Labor Party Narrowly Leads All-Party Opinion Polls A Year Of Change In Australia? A Year Of Change In Australia? Nevertheless, with all due caveats, our baseline case is for a Labor majority in 2019, however slim it may be.3 Labor is slightly ahead of the Coalition in the primary opinion polling, which includes all parties (Chart 8). In two-party preference polling, Labor has gradually widened its general lead since the July 2016 election and now holds a 10% advantage in the federal polls – albeit only a 6% lead when a moving average is taken (Chart 9). Labor is also winning or tied in every major state. Chart 9Labor Has Large Lead In Two-Party Preference Polls A Year Of Change In Australia? A Year Of Change In Australia? The dramatic shift in polling since August is significant because that is when the knives came out and the Coalition ousted Turnbull in favor of the current Prime Minister Scott Morrison. The purpose of this move was to give the party a facelift ahead of the election. It is true that public opinion views Morrison as the preferred prime minister to Labor’s Bill Shorten. Shorten has a negative net approval rating and has never been viewed as an inspiring politician, while Morrison is just barely net positive. This perception works against Labor’s lead in the party polling – which is very competitive anyway – and suggests the election will be close. Critically, the Liberal-National Coalition’s polling as a whole has not benefited from the change in leadership. And in fact the data does not support the two major Australian parties’ abiding belief that a leadership coup will boost their popularity: Australia has seen four of these coups since 2010, two from Labor and two from the Coalition, and the party in question lost an average of 8% of the popular vote and 14 seats in parliament in the succeeding election (Table 1). Table 1Intra-Party Coups Don’t Win Votes A Year Of Change In Australia? A Year Of Change In Australia? Turnbull’s ouster also calls attention to another detrimental factor for the Coalition: the challenge on the right flank from minor and anti-establishment parties. Pauline Hanson’s One Nation has a relatively low support rate both historically and in today’s race, currently at 8%, but anti-establishment feeling may have forced the Coalition into an error. Judging by the party’s weak polling since August, the negative response to Turnbull’s ouster has been more detrimental than the nomination of Morrison, an immigration hardliner and social conservative, has been beneficial. Meanwhile, Labor’s momentum has been corroborated by a string of surprise victories in by-elections and a sweeping win in the Victoria state elections on November 24. In the latter case, the party not only defended its hold on government, as one might expect in this progressive state, but exceeded expectations to win 56 seats out of 88 in the lower House, while the Coalition lost nearly half of its seats, falling from 37 to 21. Still, Labor’s lead is by no means decisive. In the average of the various primary polls its edge over the Coalition is within the margin of error. Moreover, the Coalition holds more “safe” (uncompetitive) seats than Labor.4 The bottom line is that a small swing in either party’s favor can produce a thin majority. The Coalition’s best case is the economy. But as concerns about unemployment and job creation recede, voters will make other demands. The top issues in recent polling are the cost of living, health care, housing affordability, and wages. Some polls also emphasize social mobility and climate change and renewable energy. Will Shorten’s Labor Party be able to capture the median voter? It is highly significant that the party has taken a rightward turn on immigration and taxes even as it holds out a more left-wing agenda on health, education, regulation, and social benefits. Immigration has played a major role in Australian politics and Labor is currently positioned near the political center – in other words, if Morrison hardens his line to guard against populists, he risks over-hardening and moving away from the median voter (Chart 10). Shorten has proposed a large bipartisan task force to determine the proper limits to immigration and how to deal with congestion and infrastructure pressures. Shorten’s platform also calls attention to abuse of temporary visas by foreign workers. Chart 10Labor Is Not Too Soft On Immigration A Year Of Change In Australia? A Year Of Change In Australia? On taxes, Shorten has attempted to separate small and big companies, again in a bid for the political center. When Prime Minister Morrison sought to establish his anti-tax credentials (Chart 11), Shorten met him halfway and proposed relief for middle class families and small and medium-sized enterprises. Yet he doubled down on higher taxes for multinational corporations and high-income earners. Chart 11Liberal-National Coalition Cutting Corporate Tax Rates A Year Of Change In Australia? A Year Of Change In Australia? Critically, the latter redistributive stances are more in line with the median voter than the Liberal Party’s more conservative, supply-side, tax cut agenda. All of Australia’s parties, including the increasingly popular “minority parties,” have a more favorable attitude toward redistribution than the Coalition, which is the outlier (Chart 12). Indeed, the National Party is closer in line with the others than the Liberals, highlighting the divisions within the Coalition that have been jeopardizing votes. As for tax cuts on middle income earners and small businesses, Labor’s acceptance of them speaks to voter concerns about living costs, jobs, and wages. Chart 12The Coalition Is Out Of Synch On Taxes A Year Of Change In Australia? A Year Of Change In Australia? Labor is also closer to the median voter on the aforementioned financial sector scandals. The Coalition stands to suffer because it has developed a reputation for being too cozy with the banks (Chart 13). This is one of the biggest perceived differences between the two major parties – in addition to the negative perception of intra-Coalition betrayal – and it is possibly one of the most salient issues in the election. This presents a serious danger for the Coalition. Chart 13Banks: The Coalition’s Ball And Chain A Year Of Change In Australia? A Year Of Change In Australia? What would a Labor government bring? The market will be jittery about Shorten’s attempts to increase tax revenue, which threatens a non-negligible tightening of fiscal policy. Shorten wants to raise taxes on high income earners; remove or lower deductions and discounts (such as on capital gains); crack down on tax evasion; and tighten control over a range of tax practices specific to Australia (limiting “negative gearing” and cutting cash refunds for “franking credits”). He is also taking a tough position on banks and the energy sector. At the same time, it is clear from Labor’s proposals in 2016 (Chart 14) that there will be a hefty amount of new spending coming down the pike if a Labor government is formed – primarily on education, health, infrastructure and job training. The tax cuts that Shorten does support will go to those with a higher propensity to consume, as well as to SMEs that are responsible for job creation. Chart 14Labor’s Spending Plans Unlikely To Change Much A Year Of Change In Australia? A Year Of Change In Australia? Ultimately, Australia’s recent history, taken in consideration with the global business cycle, does not suggest that the Labor Party is all that much more fiscally profligate than the Coalition – but the current budget balance does suggest that there is substantial room to increase deficits, which is convenient for a government that is predisposed to give voters more services (Chart 15). Hence fiscal easing is the path of least resistance - one that could make the RBA even more comfortable in raising interest rates if the conditions laid out earlier in this report come to pass. Chart 15Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Australia's Next Government Will Have Room To Spend! Bottom Line: The Australian Labor Party is slightly favored to win the next Australian election. This is a low-conviction call given the tight competition in public opinion polling and other mixed indicators. Broadly speaking, Labor’s shift to the political center on immigration and some tax issues makes the party more electable relative to the Coalition; meanwhile its promise of more government services fits with voter demands. We do not accept the narrative that Shorten’s Labor Party will engage in substantial fiscal tightening. The path of least resistance is for tax cuts as well as revenue collection, and for greater government spending. On the other hand, if the Coalition capitalizes on the incumbent advantage and stays in power, larger tax cuts will be in store. Hence we expect Australia to see marginally larger-than-expected budget deficits and fiscal thrust as the one reliable takeaway of next year’s election. Fixed Income Investment Implications We continue to recommend an overweight stance on Australian government bonds in currency-hedged global bond portfolios. While we have laid out the conditions that would make us change that view in this report, it is still too soon to position for such a move. Our RBA Monitor, which measures the cyclical pressures on the central bank to change monetary policy settings, is modestly below the zero line (Chart 16). This indicates a need for easier policy, although the indicator is starting to rise driven by the inflation components in the Monitor (bottom panel). In terms of market pricing, there are only 15bps of rate hikes over the next year discounted in the Australian Overnight Index Swap (OIS) curve, so markets are exposed to any shift to a more hawkish bias by the RBA as 2019 progresses. Chart 16Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Our RBA Monitor Starting To Turn Less Dovish Looking purely at Australian government bond yields, the forward curves are priced for very little change in yields over the next year (Chart 17). This suggests that outright duration trades in Australia look uninteresting from a carry perspective of betting against the forwards. We continue to prefer Australian bonds on a relative basis to global developed market peers until there is more decisive evidence pointing to convergence of Australian growth and inflation to the other major economies (bottom panel). Chart 17Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Stay Overweight Australian Government Bonds Over the past year, Global Fixed Income Strategy has recommended tactical trades in Australian money market futures to fade the pricing of RBA hikes that we did not expect to materialize. Specifically, we entered a long position in December 2018 Australian 90-Day Bank Bill futures on October 17, 2017, then switched to a long October 2019 90-Day Bank Bill futures position on May 29, 2017. The latter contract is now trading at implied interest rate levels just above the RBA’s 1.5% Cash Rate (Chart 18), suggesting that there is no more value in this trade.  Chart 18Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade Taking Profits On Our Long Bank Bill Futures Trade We therefore take a profit of 21bps on the Bank Bill futures trade, while awaiting evidence from the “RBA Hike Checklist” introduced in this report before considering trades that will benefit from a more hawkish central bank.   Robert Robis, CFA, Senior Vice President Global Fixed Income Strategy rrobis@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1      Technically the House of Representatives election could occur as late as November 2, while the half Senate election is due May 18, but the norm is to hold the election simultaneously. The 2016 election was a “double dissolution” involving the election of the entire Senate and House of Representatives.  2      Please see BCA China Investment Strategy Special Report, “China’s Property Market: Where Will It Go From Here?” dated September 13, 2018, available at cis.bcareserach.com. 3      We would slightly favor Labor leading a slim majority in the Senate as well as in the House. In the Senate, the half of the seats that are up for grabs are evenly split and the polling at this early stage favors Labor over the Coalition. The poor performance of the Greens, in recent polling and in the Victoria state election, suggests a positive development for Labor on the margin, whereas One Nation, whose polls are improving, poses a threat to the Coalition. 4      Labor is fighting for 15 “marginal” (hotly contested) seats and 28 “fairly safe” seats, while the Coalition is only fighting for 12 marginal seats and 14 fairly safe seats.  

Highlights On a 6-month horizon, go long a combination of banks and high quality 10-year bonds. The recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Stay short oil and gas versus financials. During December, use any sharp sell-offs in sterling to buy the pound… …and to downgrade the FTSE100 to underweight. Feature Chart of the WeekBanks And Bond Yields Were Connected At The Hip... Until This Year Banks And Bond Yields Were Connected At The Hip... Until This Year Banks And Bond Yields Were Connected At The Hip... Until This Year Back in June, in Oddities In The 1st Half, Opportunities In The 2nd Half we pointed out two striking oddities in financial market behaviour. One oddity was the sharp decoupling of crude oil from industrial commodity prices (Chart I-2). It is highly unusual for crude oil to outperform copper by 50 percent in the space of just six months. We argued that such an extreme deviation would have to correct one way or another. Which of course it did… Chart I-2Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled Crude Oil Abruptly Decoupled From Industrial Commodities... Then Abruptly Recoupled The other oddity was the abrupt decoupling of bank equity performance from bond yields (Chart I-3 and Chart of the Week). Bank equity prices and bond yields are usually connected at the hip. The tight connection exists because higher bond yields tend to signal stronger economic growth, either real or nominal. Stronger growth should be good for banks as it is associated with both accelerating credit growth and lower provisions for non-performing loans. Chart I-3Banks Decoupled From Bond Yields... But Will Recouple Banks Decoupled From Bond Yields... But Will Recouple Banks Decoupled From Bond Yields... But Will Recouple On the back of these two striking oddities, we recommended a compelling trade: short oil and gas versus financials. This trade is now in profit and has further to run, but today we want to introduce a new trade: go long a combination of banks and bonds. Explaining The Oddities Of 2018 The underperformance of banks from February through September was entirely consistent with similar underperformances in the other classically growth-sensitive sectors – industrials, and basic materials as well as the decline in industrial commodity prices (Chart I-4). Furthermore, these underperformances started well before any inkling of a trade war. This suggests that the cyclical sector underperformances were correctly reflecting a common or garden down-oscillation in global growth. Chart I-4Oil And Gas Was The Odd Man Out Oil And Gas Was The Odd Man Out Oil And Gas Was The Odd Man Out Oil was a striking oddity because its supply dynamics, rather than its demand dynamics, were dominating its price action, at one point lifting its year-on-year inflation rate to 70 percent for Brent and 80 percent for WTI. Part of this surge in year-on-year inflation was also to do with the ‘base effect’, the dip in the oil price to $45 in the summer of 2017. The base effect shouldn’t really bother markets. After all, most people do not consciously compare a price today with the price precisely a year ago. The problem is that central banks do compare a price today with the price precisely a year ago in their inflation targets. Clearly, when oil price inflation was running at 80 percent, it was underpinning headline CPI inflation, central bank reaction functions, and thereby bond yields. Hence, the two striking oddities – oil abruptly decoupling from industrial commodities (Chart I-5) and bond yields abruptly decoupling from banks – are two sides of the same coin. From February through September, bond yields were taking their cue, at least partly, from the rising price of oil, given its major impact on headline inflation and on central bank reaction functions. Whereas banks, industrials, and industrial commodity prices were taking their cue from fading global growth and industrial activity. Chart I-5It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months It Is Highly Unusual For Oil To Outperform Copper By 50% In Six Months A Banks Plus Bonds Combination Could Be A Win-Win The oddities of 2018 are now correcting. With the oil price sharply lower, its year-on-year inflation rate has plunged to -10 percent (Chart I-6). Furthermore, as we have pointed out in recent reports, the sharp deceleration in global credit growth from February through September has clearly arrested and even reversed. The upshot is that banks and bond yields will recouple, one way or the other. Chart I-6Oil Inflation Down from 70% To -10% Oil Inflation Down from 70% To -10% Oil Inflation Down from 70% To -10% Most likely, global growth will rebound somewhat and the beaten-down bank equity prices have considerable scope for recovery (Chart I-7), while the restraint on headline CPI inflation will keep bond yields in check. Indeed, as President Trump recently tweeted: Chart I-7Global Growth Will Rebound, So Will Banks Global Growth Will Rebound, So Will Banks Global Growth Will Rebound, So Will Banks “Inflation down, are you listening Fed!” But if we are wrong and growth disappoints, bank equities are already beaten-down while a further downdraft in inflation will pull down bond yields. Either way, on a six month horizon a combination of banks and high quality 10-year bonds should be a win-win strategy. Given the different betas of the two investments, the recommended combination is 25 cents in the banks and 75 cents in the bonds. The preferred banks are European or euro area and the preferred bonds are U.S. T-bonds. Focus On Sectors And Currencies The remainder of this report is a reminder that successful macro investing requires the application of the Pareto Principle, also known as 80:20 rule. In macro investing, the vast majority of performance outcomes, ‘the 80’, are explained by a very small number of drivers, ‘the 20’. We find that the vast majority of a region’s or a country’s stock market relative performance is explained just by its distinguishing sector fingerprint combined with its currency (Chart I-8 - Chart I-12). Chart I-8Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Euro Stoxx 600 Vs. MSCI Emerging Markets = Global Healthcare In Euros Vs. Global Technology In Dollars Chart I-9Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Euro Stoxx 50 Vs. S&P 500 = Global Banks In Euros Vs. Global Technology In Dollars Chart I-10FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars FTSE 100 Vs. S&P 500 = Global Oil And Gas In Pounds Vs. Global Technology In Dollars Chart I-11FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen FTSE 100 Vs. Nikkei 225 = Global Oil And Gas In Pounds Vs. Global Industrials In Yen Chart I-12FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros FTSE 100 Vs. Euro Stoxx 50 = Global Oil And Gas In Pounds Vs. Global Banks In Euros Major stock markets comprise of multinational companies whose sales and profits are internationally diversified. But each major stock market has a distinguishing ‘long’ sector in which it contains up to a quarter of its total market capitalisation, as well as a distinguishing ‘short’ sector in which it has a significant under-representation. The combination of this long sector and short sector gives each equity index its distinguishing fingerprint (Table I-1): FTSE100 = long energy, short technology. Eurostoxx50 = long banks, short technology. Nikkei225 = long industrials, short banks and energy. S&P500 = long technology, short materials. MSCI Emerging Markets = long technology, short healthcare. Table I-1Each Major Stock Market Has A Distinguishing Fingerprint Oil, Banks, And Bonds: The Oddities Of 2018 Oil, Banks, And Bonds: The Oddities Of 2018 The other important factor is the currency. The FTSE100 oil and gas stock, BP, receives its revenue and incurs its costs in multiple major currencies, such as euros and dollars. In other words, BP’s global business is currency neutral. But BP’s stock price is quoted in London in pounds. Hence, if the pound strengthens, the company’s multi-currency profits will decline relative to the stock price and weigh it down. Conversely, if the pound weakens, it will lift the BP stock price. This means that the domestic economy can impact its stock market through the currency channel. Albeit it is a counterintuitive relationship: a strong economy via a strong currency hinders the stock market; a weak economy via a weak currency helps the stock market. What does all of this mean for our European country allocation right now? From a sector perspective, a stance that is short oil and gas versus financials penalises the FTSE100 versus the Eurostoxx50, given the FTSE100’s oil and gas fingerprint and the Eurostoxx50’s banks fingerprint. Against this, a weakening pound would support the FTSE100. Given that Theresa May’s Brexit agreement will meet stiff resistance when it comes to Parliament in the second week of December, the point of maximum risk for the pound is still ahead of us. But as we argued last week, we ultimately expect relief for the pound as: either the Article 50 process is extended, or the U.K. moves into a transition period within a negotiated Brexit.1 Hence, during December, use any sharp sell-offs in sterling to buy the pound, and to downgrade the FTSE100 to underweight.   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week we note that this year’s sell-off in Italian equities is technically very stretched. Therefore, in a continued de-escalation of the budget spat between Italy and the EU, Italian equities would be ripe for a strong countertrend burst of outperformance. On this basis, our recommended trade is long MIB versus the Eurostoxx with a profit target of 5% and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-13 Long MIB Vs. Euro Stoxx Long MIB Vs. Euro Stoxx 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 Footnote 1 Please see the European Investment Strategy Weekly Report “DM Versus EM, And Two European Psychodramas”, November 22, 2018 available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Turkish commercial banks have been ramping up purchases of local currency government bonds. Given that commercial banks create new money “out of thin air” when they buy assets from non-bank entities, should investors interpret this phenomenon positively or negatively? Under the backdrop of a severe recession, we view this phenomenon as a stabilizing factor that can provide moderate relief - a painkiller rather than a poison. Meanwhile, record-wide net interest rate spreads as well as rising purchases of government bonds yielding around 20% are positive for banks’ earnings amid an otherwise dismal economic outlook. To express a selective positive bias toward this depressed and still fundamentally challenged market versus other EMs, we recommend a relative equity trade: long Turkish banks / short EM banks, currency unhedged. Feature On August 15, 2018, we upgraded our stance on Turkish markets from underweight to neutral and closed our shorts in the currency and bank stocks after having been bearish/underweight for several years.1 Our rationale was that Turkish equity and currency valuations had become cheap, and its financial markets oversold. Yet we stated that the adjustment in interest rates and ensuing economic slowdown were still pending – preventing us from going overweight. Are Turkish interest rates now sufficiently high to put a floor under the currency? In other words, is monetary demagoguery – relentless bank lending promoted by the authorities amid high inflation – a thing of the past?2 At first glimpse, the answer appears to be no. Turkish banks have been aggressively buying local currency government bonds – at a time when foreigners have been selling their holdings (Chart I-1). Chart I-1Turkish Banks Have Been Buying Local Government Bonds Turkish Banks Have Been Buying Local Government Bonds Turkish Banks Have Been Buying Local Government Bonds As we demonstrate in Box I-1 on page 9, commercial banks in all countries create new money when they purchase any asset, including any security, from non-bank entities. One can argue that the Turkish banks’ creation of money “out of thin air” holds the potential to trigger renewed currency depreciation. Furthermore, banks’ financing of the government depresses government bond yields, bringing down market-determined local currency interest rates. On the other hand, there is also evidence that banks have drastically curtailed financing to the real economy, which is causing a severe collapse in domestic demand. This has already squeezed imports and has started to narrow the current account deficit - a necessary condition for macro and exchange rate stabilization (Chart I-2). As such, it seems Turkey’s necessary macro adjustment is already under way. Chart I-2Turkey: Current Account Deficit Is Narrowing Turkey: Current Account Deficit Is Narrowing Turkey: Current Account Deficit Is Narrowing These two dynamics – (1) banks financing the government by creating money “out of thin air” and (2) banks inhibiting financing to households and companies – are conflicting. While many economists refer to this phenomenon as a crowding out of the private sector by the government, we disagree with this analytical framework. Please refer to Box I-1 on page 9 for a more detailed discussion. Our assessment of these dynamics is as follows: In the current context of rapidly shrinking domestic demand, banks’ financing of the government is a mitigating factor in the ongoing macro adjustment. Commercial banks’ financing of the public sector via bond purchases caps market-determined interest rates and allows the government to spend, therefore diminishing the blow to the real economy. Consequently, the expansion of Turkish banks’ purchases of government bonds is a silver lining in an otherwise harsh macro adjustment. So long as this phenomenon is not prolonged indefinitely and does not cause the currency to plunge anew, it is an acceptable strategy for both banks and the government. In fact, it could form a fertile ground for Turkish banks’ stock prices to start rising from the ashes, at least relative to other emerging markets. Fiscal Deficit Financing By Banks: Poison Or Painkiller? Diagnosing a patient in critical condition and prescribing the right medicine is a complex task. Assessing monetary conditions in a financial crisis-stricken economy and determining the correct policy mix is no different. While monetary tightening may be the right medicine for some parts of the economy, monetary easing can be appropriate for others parts. In fact, this is what is currently happening in Turkey. There is a dichotomy occurring between monetary easing for the government (in the local currency bond market) and monetary tightening for companies and households. Chart 3 demonstrates that local currency broad money growth now slightly exceeds bank loan growth. One of the reasons for this is that banks are literally creating money by purchasing government securities. With a low likelihood of default and a yield of 20%, government securities are currently attractive for Turkish banks. On the surface, government deficit financing via money creation by banks might seem like a recipe for higher inflation. Yet, we have to put this phenomenon in the context of current cyclical economic conditions in Turkey. The economy is on the precipice of a major recession which will likely produce a major deflationary shockwave. Money and credit growth in real terms is negative (Chart I-3, bottom panel). In addition, government expenditures in real terms are now contracting, suggesting that fiscal policy is tight (Chart I-4). Furthermore, government debt levels are low – total public debt stands at 31% of GDP. This means that fiscal expansion is a lever that authorities can and should be using. Chart I-3Turkey: Money And Loan Growth Are Negative In Real Terms Turkey: Money And Loan Growth Are Negative In Real Terms Turkey: Money And Loan Growth Are Negative In Real Terms Chart I-4Turkey: Fiscal Policy Is Tight Turkey: Fiscal Policy Is Tight Turkey: Fiscal Policy Is Tight Hence, we infer that banks’ financing of government expenditures are not excessive from a macro perspective; particularly when considering the currently heightened recessionary crosscurrents. Bottom Line: The expansion of Turkish banks’ purchases of government bonds are capping local bond yields and, on the margin, allowing the government to support the economy. Given the backdrop of a severe recession, we view this as a stabilizing factor – a painkiller rather than a poison. Monetary Tightening In The Real Economy Commercial banks have substantially tightened financing to companies and households. Interest rates on bank loans to businesses and consumers have risen much more than the central bank’s policy rate. The former are now 850 basis points higher than the latter (Chart I-5, top panel). Chart I-5Turkey: Tight Monetary Conditions In The Real Economy Turkey: Tight Monetary Conditions In The Real Economy Turkey: Tight Monetary Conditions In The Real Economy In real terms (deflated by core CPI), commercial bank loan interest rates are now 8% (Chart I-5, bottom panel). High real bank loan rates charged to households and companies will cause domestic demand to collapse – despite a real policy rate at zero. Provided economic activity is already shrinking, it will be difficult for debtors to achieve a hurdle real rate of 8%. This is already producing a collapse in loan demand and a material retrenchment in consumer and business spending. A statistical regression of economic activity variables on the change in borrowing costs demonstrates that the Turkish economy is in for a severe recession across all sectors, with capital expenditures being the hardest hit (Chart I-6). Chart I-6Turkey: The Recession Will Be Severe Turkey: The Recession Will Be Severe Turkey: The Recession Will Be Severe A cheapened currency and high borrowing costs are the correct medicine for the nation’s deep economic imbalances – i.e. its large and persistent current account deficits. In fact, the real economy has already been adjusting: the current account excluding oil is starting to narrow (refer to Chart I-2 on page 2). This together with cheap valuations may help put a floor under the lira (Chart I-7). Chart I-7The Turkish Lira Is Cheap The Turkish Lira Is Cheap The Turkish Lira Is Cheap Bottom Line: Interest rates on bank loans have increased much more than the central bank policy rate and are sufficiently high in real terms, foreshadowing a severe, but necessary, domestic demand contraction. Go Long Turkish Banks / Short EM Banks There appears to be a relative tactical opportunity to go long Turkish banks while shorting EM banks. Relative share prices in dollar terms between Turkish and EM banks are at an all-time low (Chart I-8). Odds are that Turkish banks will outperform for the time being. Chart I-8Long Turkish Banks / Short EM Banks Long Turkish Banks / Short EM Banks Long Turkish Banks / Short EM Banks Not only are Turkish banks charging a large spread on loans relative to the policy rate, they are also enjoying a wide net interest rate spread – lending rates minus deposit rates. In fact, Turkish banks’ net interest rate spread is presently the highest in recorded history (Chart I-9, top panel). This is very positive for banks’ net interest margins (NIM) – net interest income as percent of loans - and earnings (Chart I-9, bottom panel). Chart I-9Turkish Banks' Margins Are Widening Turkish Banks' Margins Are Widening Turkish Banks' Margins Are Widening In addition, banks’ purchases of government bonds allows them to expand their balance sheets and earn a yield that is around 20%. Given the government’s low credit risk, this is also positive for banks’ profits. On the negative side, non-performing loans (NPLs) are set to surge. Therefore, any investment consideration should take into account banks’ equity erosion due to surging NPLs. Turkish banks are presently extremely under-provisioned, as illustrated in Chart I-10. Yet their share prices have already plunged substantially, discounting a higher level of NPLs than banks have acknowledged and provisioned for. Chart I-10Turkey: NPLs Are Set To Surge Turkey: NPLs Are Set To Surge Turkey: NPLs Are Set To Surge We have performed a credit stress test for the Turkish banking system. The scenario analysis shown in Table I-1 illustrates that banks’ share prices are already pricing in a significant amount of bad news regarding the NPL cycle. For example, in a scenario where the non-performing credit assets (NPCA) ratio rises to 20% from its current 3.5% level, bank stocks would be fairly valued at current levels. Table I-1Credit Stress Test For Turkish Banks Turkish Monetary Demagoguery: A Thing Of The Past? Turkish Monetary Demagoguery: A Thing Of The Past? Considering that the NPL-to-total-loan ratio reached 18% after the 2001 currency crisis, we believe 20% is a reasonable estimate. The key difference between now and the 2001 crisis is that woes in 2001 were related to unsustainable government debt, while Turkey’s present problems stem from excessive private debt. This valuation part of the stress test assumes that the fair value for the price-to-book value (PBV) ratio adjusted for all credit losses is 1.3 - the average PBV ratio for EM banks since 2011. In short, banks’ stock prices are currently trading close to their fair value assuming 20% NPCA (Table I-1). In all scenarios, we assume a recovery rate of 40%. In terms of structural valuations, using our model for the cyclically-adjusted P/E (CAPE) ratio, Turkish banks are currently trading at two standard deviations below their fair value in absolute terms, and two-and-half standard deviations relative to the other EM banks (Chart I-11). Chart I-11Turkish Bank Stocks Are Cheap Turkish Bank Stocks Are Cheap Turkish Bank Stocks Are Cheap Given that we expect an additional selloff in EM risk assets, Turkish bank stocks will likely relapse in absolute terms. This is why we recommend a market-neutral bet. In short, we expect more downside in the share price of EM banks than in Turkish ones for now. Investment Conclusions Given our overarching negative view on emerging markets as a whole, we are reluctant to be bullish on Turkish risk assets in absolute terms. The basis behind why we are not upgrading our stance on Turkey’s overall stock index is as follows: Non-financials companies are about to experience severe profit shrinkage as the recession deepens. Conversely, contraction in banks’ earnings will be mitigated by a very wide NIM and an increased financing of the government at yields above 20%. In addition, we expect EM currencies and high-yielding local bonds to resume their selloff, and corporate and sovereign credit spreads to widen. Given Turkey has historically been a high-beta market, it is difficult to bet on its financial markets outperforming EM peers in a bear market. Finally, the recent rebound in Turkish markets was from quite oversold levels and is currently facing its first technical resistance (Chart I-12). Chart I-12The Lira And Local Government Bonds Are Facing Their First Technical Resistance The Lira And Local Government Bonds Are Facing Their First Technical Resistance The Lira And Local Government Bonds Are Facing Their First Technical Resistance Overall, we continue to recommend a neutral allocation to Turkey for EM dedicated equity investors, as well as local currency bond and credit portfolios. Nevertheless, to express a selective positive bias toward this depressed market versus other EMs, we recommend a relative equity trade: Long Turkish banks / short EM banks, currency unhedged. Stephan Gabillard, Senior Analyst stephang@bcaresearch.com Box 1 How Banks Create Money By Purchasing Assets From A Non-Bank Entity We demonstrate, in a stylized example, how a commercial bank (Bank 1) creates a new deposit in the banking system – which consists of two banks (Bank 1 and Bank 2) - when it purchases a bond from an investor (Investor A) that is a non-bank. For simplicity, we presume that this is the only transaction in the banking system on that day. All numbers we cite here are local currency values and all transactions take place in local currency. We assume at the beginning of Day 1 that both Bank 1 and Bank 2 each have excess reserves (ERs) of 1000 and existing deposits of 1000 (Figure I-1). Hence, the overall banking system ERs amount to 2000 and total deposits are equal to 2000. Figure I-1Begining Of Day 1 Balance Sheet & Transactions Turkish Monetary Demagoguery: A Thing Of The Past? Turkish Monetary Demagoguery: A Thing Of The Past? As Bank 1 purchases a bond at the price of 300 from Investor A, the following balance sheet accounting entries take place (these entries are shown in red in Figure I-1): Bank 1 acquires a bond and its assets now include a bond valued at 300. Investor A has an account at Bank 2, so to pay for this purchase Bank 1 transfers 300 from its ERs to Bank 2’s ERs account at the central bank. Bank 1 ERs decline by 300. Hence, its assets and liabilities have not changed – it has just swapped 300 in ERs with 300 in bond (Figure I-1). Bank 2 credits Investor A’s deposit account by 300. Hence, Investor A received a deposit valued at 300 that it previously did not have. This is a new deposit for the whole banking system that was created “out of thin air”. Bank 2’s ERs and hence its total assets have risen by 300. This rise in Bank 2’s assets is balanced by the increase of its deposit by 300 (Figure I-2). In brief, this deposit is nothing more than an accounting entry to balance Bank 2’s assets and liabilities. Yet, deposits represent money and give their holders purchasing power. Figure I-2End Of Day 1 Balance Sheet Turkish Monetary Demagoguery: A Thing Of The Past? Turkish Monetary Demagoguery: A Thing Of The Past? Assuming that during the day there was no other transaction in this banking system, the latter’s ERs have remained unchanged at 2000 yet its total deposits have risen from 2000 to 2300. A new deposit worth 300 was created without the central bank providing any funding (new ERs) to the banking system. Money supply is the sum of all deposits in the banking system and commercial banks create deposits “out of thin air” when they lend to non-banks or purchase assets from non-banks. As such, banks do not need to reduce private sector lending to fund the government. In other words, no “crowding out” of the private sector needs to take place for banks to buy government bonds.   Footnotes 1      Please see Emerging Markets Strategy Special Alert "Turkey: Booking Profits On Shorts," dated August 15, 2018, the link available on page 14. 2      Please see Emerging Markets Strategy Special Report "Turkey's Monetary Demagoguery," dated June 1, 2016, available at ems.bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Bond yields have trapped equities, and equities have trapped bond yields. The double-digit investment opportunities are within asset-classes. From a tactical perspective: Banks will outperform the broad market. EM will outperform DM. The Eurostoxx50 will briefly outperform the S&P500. Raw industrial commodities will outperform crude oil. Feature What has been the biggest driver of financial markets this year? Trade wars and the emerging market slowdown? The budget spat between Italy and the EU Commission? The U.S. mid-term elections? Or perhaps, central bank policy normalization? These are all sensible answers, and each one has generated endless output of commentary and analysis. But none of these tells the biggest story of 2018. Chart of the WeekIn 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields In 2018, Bond Yields Have Trapped Equities, And Equities Have Trapped Bond Yields The Biggest Story Is Not Economics Or Politics... It Is Mathematics This year, the two largest five-day plunges in the global stock market - 6 percent in February and 7 percent in mid-October - resulted directly from the two largest five-day spikes in the global bond yield (Chart I-2 and Chart I-3). This simple observation reveals the biggest story in the financial markets this year: the hypersensitivity of the stock market to rising bond yields, and especially when the global 10-year yield approaches 2 percent - or equivalently 'the rule of 4': when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent (Chart of the Week).1 Chart I-2Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Chart I-3Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields With the global stock market now flat year-to-date, it follows that excluding these two five-day plunges, global equities would be comfortably higher even with the emerging market slowdown, trade war quarrels, and political spats. Meaning that this year's market action is not explained by economics or by politics. It is explained by mathematics, and specifically the great misunderstanding of investment risk. Previous reports have focused on this great misunderstanding, most recently Risk: The Great Misunderstanding Of Finance, to which we refer our readers. Here, we will just summarize:2 An investment's risk depends on the negative asymmetry of its short-term returns. At very low bond yields, bond returns develop the same negative asymmetry as equity returns. This means that equities lose their excess riskiness versus bonds, requiring equity valuations to experience a phase transition sharply higher. But when bond yields normalize, equities regain their excess riskiness versus bonds - and their valuations must suffer a phase transition sharply lower. This phase transition to sharply lower equity valuations is most pronounced when the global 10-year bond yield rises to 2 percent. This dynamic has proved to be the biggest driver of financial markets in 2018, and is likely to be the biggest driver in 2019 too. Essentially, higher bond yields can suddenly and viciously undermine the valuation support of equities, limiting the upside in the stock market (Chart I-4). In turn, a plunge in the stock market and other risk-assets threatens a disinflationary impulse, limiting the sustainable upside in bond yields. Chart I-4Equities Remain Richly Valued Equities Remain Richly Valued Equities Remain Richly Valued In effect, bond yields have trapped equities, and equities have trapped bond yields (Chart I-5). The result is that in 2018 the global asset-classes: equities, bonds, commodities, and cash have all ended up going nowhere. Indeed, the global 30-year bond yield has been trapped since early 2017!3 Chart I-5The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Global 30-Year Bond Yield Has Been Trapped For Two Years The Double-Digit Investment Opportunities Are Within Asset-Classes Although the global asset-classes have ended up going nowhere this year (Chart I-6), 2018 has still provided double-digit investment opportunities. But to find these double-digit opportunities, you have to look below the main asset allocation decision to within the asset-classes, in sector, region and country allocation. Chart I-6In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere In 2018, Global Asset-Classes Have Ended Up Going Nowhere For example, until very recently: banks had underperformed the broad equity market by 10 percent globally and 25 percent in Europe; emerging market equities had underperformed developed market equities by 15 percent; the Eurostoxx50 had underperformed the S&P500 by 13 percent; and raw industrial commodities had underperformed crude oil by 30 percent. But in the last month or so, these strong trends have exhausted and even started to reverse: banks have started to outperform the market; the Eurostoxx50 has eked ahead of the S&P500; emerging market equities have retraced versus developed market equities; and raw industrial commodities have made up much lost ground on crude oil (Charts I-7 - Chart I-10). One important reason is that the sharp down-oscillation in global credit growth which was responsible for many of this year's intra asset-class trends has now clearly rebounded into an up-oscillation. Chart I-7Banks Have Started To Outperform Banks Have Started To Outperform Banks Have Started To Outperform Chart I-8The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 The Eurostoxx50 Is Starting To Outperform The S&P500 Chart I-9EM Has Started To Outperform DM EM Has Started To Outperform DM EM Has Started To Outperform DM Chart I-10Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Industrial Commodities Are Starting To Outperform Crude Oil Hence, we expect these trend reversals to continue in the coming months. From a tactical perspective only, this means: 1. Banks will outperform the broad market. 2. EM will outperform DM. 3. The Eurostoxx50 will briefly outperform the S&P500. 4. Raw industrial commodities will outperform crude oil. Such an inflection point can leave investors scratching their heads in confusion, because sector performances seem to conflict with the economic data releases. But the conflict is easily resolved. Though we are now in mid-November, the economic data releases - for example, German exports - are a lagging indicator, referring to a time in the past, September, when global credit growth might still have been in a down-oscillation. Whereas the financial markets - for example, bank equities' relative performance - are a contemporaneous indicator, sensing credit growth's switch to an up-oscillation in real-time. Always remember that market prices move on the marginal change in information and expectations. To be absolutely clear, we are not referring to the business cycle. We are referring to predictable oscillations in credit growth that occur within the business cycle, but which nevertheless create double-digit investment opportunities - such as bank equities' relative performance. The Importance Of 6-Month Credit Growth Still, several clients have asked about our choice of 6-month credit growth, as it appears to be an arbitrary period plucked out of thin air or, more cynically, 'data-mined'. In fact, our choice of 6-month growth has a rock-solid foundation in economic theory.4 For any item, if supply lags demand by a period t, then economic theory proves that both the quantity of the item and its price will experience oscillations with half-cycle length t. Clearly, bank credit is such an item whose supply does lag demand. For example, a mortgage is only allocated and released after a time-consuming process of checking collateral and creditworthiness. For bank credit in aggregate, the lag between demand and supply, and specifically final spending of the funds, averages six to eight months. Once you accept this fundamental truth, it follows that credit growth must also experience oscillations whose half-cycles last six to eight months. So we end with a very important investment lesson. If you only look at the conventionally examined year-on-year credit growth data, you will not see the predictable oscillations in 6-month credit growth. And if you do not look at 6-month credit growth, you will miss the double-digit investment opportunities that are always on offer (Chart I-11). Chart I-11A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation A Sharp Down-Oscillation In Global Credit Growth Has Rebounded Into An Up-Oscillation The choice is yours. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 We use the MSCI All Country World Index in local currency terms to capture the global stock market. 2 Negative asymmetry of returns means the possibility of larger short-term losses than short-term gains. Please see the European Investment Strategy Weekly Report, "Risk: The Great Misunderstanding Of Finance", October 25, 2018 available at eis.bcaresearch.com. 3 Please see the European Investment Strategy Weekly Report, "Trapped: Have Equities Trapped Bonds?", September 13, 2018 available at eis.bcaresearch.com. 4 Please see the European Investment Strategy Special Report, "The Cobweb Theory And Market Cycles", January 11, 2018 available at eis.bcaresearch.com. Fractal Trading Model* Palladium has outperformed nickel by 50% in the past three months, but this strong trend is nearing exhaustion according to its 65-day fractal dimension. Hence, this week's trade recommendation is long nickel/short palladium setting a profit target of 14% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 Long Platinum / Short Nickel Long Platinum / Short Nickel 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 Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Feature In the late 1980s, half of the global stock market capitalization resided in Japan Furthermore, almost a third of the Japanese stock market capitalization resided in banks. It followed that to have a view on the global stock market you had to have a view on Japanese banks. Indeed, in 1988, five of the ten largest companies in the world were Japanese banks. Less than ten years later, the weighting of Japanese banks in the global stock market had collapsed to less than one percent, rendering Japanese banks a largely irrelevant part of a global equity portfolio. In the new millennium, it was the turn of European banks to step into the limelight. By 2007, the proportion of the euro area's stock market capitalization in banks had ballooned to a quarter. And then, Europe followed in Japan's footsteps. Today, the weighting of banks in the Euro Stoxx has plunged to around a tenth. Could European banks now become a global investment irrelevance too (Feature Chart)? Feature ChartAre Europe's Banks Following In Japan's Footsteps? Are Europe's Banks Following In Japan's Footsteps? Are Europe's Banks Following In Japan's Footsteps? European banks have performed very poorly. From their peak in 2007, a one dollar investment in euro area banks relative to the world index would now be worth just 15 cents. But Japanese banks have performed abysmally: from their peak in the late 1980s, a one dollar investment in Japanese banks relative to the world index would now be worth a pitiful 3 cents (Chart I-2 and Chart I-3).1 Chart 2Japan Dominated The Global Stock Market In The Late 1980s Japan Dominated The Global Stock Market In The Late 1980s Japan Dominated The Global Stock Market In The Late 1980s Chart 3Banks Have Performed Abysmally Banks Have Performed Abysmally Banks Have Performed Abysmally What turned Japanese bank shares from heroes to zeroes? Some people point to sky-high valuations: in the late 80s, Japanese bank dividend yields dropped below 0.5 percent (Chart I-4), and these high valuations clearly contributed to their subsequent poor investment performance. But this was not the main reason. Chart 4Japanese Banks Offered Miserly Dividend Yields Japanese Banks Offered Miserly Dividend Yields Japanese Banks Offered Miserly Dividend Yields Banks' Lifeblood Is Credit Creation The main reason for the severe underperformance of Japanese banks was that they lost their lifeblood: credit creation. Put simply, if bank assets stop growing structurally, then it is impossible for bank revenues to grow structurally. But in Japan, it was worse: from the 1990s through the mid noughties, private sector indebtedness actually shrank from 220 percent to 160 percent of GDP, and this explains the bulk of the abysmal performance of bank equities (Chart I-5). Chart 5Banks' Lifeblood Is Credit Creation Banks' Lifeblood Is Credit Creation Banks' Lifeblood Is Credit Creation The important lesson is that the structural outlook for bank equities depends first and foremost on the structural outlook for bank credit creation. This is especially true in Europe because the majority of credit intermediation occurs via the banking system rather than via the bond market. So how can we assess the structural outlook for bank credit creation? Basically by noting that there appears to be an upper limit at which all the good lending has been done. Additional bank credit then generates misallocation of capital and mal-investments. At which point, the economy and bank asset quality start to suffer, limiting any further increase in profitable lending. The precise point at which this happens is not set in stone, because high levels of public indebtedness, through 'crowding out', can pull down the limit of productive private indebtedness. And vice-versa. Nevertheless when private indebtedness, as a percentage of GDP, reaches the mid-200s, the evidence suggests that the scope for further growth becomes limited. On this basis, the outlook for bank asset growth in Europe is a mixed bag. In Switzerland, Sweden and Norway, private indebtedness already stands at 250 percent of GDP, implying that the stock of profitable bank assets is close to its upper limit (Chart I-6). Chart 6In Switzerland, Sweden And Norway, Private Indebtedness Is Very High In Switzerland, Sweden And Norway, Private Indebtedness Is Very High In Switzerland, Sweden And Norway, Private Indebtedness Is Very High Meanwhile in the euro area, private indebtedness ratios in the Netherlands and Belgium are already well above 200 percent, and in France at 200 percent. On the other hand, the ratios in Germany and Italy - the largest and third largest euro area economies - are barely above 100 percent (Chart I-7). This bestows on them the honour of the lowest privately indebted major economies in the world (Chart I-8), with considerable theoretical capacity for bank asset growth. Admittedly, Italy has a high level of public indebtedness. Nevertheless, it is hard to deny that if the banking system in Italy could be unfrozen, there is great scope for economically productive lending. Chart 7In Germany And Italy, Private Indebtedness Is Very Low In Germany And Italy, Private Indebtedness Is Very Low In Germany And Italy, Private Indebtedness Is Very Low Chart 8In Japan, Private Indebtedness Has Plunged In Japan, Private Indebtedness Has Plunged In Japan, Private Indebtedness Has Plunged Having said all that, we now turn to something that bank investors everywhere in the world should fear: blockchain. Blockchain Is A Mortal Threat To Banks The internet's major innovation was to decentralize and democratize information. Before the internet, the creation, ownership and dissemination of information was a function centralized to privileged organizations: governments, media and entertainment companies. But after the internet, anybody and everybody could create, receive and share content - and this has proved to be a game changer for the governments, media and entertainment companies that previously owned and/or controlled the information. In the same way, blockchain's major innovation is to decentralize and democratize trust. The Economist even described blockchain as "the trust machine".2 It follows that blockchain will be a game changer for the privileged organizations whose raison d'être is to supply trust and integrity in transactions - essentially, those that act as a middleman. Clearly, one such privileged organization is the banking system, because the banking system is really nothing more than a middleman that provides trust and integrity in the transaction between the people with savings and the people who want to borrow those savings. Granted, banks also assess and price the credit risk of borrowers as well as provide a degree of insurance for savers. But with the prevalence of universal credit scoring systems and compensation schemes, there is a growing tendency to decentralize those functions too. Put simply, blockchain removes the need for a middleman. Until now, counterparties without an established trust relationship could only transact through a middleman who could add the trust and integrity overlay. But once each participant in the transaction trusts the blockchain itself, they no longer need to use a costly intermediary, like a bank. Therefore, just as the internet has revolutionized politics, media and entertainment, it is our very high conviction view that blockchain will revolutionize the way that money, assets and securities are held, transferred and accounted for. And the major casualty will be the banking system as we now know it. Investment Considerations The structural case for European banks is that Germany and Italy - the largest and third largest euro area economies - have considerable scope for bank credit expansion. The structural case against is that the other European economies have very limited scope for bank credit expansion. Furthermore, we confidently predict that within a decade blockchain will have decentralized and democratized financial intermediation, transforming it to something that is unrecognizable from today. Overall, this will not be a good thing for bank investors. With this in mind, German and Italian real estate and real estate equities are a much cleaner structural play on the potential for increased private indebtedness in those economies, whether intermediated by the banking system or not (Chart I-9 and Chart I-10). Chart 9The Evolution Of Private Indebtedness... European Banks: The Case For And Against European Banks: The Case For And Against Chart 10...Drives The Real Estate Market Drives The Real Estate Market Drives The Real Estate Market We end with another important lesson from Japan. Even in a three decade long bear market, the banks had the capacity for countertrend bursts of outperformance from oversold levels, sometimes by as much as 50 percent in a year. This is because even within a structural bear trend, there are cycles of excessive depression. European banks could be ripe for such a countertrend burst of outperformance. This year, European banks sank by 35 percent versus European healthcare. However, the sharp deceleration in global credit growth which dragged them down has now clearly reversed (Chart I-11). On this basis, the next six months could be a countertrend phase: a brief opportunity to own some European banks, at least relative to other equity sectors. Chart 11European Banks Are Ripe For A Burst Of Outperformance European Banks Are Ripe For A Burst Of Outperformance European Banks Are Ripe For A Burst Of Outperformance Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Performances are calculated in common currency terms. 2 Please see 'the trust machine', The Economist, October 31, 2015.

Highlights Five risks to our bullish dollar stance need to be monitored: further weakness in the S&P 500; rebounding gold prices; stabilizing EM exchange rates and bond prices; Spanish bank stocks at multi-decade lows; and large, long-exposure by speculators to the greenback. However, China's lackluster response to stimulus and the U.S.'s domestic strength still favor the dollar. In fact, the key force likely to cause U.S. growth to converge toward weaker global growth will be a stronger U.S. dollar. Feature BCA has a positive bias toward the dollar for the coming six to nine months. Admittedly, the dollar is expensive, but cyclical determinants still favor a rally. The Federal Reserve is hiking rates as the U.S. economy is at full capacity and goosed up by fiscal injections. Yet global growth is very wobbly. This combination is a potent cocktail for USD strength. Despite these key sources of support, we cannot be dogmatic, especially as financial markets are anticipatory mechanisms, and therefore the dollar could have already priced in some of these developments. As such, this week we explore the key risks to our dollar view. While serious threats for the dollar exist over the upcoming two to three quarters, the key macro and financial drivers remain dollar bullish. The Threats 1) The S&P Sells Off Further The MSCI EAFE index, expressed in USD terms, is down nearly 20% since its January 2018 highs. Meanwhile, the S&P 500 has fallen 9% since its recent all-time high, or 7% vis-Ã -vis where it stood in late January. The risk is that as the global economic slowdown deepens, investors end up selling their good assets along with their bad ones. This means the S&P 500 could fall more. In fact, our colleague Peter Berezin writes in BCA's Global Investment Strategy that U.S. equities could fall an additional 6% from current levels before finding a durable support.1 The problem for the dollar is not whether stock prices fall. It is about what it means for the Fed. Until earlier this week, equity weakness had no impact at all on bonds. However, now, weak stock prices are dragging down U.S. bond yields. Moreover, while the U.S. yield curve slope steepened between August 24 and October 5, it is flattening anew (Chart I-1). All these market moves suggest investors are beginning to price out anticipated interest rate hikes. If U.S. stocks were to fall further, these dynamics would most likely deepen. However, since there is little monetary tightening to price out of the European or Japanese interest rate curves, such a move would likely lead to a dollar-bearish narrowing of interest rate differentials. Chart I-1It Took A Stock Market Rout For Investors To Reconsider The Fed's Path It Took A Stock Market Rout For Investors To Reconsider The Fed's Path It Took A Stock Market Rout For Investors To Reconsider The Fed's Path 2) Gold Is Rebounding Keynes might have called gold a barbarous relic of a bygone era, but as an extremely long-duration asset with no cash flow, the yellow metal remains an important gauge of global monetary and liquidity conditions. As the stock of dollar foreign-currency debt is large, a strong dollar is synonymous with tightening global liquidity conditions. Unsurprisingly, since 2017, gold and the dollar have been tightly negatively correlated (Chart I-2). However, since October, this correlation has been breaking down. Both the dollar and gold are moving up. This suggests that the recent increase in U.S. interest rates and in the dollar might not be as deleterious for the world as markets are currently anticipating. Chart I-2Is Gold Not Hating A Strong Dollar Anymore? Is Gold Not Hating A Strong Dollar Anymore? Is Gold Not Hating A Strong Dollar Anymore? Moreover, gold prices often lead EM asset prices. Since gold prices are highly sensitive to global liquidity, this makes sense. When the yellow metal sniffs out whiffs of reflation, it is only a matter of time before EM assets do as well. Since a rally in EM assets would lead to an easing in EM financial conditions, this easing would improve the global growth outlook (Chart I-3). Hence, rising gold prices might be a sign that while investors are increasingly negative on global industrial activity, the light at the end of the tunnel could be around the corner. The dollar would suffer if the outlook for global growth were to improve. Chart I-3EM Financial Conditions Hold The Key To Global Growth EM Financial Conditions Hold The Key To Global Growth EM Financial Conditions Hold The Key To Global Growth 3) EM Currencies And EM High-Yield Bonds Stabilizing Something strange is happening. While EM equity prices are still falling, EM high-yield bonds and currencies are not. In fact, EM FX and EM debt prices bottomed at the beginning of September, despite rising U.S. interest rates. However, since then, EM stock prices denominated in USD terms have fallen nearly 10% (Chart I-4). EM exchange rates and yields are the most important determinants of EM financial conditions. This suggests that despite EM stock prices falling fast, EM financial conditions may not be deteriorating as quickly as assumed. Chart I-4Are EM Financial Conditions Easing? Are EM Financial Conditions Easing? Are EM Financial Conditions Easing? This market action is in fact consistent with the development we highlighted in the gold market. We must therefore maintain a watchful eye on EM bonds and EM FX. Further meaningful improvement in these assets, while not BCA's base-case, would dangerously challenge our view that global industrial activity slows further, undermining our dollar-bullish view. 4) Spanish Banks Near Post-2008 Lows As we highlighted in August, Spanish banks are the most exposed major banks in the world to EM woes (Chart I-5).2 The exposure of the Spanish banking sector to the weakest EM economies represents 170% of capital and reserves, which is driving the entire euro area's exposure to these markets to 32% of Eurozone banks' capital and reserves. Chart I-5Who Has More Exposure To EM? Risks To The Dollar View Risks To The Dollar View The weakening in EM expected growth and the fall in EM currencies is a risk for Spanish banks. However, Spanish banks also maintain a large chunk of their EM exposure in wholly or partly owned subsidiaries. This means that while an EM crisis will definitely have an important impact on Spanish bank earnings, the impact on the balance sheet of Spanish banks is likely to be more limited. However, Spanish banks now trade in line with the levels that prevailed in Q1 2009, Q3 2012 and Q1 2016 (Chart I-6). In other words, Spanish banks are already pricing in a crisis, especially after the Spanish Supreme Court ruled that banks - not customers - must pay mortgage duties. Chart I-6Spanish Banks Are Discounting Plenty Of Bad News Spanish Banks Are Discounting Plenty Of Bad News Spanish Banks Are Discounting Plenty Of Bad News While markets may not be the most efficient mechanism when it comes to pricing future shocks, markets are very efficient at lateral pricing - i.e. the pricing of an event in one market, even if wrong, will be equally reflected in other markets. If the impact of an EM crisis is fully priced into Spanish banks, the impact of such a crisis is likely to also be reflected in the expectations of what the European Central Bank will do over the coming quarters, and thus it is also priced into the euro. The pessimism already present in Spanish banks and euro area financial equities may explain why the euro has not cracked below its August 17 lows, while global stock prices have. The bad news could simply already be baked into the cake! If Spanish bank stocks rebound, the dollar is likely to suffer; if they break down, the dollar will likely rally more. 5) Speculators Are Already Long The Dollar For the dollar to rise further, someone needs to buy it. The problem is that speculators have already been buying the greenback, and they are now aggressively long the dollar (Chart I-7). This means that it may become more difficult to find new buyers for U.S. dollars, especially as investors may be in the process of unloading their U.S. equities. To be fair, while it is true that the net speculative positions are elevated, they also can remain so for extended periods. Chart I-7Investors Are Long The Dollar Investors Are Long The Dollar Investors Are Long The Dollar Bottom Line: There are important risks to our dollar-bullish view that we need to closely monitor. They are: the global stock selloff migrating to the U.S., which could prompt investors to price out Fed rate hikes; gold rebounding, which might indicate marginal improvement in global liquidity conditions; EM exchange rates and high-yield bonds not weakening anymore, which could result in an easing in financial conditions, ending the deterioration in global growth; Spanish banks potentially already pricing in a dire outcome in EM; and speculators being already long the dollar. Despite these Risks, Why Do We Still Like The Dollar? The first reason relates to global growth. Ultimately, the dollar is a counter-cyclical currency. When global growth weakens, the dollar strengthens. China continues to generate potent headwinds for the world economy. Beijing has been stimulating the Chinese economy, but this stimulus is having a muted impact. As Arthur Budaghyan writes in the week's Emerging Market Strategy report, China's monetary stimulus is falling flat.3 Not only are excess reserves in the banking sector rather meager, Chinese banks are not showing a deep propensity to lend. It is not just about the behavior of Chinese banks: Chinese firms are also not displaying a high propensity to spend and borrow, which is weighing on the velocity of money in China (Chart I-8). As a result, this means that liquidity injections are not generating much impact in terms of loan growth and economic activity. Chart I-8Chinese Stimulus Is Falling Flat Because Economic Agents Are Cautious bca.fes_wr_2018_10_26_s1_c8 bca.fes_wr_2018_10_26_s1_c8 This is evident when looking at two variables. China's Li-Keqiang Index, our preferred measure of Chinese industrial activity, has stopped rebounding. In fact, it is currently weakening anew, which suggests that Chinese growth, despite all the supposed easing in monetary conditions, is not responding (Chart I-9, top panel). Moreover, Chinese infrastructure spending is also contracting at its fastest pace in 14 years (Chart I-9, bottom panel). Further, the slowing in Chinese real estate sales suggests that construction will not come to the rescue, especially as vacancy rates in Chinese major cities currently stand at elevated levels. Chart I-9Chinese Growth Outlook Is Deteriorating Anew Chinese Growth Outlook Is Deteriorating Anew Chinese Growth Outlook Is Deteriorating Anew We continue to monitor our China Play index (Chart I-10) to see if China is showing any underlying improvement, but the rally evident from June to October is now dissipating. The impact of stimulus thus looks like it is leaving investors wanting for more. Yet, as Matt Gertken and Roukaya Ibrahim argue in this week's Geopolitical Strategy service, additional stimulus will be limited as Xi Jinping is not yet abandoning his three battles against indebtedness, pollution and poverty.4 Hence, we expect China to remain a significant drag on global growth over the coming two to three quarters. Chart I-10China-Related Plays Are Losing Momentum China-Related Plays Are Losing Momentum China-Related Plays Are Losing Momentum The second issue that supports our bullish-dollar stance is the mechanism required for U.S. and global growth to converge. As Ryan Swift argues in BCA's U.S. Bond Strategy service, U.S. growth will not be able to avoid the gravitational pull of a weaker global economy.5 The type of divergence currently on display between the global and U.S. Leading Economic Indicators (LEIs) is generally followed by a deteriorating U.S. growth outlook (Chart I-11). Chart I-11U.S. Growth Ultimately Converges With The Rest Of The World U.S. Growth Ultimately Converges With The Rest Of The World U.S. Growth Ultimately Converges With The Rest Of The World However, this weakening in U.S. growth won't happen out of nowhere. Either there will be domestic vulnerabilities that prompt the U.S. to become more sensitive to foreign shocks, or the dollar will force this adjustment. Today, unlike in 2015 and 2016, the sales-to-inventory ratio does not point to any imminent decline in U.S. industrial activity; to the contrary, it suggests further improvements in the coming months (Chart I-12). This leaves the dollar as the main culprit to put the brakes on U.S. growth. Chart I-12U.S. Domestic Fundamentals Are Fine U.S. Domestic Fundamentals Are Fine U.S. Domestic Fundamentals Are Fine Since 2009, the greenback has been very responsive to the relative growth outlook between the U.S. and the rest of the world. The accumulated gap between the U.S. and global LEIs shows the total impact of growth divergences. This indicator has done a good job at foretelling how the dollar will trade (Chart I-13). The dollar tends to respond to U.S. growth outperformance. Only once the dollar has rallied enough to meaningfully tighten U.S. financial conditions does the U.S. growth outlook deteriorate vis-Ã -vis the rest of the world. Currently, this chart suggests we are nowhere near having reached a chokepoint for U.S. growth. Chart I-13A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World Since the Fed remains quite unconcerned by the weakness in global growth and global stock prices, we expect that world financial markets will have to plunge deeper, the dollar to rally higher and U.S. financial conditions to tighten further before the FOMC shows enough concern to hurt the dollar. We are not there yet. Bottom Line: The absence of a meaningful response by the Chinese economy to stimulus suggests that China may have hit a debt wall. This implies that Chinese growth remains fragile and therefore a drag on global growth. Hence, international economic activity and trade will continue to provide an important tailwind for the U.S. dollar. Meanwhile, the U.S. economy is not displaying enough domestic vulnerabilities to be overly sensitive to the softness in global growth. Instead, more rounds of dollar strength will be required to force U.S. growth to converge lower toward global economic activity. As such, these two forces remain powerful enough to overweight currency exposure to the USD within global portfolios. That said, the five risks described in the previous section must be kept in mind. At the current juncture, they only warrant buying a few hedges, such as our long NZD/USD recommendation, but they do not warrant underweighting the greenback. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Chinese Stimulus: Not so Stimulating", dated October 26, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth", dated October 25, 2018, available at ems.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "China Sticks To The "Three Battles", dated October 24, 2018, available at gps.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: Markit Services PMI outperformed expectations, coming in at 54.7. This measure also increased from the previous month's reading of 53.5. However, durable good ex-defense month-on-month growth underperformed expectations, coming in at -0.6%. Finally, monthly new homes sales underperformed expectations, coming in at an annualized pace of 553 thousand. DXY has appreciated by 0.8% this week. We are bullish on the U.S. dollar on a cyclical basis. Furthermore, momentum, one of the strongest predictive factors for the dollar continues to be positive. Finally, global growth should continue to slowdown, as the monetary tightening by Chinese authorities starts to weigh on the global industrial cycle. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area has been negative: Markit Manufacturing PMI surprised to the downside, coming in at 52.1. Moreover, Markit Services PMI also underperformed expectations, coming in at 53.3. Finally, private loan yearly growth surprised negatively, coming in at 3.1%. EUR/USD has fallen by 0.8% this week. We are bearish on the euro on a cyclical basis, as inflationary pressures continue to be too weak in the euro area for the ECB to start raising rates. Moreover, the fact that the euro area's economy is highly dependent on exports, makes it very sensitive to global growth and emerging markets. This means that the tightening by Chinese authorities should impact the euro area economy negatively, and consequently, put downward pressure on EUR/USD. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The leading economic Index outperformed expectations, coming in at 104.5. However, the coincident index surprised to the downside, coming in at 116.7. USD/JPY has been flat this week. We are neutral on the yen on a tactical basis, given that the current risk-off environment should continue to help safe havens like the yen. However, we are bearish on the yen on a cyclical basis, as inflation expectations are not well anchored in Japan. This means that the BoJ will continue to conduct ultra-dovish monetary policy for the foreseeable future, putting a cap on how high the yen can rise. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 GBP/USD has decreased by 1.5% this week. Given the lack of a geopolitical risk premium embedded into the pound, we expect GBP volatility to remain elevated. This means that any hiccups in Brexit negotiations could bring about some downside for the pound. Furthermore, inflation should remain contained, even amid a tight labour market. This is mainly because inflation dynamics in the U.K. are much more driven by the external sector, as imports represent a very large portion of British final demand. Given that the pound has remained stable this year, inflation will remain subdued. We are currently short GBP/NZD in our portfolio, to take advantage of the dynamics mentioned above. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD/USD has been flat this week. We are most bearish on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that the oil currencies should fare better than other commodity currencies, given that OPEC supply cuts, as long as Iranian sanction in oil will keep upward pressure on oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 NZD/USD has been flat this week. We are positive on the New Zealand dollar, particularly against the GBP, as there is very little room for kiwi rate expectations to fall. Moreover, this currency should also outperform the Australian dollar, given that New Zealand is less exposed to the Chinese industrial cycle than Australia. Nevertheless, we remain bearish on the NZD on a long-term basis, given that the new government proposals to reduce immigration and add an unemployment mandate to the RBNZ will lower the neutral rate in New Zealand, which will limit the central bank's ability to tighten monetary policy. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been negative: Core inflation underperformed expectations, coming in at 1.5%. This measure also decreased form 1.7% last month. Headline inflation also surprised to the downside, coming in at 2.2%. This measure decreased significantly, coming down from 2.8% the previous month. The Bank of Canada increased rates to tk% on Wednesday, and highlighted the potential for additional rate hikes over the coming 12 months. USD/CAD has been mostly flat this week. The upside in the CAD versus the USD is likely to be limited as the policy tightening by the BoC now seems well anticipated by market participants. To take advantage of this reality, we went short CAD/NOK in our portfolio. This cross also serves as a hedge to our long dollar view, given its positive correlation to the DXY. Despite some headwinds, the CAD should outperform the AUD, as we expect that oil will do better than base metals within the commodity complex. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has fallen by 0.5% this week, as investors have grown worried with the recent sell off in equities. We are bearish on the franc on a cyclical basis, given that inflation in Switzerland is still too weak for the SNB to move away from their ultra-dovish monetary policy. Moreover, Helvetic real estate prices should continue to fall, as the restrictions on immigration put forth by the Swiss government since 2014 should continue to weigh on housing demand. This will further hamper the ability of the SNB to tighten its extraodinarly accommodative monetary policy. That being said, EUR/CHF could continue to fall in the near term, as money flows into safe heaven assets amid the current sell off in equities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has risen by 0.9% this week. As expected, yesterday the Norges Bank left rates unchanged at 0.75%. In its report, the Norwegian central bank highlighted that although economic growth has been a little lower than anticipated, inflation has been somewhat higher than expectations. We are bullish on the krona against the Canadian dollar, given that rate hike expectation in Canada are much more fully priced in than in Norway even though the inflationary backdrop is very similar. Moreover, we are positive on the krone relatively to other commodity currencies like the AUD or the NZD, as we expect oil to outperform other commodities thanks to supply cuts by OPEC and sanctions against Iran. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 USD/SEK has rallied by 1% this week. We are positive on USD/SEK on a short-term basis, given that the SEK is the currency which is most negatively affected by the strength of the U.S. dollar. Furthermore, tightening by Chinese authorities should also weigh on the krona, given that the Swedish economy is very levered to the global industrial cycle, as many of its exports are intermediate goods that are then re-exported to emerging markets. That being said, we are bullish on the krona on a longer-term basis, as the Riksbank is on the verge of beginning a tightening cycle as imbalances in the Swedish economy are only growing more dangerous. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Overweight - Downgrade Alert Between Friday of this week and Monday of next, roughly 75% of the S&P banks index, representing the nation's largest lenders, will be reporting their Q3 earnings results. Our loan growth and earnings models continue to point significantly higher, particularly the former which is near a 30-year high, a result of a booming economy and record low unemployment. The question becomes whether or not the market cares; the S&P banks index delivered earnings outperformances in both Q1 and Q2 of this year and still underperformed the broad market. Further, the spread between relative performance and yields is widening and even a steepening in the yield curve has not been enough to stimulate a banks rally. We put the S&P banks index on downgrade alert in mid-May when we locked in gains vs. the SPX of 6% and removed it from the high-conviction overweight list, and warned that were banks not to participate in the next bond market selloff we would pull the trigger and downgrade to neutral. Our patience is wearing thin as we await the market's reaction to what should be another solid earnings quarter. Bottom Line: Stay overweight banks, but stay tuned. Bank Earnings Should Be Revealing Bank Earnings Should Be Revealing

Highlights Set your overall investment strategy with two 'rules of 4' based on 10-year bond yields: If either the Italian BTP or the sum of the U.S. T-bond, German bund and JGB stays above 4 percent, then sell equities and buy bonds. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB are in the 3-4 percent range, then remain broadly neutral. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB fall below 3 percent, then buy equities and sell bonds. Stay neutral to Italy's MIB and Italian banks for the time being. Among the mainstream European equity markets our top pick remains France's CAC. Feature Many people believe that Italy has one of the world's most indebted economies, but this widely-held belief is wrong. Although Italy's public indebtedness is high, Italy's private indebtedness is one of the lowest in the world (Chart of the Week). This means that Italy's total indebtedness is less than that of France and the U.K., and broadly similar to that of the U.S. (Chart I-2 - Chart 1-5).1 Chart of the WeekItaly's Private Sector Indebtedness Is One Of The Lowest In The World Italy's Private Sector Indebtedness Is One Of The Lowest In The World Italy's Private Sector Indebtedness Is One Of The Lowest In The World Chart I-2Italy: Total Indebtedness = 260% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Italy: Total Debt Up From 195% To 265% Of GDP Chart I-3France: Total Indebtedness = 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP France: Total Debt Up From 190% To 305% Of GDP Chart I-4U.K.: Total Indebtedness = 280% Of GDP U.K.: Total Indebtedness = 280% Of GDP U.K.: Total Indebtedness = 280% Of GDP Chart I-5U.S.: Total Indebtedness = 250% Of GDP U.S.: Total Indebtedness = 250% Of GDP U.S.: Total Indebtedness = 250% Of GDP The Myth Of Italian Indebtedness An economy's debt sustainability depends on its total indebtedness, and not on its public indebtedness or its private indebtedness in isolation. Debt becomes unsustainable when the marginal extra euro of debt results in misallocation of resources and mal-investment. At this point, the extra debt adds nothing to growth or, worse, it subtracts from growth. Therefore, debt reaches its sustainable limit when the economy has exhausted all productive uses for it. But it does not matter whether these productive uses are funded with private debt or with public debt. For example, successful economies require investment in high-quality healthcare and education. Some economies fund this with private debt, while others fund it with public debt. This means that if productive private indebtedness is low, there is more scope for productive public indebtedness. The crucial point is that Italy has extremely low private indebtedness, which means that it can afford relatively high public indebtedness before reaching the limit of debt sustainability. Right now, this is especially true because the Italian banking system remains dysfunctional, preventing the private sector from borrowing (Chart I-6). Under these circumstances, the Italian government can borrow the private sector's excess savings and debt repayments and put them to highly productive use - which will paradoxically reduce the deficit in the long term. Chart I-6Italy's Private Sector Is Not Borrowing Italy's Private Sector Is Not Borrowing Italy's Private Sector Is Not Borrowing Hence, the M5S/Lega government is following excellent economic policy in proposing a modest increase in the fiscal deficit in 2019. An appropriately sized and targeted fiscal stimulus is exactly what Italy needs right now. But this excellent economic policy will take time to bear fruit and show up in Italy's growth and deficit data. Italy's big problem is that bond vigilantes do not wait, they shoot first and ask questions later. Italy Is Especially Vulnerable To Bond Vigilantes Italy is also a world leader in running primary surpluses (Chart I-7 and Table I-1). In plain English, this means that the Italian government spends considerably less than it receives, if interest payments are excluded. Chart I-7Italy Is A World Leader In Running Primary Surpluses Italy Is A World Leader In Running Primary Surpluses Italy Is A World Leader In Running Primary Surpluses Table I-1Italy Has Consistently Run Primary Surpluses Italy, Bond Vigilantes, And Bubbles Italy, Bond Vigilantes, And Bubbles Put differently, Italy's government deficit results not from its operational spending relative to its income, but from the interest payments on its debt. This makes Italy especially vulnerable to the bond vigilantes. If the bond vigilantes distort Italy's interest rate, they can tip the Italian government into financial distress, even if that distress is not justified by the economic fundamentals. Is this a real risk? Sadly, yes. The euro debt crisis was essentially a liquidity crisis which resulted from bond vigilantes running amok. When irrational markets refuse to lend to sovereigns at a fair interest rate, maturing debt has to be refinanced at a penalising interest rate, causing an undeserved deterioration in the government's finances. Thereby, the irrational fear of insolvency becomes a self-fulfilling prophecy. Italy has an additional problem. When Italian bond prices decline, it erodes the value of the banking system's euro 350 billion portfolio of BTPs and weakens the banks' fragile balance sheets. If a bank's equity capital no longer covers its net non-performing loans (NPLs), investors get nervous. In this regard, the largest Italian banks now have euro 160 billion of equity capital against euro 130 billion of net NPLs, implying a cushion of euro 30 billion (Chart I-8). Chart I-8Italian Banks' Equity Capital Exceeds ##br##Net NPLs By Euro 30 Bn... Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn... Italian Banks' Equity Capital Exceeds Net NPLs By €30 Bn... So the markets would start to worry about Italian banks' mark-to-market solvency if their bond portfolios sustained a loss of €30 billion. We estimate this equates to the 10-year BTP yield breaching and remaining above 4 percent (Chart I-9).2 Chart I-9...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% ...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% ...The Excess Would Disappear If The 10-Year BTP Yield Stayed Above 4% The ECB solved the euro debt crisis at a stroke by committing to act as lender of last resort to distressed sovereigns at an 'undistorted' interest rate. Indeed, the commitment alone was enough to defeat the bond vigilantes without the ECB spending a single cent from its Outright Monetary Transaction (OMT) program.3 But recall that the ECB only threatened its firepower when the 2-year Spanish Bono yield had breached 6.5 percent and the 10-year yield had breached 7.5 percent. It follows that if the 10-year Italian BTP yield breached 4 percent, the yield would be high enough to hurt the Italian banks, but not nearly high enough for any powerful intervention from the ECB. Hence, the 10-year BTP yield at 4 percent is the level at which we would return to a pro-defensive strategy. Conversely, a level below 3 percent would create some margin of safety providing one precondition for a more pro-cyclical investment stance. In the meantime, the current level at 3.3 percent justifies a neutral cyclical stance to Italy's MIB and Italian banks. Among the mainstream European equity markets our top pick remains France's CAC. The Connection Between Bubbles And Liquidity Crises Bubble formation may seem to have no connection with a liquidity crisis but the two phenomena are closely related. Bubble formation is simply a brewing liquidity crisis resulting from irrational euphoria rather than irrational fear. A bubble forms when value investors stop investing on the basis of a valuation framework. Instead, they get lured into the momentum herd that is participating in a strong rally, and the additional buy orders fuel the euphoria. However, once all of the value investors have joined the momentum herd, and a value investor then suddenly reverts to type and puts in a sell order, the market will suffer a liquidity crisis. There are no buyers left! And finding one might require a substantial reversal in the price to attract an ultra-long-term deep value investor. As regular readers know, fractal analysis measures whether the herding behaviour in any financial instrument is becoming excessive. The analysis suggests that developed market equities are not yet at the tipping point of excessive euphoria that signalled the last two trend exhaustions in May 2017 and January 2018 (Chart I-10). But this does not mean that there are clear blue skies ahead. Chart I-10Developed Market Equities Are Not Yet At A Trend Exhaustion Developed Market Equities Are Not Yet At A Trend Exhaustion Developed Market Equities Are Not Yet At A Trend Exhaustion The danger is not that the rich valuation is irrationally excessive, but that it is hyper-sensitive to bond yields. At low bond yields, bonds offer no price upside but substantial price downside. Confronted with this increased riskiness of bonds, equity returns justifiably collapse to the feeble returns offered by bonds with no additional 'risk premium', giving equity valuations an exponential uplift. But if bond yields normalise, the process goes into vicious reverse - the rich valuation of equities must decline as exponentially as it rose. We have defined the danger point as when the sum of the 10-year yields on the U.S. T-bond, German bund, and JGB breaches and stays above 4 percent. In summary, set your overall investment strategy with two 'rules of 4' based on 10-year bond yields: If either the Italian BTP or the sum of the U.S. T-bond, German bund and JGB stays above 4 percent, then sell equities and buy bonds. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB are in the 3-4 percent range, then remain broadly neutral. If both the Italian BTP and the sum of the U.S. T-bond, German bund and JGB fall below 3 percent, then buy equities and sell bonds. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com 1 Indebtedness defined as a share of GDP. 2 Assuming that the average maturity of Italian banks' BTPs is around 5 years. 3 The ECB's Outright Monetary Transaction (OMT) program was created in 2012 in response to the euro debt crisis and facilitates the ECB's lender of last resort function to solvent but illiquid sovereign borrowers. Fractal Trading Model* We are pleased to report that our long China/short India trade achieved its 9% profit target and is now closed. This week, we note that the underperformance of the Eurostoxx50 versus the Nikkei225 is technically stretched, with a 65-day fractal dimension approaching the limit which signaled a very recent trend reversal. Hence, this week's recommended trade is long Eurostoxx50 versus Nikkei225. The profit target is 3.5% with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment's fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 Long Eurostoxx50 VS. Nikkei 225 Long Eurostoxx50 VS. Nikkei 225 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 Fractal Trading Model Recommendations Equities Bond & Interest Rates Currency & Other Positions Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations