Corporate Profits

Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1  We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Kumbaya Kumbaya Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Kumbaya Kumbaya Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Successive Rounds Of Tariffs Have Started To Add Up Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Kumbaya Kumbaya Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3  All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound Substantial Upside In The Pound Substantial Upside In The Pound   Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Growth Slowdown Has Been More Pronounced In The Soft Data Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump Manufacturing Output Rebounds Amid The ISM Slump Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth Easier Financial Conditions Will Boost Global Growth   Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Chinese Credit Should Support The Recovery In Global Growth Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Kumbaya Kumbaya Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step Earnings And Nominal GDP Growth Tend To Move In Lock-Step Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15).   Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives   Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. The Equity Risk Premium Is Quite High, Especially Outside The U.S. The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Kumbaya Kumbaya Strategic Recommendations Closed Trades

Brief Market Overview The S&P 500 convulsed last week, as a slew of weaker-than-expected data shattered investors’ confidence in the longevity of the business and profit cycles. Importantly, both ISM surveys declined month-over-month, arguing that the manufacturing sector’s ails are infecting services industries (second panel, Chart 1). Chart 1The U.S. Dollar Is The Key Indicator To Monitor The U.S. Dollar Is The Key Indicator To Monitor The U.S. Dollar Is The Key Indicator To Monitor The “In Fed We Trust” doctrine will get severely tested in upcoming weeks. The Federal Reserve’s reaction function to the poor data took center stage with bond investors pricing a 75% probability of a rate cut in late October. However, our four factor EPS growth model continues to predict that earnings will remain weak for the rest of 2019 (not shown). Thus, next year’s 10% EPS growth is wishful thinking and profit growth will begin to bottom in Q1/2020 at the earliest. Absent profit growth, stocks will have to face reality and continue to drift lower. Importantly, the U.S. dollar – the great reflator – is the key determinant of both profit and global economic growth in coming quarters. The third panel of Chart 1 shows that currently that are no advanced economy central banks that have a policy rate higher than the Fed. Historically, this has been U.S. dollar bullish and has weighed on SPX momentum (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 1). It remains to be seen if aggressive Fed easing can change this relationship, stave off recession and engineer a soft landing. U.S. Equity Strategy’s view remains intact that things will get worse before they get better and therefore a cautious overall U.S. equity market stance is still warranted on a cyclical 9-12 month time horizon. NIPA VS. SPX Profit Margins On the eve of earnings season, we decided to delve deeper into corporate profits and margins, and tally where we are in the cycle, specifically with regard to profit margin drivers. To start off, we compare overall economy profits, as measured by the NIPA accounts, with SPX earnings (Chart 2). While a lot of ink has been spent on this topic and the differences between these two profit measures are more or less well recognized and understood, Kenneth A. Petrick’s commentary on the issue is worth re-reading. Without going into much detail, according to Petrick four key reasons explain the differences between NIPA and S&P 500 profits: “coverage, changing shares, industry representation and accounting principles”.1 What interests us is the leading property of NIPA profits. Importantly, NIPA profits have peaked in advance of SPX earnings in the previous three cycles. Economy-wide profits may have already peaked this cycle, warning that the SPX earnings juggernaut is long in the tooth (top panel, Chart 2). Chart 2Earnings Fatigue Earnings Fatigue Earnings Fatigue Given that NIPA profits include a broader universe of firms, small and medium enterprise (SME) profits are weighing on the overall NIPA number. The recent drubbing in economically hypersensitive S&P 400 (mid-caps) and S&P 600 (small-caps) profit estimates confirms this SME profit deterioration and forewarns that SPX profits are likely running out of fuel. While the SPX has not cracked yet courtesy of the heavyweight S&P software index, the Value Line Arithmetic (VLA, gauging the average stock) and Value Line Geometric (VLG, gauging the median stock) indexes appear to have peaked and correspond better to the NIPA profits as these indexes are broad-based are not market capitalization weighted (bottom panel, Chart 3). Chart 3Top Chart Of The Year Top Chart Of The Year Top Chart Of The Year Worryingly for the S&P 500, the VLG index is an excellent leading indicator of the SPX. Based on empirical evidence, it has led the SPX tops in the past three cycles, making it a serious contender for our “Chart Of The Year” award (top panel, Chart 3). Not only have NIPA profits likely crested, but NIPA profit margins are in steep retreat and have definitively peaked. Similar to earnings, NIPA margins lead SPX profit margins (top panel, Chart 4). Importantly, the delta between the two margin gauges is surprisingly wide. This margin gap now sits nearly three standard deviations above the historical mean and has only been wider during the dotcom bubble (bottom panel, Chart 4). Our sense is that such an acute divergence is unsustainable and will likely narrow via a mean reversion in SPX margins. Chart 4Mind The Gap Mind The Gap Mind The Gap Primary Margin Drivers Taking a deeper dive into traditional margin drivers is instructive. We use SPX margins since 1960 and prior to that we have used reconstructed SPX earnings divided by U.S. GDP (gauging SPX sales) to recreate a longer-term equity market profit margin proxy. The primary net-profit margin drivers are: Interest rates, Tax rates, Labor costs / Globalization, And corporate pricing power. Globalization has been another significant profit margin booster in the U.S. As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit maximizing projects. The bond bull market since the early 1980s has been a clear contributor to the secular advance in profits margins. Interest rates cut both ways and the big rise in long-term bond yields post World War II ate into margins. If the bond bull market is ending, then interest rates will start eating into margins anew (interest rates shown inverted, top panel, Chart 5). Intuitively, taxes and margins are also inversely correlated (tax rate shown inverted, bottom panel, Chart 5). Following the 2018 fiscal easing package, the effective corporate tax rate is now hovering in the mid-teens and explains the jump to all-time highs in SPX margins. We doubt corporate tax rates will drop further. At best, taxes will be margin-neutral in the coming years. Rising labor input costs squeeze margins and declining wages boost corporate profit margins. While labor’s share of income tentatively peaked in 1980, the late-1990s is this series’ ultimate peak and since then, it has been in a steady decline (employee compensation shown inverted, second panel, Chart 5). This labor input cost suppression has likely run its course and given that the U.S. economy is at full employment, wage inflation should also start denting margins. Globalization has been another significant profit margin booster in the U.S. As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit maximizing projects. Following the end of the Great Recession and similar to the Great Depression, de-globalization has commenced (third panel, Chart 5). Chart 5Primary... Primary... Primary... Clearly, the Sino-U.S. war has accentuated and accelerated the inward movement of countries including Korea and Japan, and has had negative knock on effects on trade as evidenced by the now nearly two-year old global growth deceleration. The longer the U.S./China trade war remains unresolved, the deeper the cracks in the foundations of global trade. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will weigh on margins at a time when final demand suffers a setback. Corporate pricing power is deteriorating, which will negatively impact profit margins, given that they are joined at the hip. The current global manufacturing recession is wreaking havoc on selling prices around the world as a number of countries are experiencing outright producer price deflation. To compete, the U.S. corporate sector is doomed to suffer the same fate, which is depressing our Corporate Pricing Power proxy, an indicator composed of 60 top-down sector price series (bottom panel, Chart 6). Chart 6...And Secondary Profit Margin Drivers ...And Secondary Profit Margin Drivers ...And Secondary Profit Margin Drivers Secondary Margin Drivers The ability of the overall corporate sector to lift prices is largely a function of firming final demand (i.e. volumes) and a falling greenback for the 40% of SPX sales that are international. This leads us to two secondary profit margin drivers: The trade-weighted U.S. dollar, And the yield curve. The ability of the overall corporate sector to lift prices is largely a function of firming final demand (i.e. volumes) and a falling greenback for the 40% of SPX sales that are international. Thus, not only is S&P 500 revenue growth and the trade-weighted U.S. dollar tightly inversely correlated, but also the same holds true for the greenback and profit margins (U.S. dollar shown inverted, top panel, Chart 6). Given that the U.S. dollar refuses to fall and is breaking out according to some Federal Reserve trade-weighted indexes, the path of least resistance for profit margins points south. The yield curve is related to the primary “interest rate” driver discussed above, but its most important signal concerns the business cycle. Empirically, profit margins mean revert at the onset of recession (yield curve shown advanced, middle panel, Chart 6). As a reminder, parts of the yield curve inverted last December, signaling that a corporate profit margin squeeze is looming. Income Inequality And Margins Finally, we make an interesting geopolitical observation. Rising profit margins are synonymous with wealth accruing to the top 1% of U.S. families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data excluding capital gains it is clear that profit margin expansion accentuates income inequality (Chart 7).2 Chart 7Income Inequality And Margins Income Inequality And Margins Income Inequality And Margins Rising profit margins lead to rising profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and potentially explains the rise of populism. Income re-distribution is therefore a rising probability event in the coming decades.3 Bottom Line: Unequivocally, all six key drivers we have identified (interest rates, tax rates, labor costs / globalization, corporate pricing power, yield curve and the U.S. dollar) are firing warning shots that profit margins have peaked and a “catch down” phase of SPX margins to NIPA margins is in store in the coming quarters.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      https://apps.bea.gov/scb/pdf/national/niparel/2001/0401cpm.pdf 2      https://eml.berkeley.edu/~saez/TabFig2017.xls 3      Please see BCA Geopolitical Strategy Special Report, “The End Of The Anglo-Saxon Economy?” dated April 13, 2016, available at gps.bcaresearch.com.

Dear Client, Owing to BCA’s 40th Annual Investment Conference at the Grand Hyatt in New York City next week, there will be no report on Wednesday, September 25. We will return to our regular publication schedule on Wednesday, October 2. I look forward to meeting China Investment Strategy clients in person at our conference. Please do not hesitate to say hello. Best regards, Jing Sima China Strategist Highlights China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in the coming few months if the economy slows further, but policymakers will be reactive rather than proactive. Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy. Over a 6-12 month time horizon, investors should continue to overweight Chinese stocks versus the global benchmark in currency hedged terms, but the risk of further underperformance over the near-term is high. Feature Chinese economic growth continues to weaken. The Caixin manufacturing PMI for August, along with the New Export Orders component of the manufacturing PMI released by China’s National Bureau of Statistics, registered small gains in August from July. However, any hopes pinned on this being an emerging sign of turnaround in the Chinese economy soon faded. A slew of August data showed continued sluggishness in exports, an even worse domestic-demand picture, and further deflation in ex-factory producer prices. Most importantly, we continue to witness “half-measured” stimulus. In explaining past and existing economic weakness, many investors point to the trade war with the U.S. However, Charts 1 and 2 serve as an important reminder that domestic weakness predates U.S. protectionism. The trade war tensions and tariffs are magnifying this weakness, but China’s slowdown is, at its core, policy driven. Chart 1Weakness In Chinese Economy Predates The Trade War... Weakness In Chinese Economy Predates The Trade War... Weakness In Chinese Economy Predates The Trade War... Chart 2…And Has Been A Byproduct Of Financial De-Risking Campaign ...And Has Been A Byproduct Of Financial De-risk Companion ...And Has Been A Byproduct Of Financial De-risk Companion Given this, investors should be more focused on identifying signs of a major reversal in policy. So far Chinese policymakers have been firmly holding their line in keeping credit growth somewhat in check.  Policy-Induced Economic Stabilization: A Tough Forecast To Make Our baseline view is that the current scale of stimulus should be sufficient to stop economic growth from decelerating further.  Two factors support our baseline view: The direct impact from tariffs on the Chinese economy is limited. Growth in China’s exports to the U.S. in 2019 is likely to be somewhere close to a 9% contraction, down from the 10.8% increase registered in 2018. Based on a simple calculation with all else being equal, this is likely to shave 1.6 percentage points off China’s total export growth and 0.3 percentage points off nominal GDP growth in 2019. This is not trivial, but arguably not devastating to China’s aggregate economy either. There is anecdotal evidence suggesting some Chinese exports have been re-routed to peripheral countries such as Vietnam and Taiwan in order to avoid the U.S. import tariffs on Chinese goods (Chart 3). This suggests that real growth in Chinese exports to the U.S. could be stronger than the current data suggests. Chart 3Exports Finding Alternative Routes? Exports Finding Alternative Routes? Exports Finding Alternative Routes? Chart 4Bottoming in the economy In Sight? Bottoming in the economy In Sight? Bottoming in the economy In Sight? Credit growth has picked up since the beginning of this year. Based on the historical relationship between China’s credit impulse (measured by the 12-month change in BCA’s adjusted total social financing as a percentage of nominal GDP) and domestic demand, the economy should bottom out at some point before the end of the year (Chart 4). Although, import growth, a key measure of China’s domestic demand, remains in deep contraction, some of its components that usually lead industrial activities are showing signs of improvement (Chart 5). Chart 5Early Signs of Improved Domestic Demand Early Signs of Improved Domestic Demand Early Signs of Improved Domestic Demand Chart 6Manufacturing Investment Growth In Contraction Manufacturing Investment Growth In Contraction Manufacturing Investment Growth In Contraction However, our level of confidence that the existing stimulus will be sufficient to stabilize economic growth is lower than it otherwise would be. This is due to the fact that the challenges facing the Chinese economy are unprecedented in nature.  For one, the indirect impact of the trade war on China’s economy through business sentiment and manufacturing investment has yet to be fully revealed in the data. As Chart 6 shows, manufacturing investment is already deteriorating, particularly in export-intensive sectors. The ultimate impact on investment from the trade war is still uncertain, and can pose significant downside risks to the Chinese economy in the coming year. More importantly, as Chart 7 suggests, a weak credit impulse will at best lead to a very subdued economic recovery even if growth does indeed bottom. In terms of the link between policy and the economy, Chart 8 points out a key difference between the current slowdown and previous down cycles: Monetary conditions have been ultra-loose for more than a year, but current economic conditions remain on a downward trend – much more so than in the previous cycles. This huge gap and lag in economic response to monetary stance can only be explained by an impaired policy transmission mechanism. An expansionary monetary stance has not proportionally translated into credit expansion or economic recovery. This challenges the effectiveness and timeliness of future monetary loosening in terms of its ability to revive the Chinese economy. Chart 7Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Current Pace Of Credit Growth Will Lead To A Fragile Recovery, At Best Chart 8An Impaired Monetary Policy Transmission An Impaired Monetary Policy Transmission An Impaired Monetary Policy Transmission The scale and timing of the current stimulus measures have been “behind the curve.” Therefore, the historical relationship between China’s credit impulse and the turning points in the economy may not apply to the current cycle. Bottom Line: China’s economy should bottom as a result of the pickup in credit that occurred earlier this year, but the circumstances surrounding the ongoing slowdown are unprecedented in nature. This raises the risk that policymakers will have to do more in order to stabilize growth. An Unusually Prudent Policy Bias For some, the recent slew of announcements on upcoming stimulus qualified as a major shift in policy bias. Our analysis suggests otherwise. The bank reserve requirement ratio (RRR) cuts announced late in August have been among the most cited policy announcements, with the PBoC stating that the new cuts will release RMB 900 billion of fresh liquidity.1 In our view, this measure is more about maintaining liquidity in China’s large commercial banks than adding to it (on a net basis). Chart 9RRR Cuts May Not Be That Stimulative RRR Cuts May Not Be That Stimulative RRR Cuts May Not Be That Stimulative Chart 9 shows that, in previous episodes of meaningful RMB depreciation against the U.S. dollar, in order to prevent the RMB from falling at an undesirable pace, PBoC has had to intervene in the spot market by selling U.S. dollars. The selling of U.S. dollars in this round of RMB depreciation has been much more muted than in 2015-2016, but we suspect some intervention has taken place following each bout of escalation in the trade war. This has had a liquidity tightening effect on banks, as selling central bank foreign-exchange reserves reduces liquidity in the banking system. It is very likely that following the PBoC’s defense of the RMB in the last two months, the RRR cuts were a measure aimed at preventing a liquidity crunch ahead of the September tax season. If true, this hardly qualifies as net new stimulus for the economy. There were also two important announcements that came out of the September 5th State Council meeting: The entire 2019 quota for local government special project bonds must be issued by the end of September, and all money raised from the bonds must be disbursed to projects by the end of October. This too is not exactly “stimulative,” as over 90% of the 2019 local government special-project bond quota has already been issued. This leaves less than 10% of the quota outstanding, an 80% decline from what was issued last September. On a quarterly basis, special-bond issuance in the third quarter of 2019 will end up being 30% lower than the same period last year.   It was also announced that, in order to meet the local needs for construction of key projects, part of 2020’s special bonds quota will be allocated in advance to ensure that the funds are available for use at the beginning of next year.2  While the announcement did not indicate how much in the way of special-purpose bonds local governments are allowed to frontload through the remainder of this year, we maintain our view that this is not a policy shift towards materially larger stimulus than we have seen so far this year: Without an additional quota, local government special-purpose bond issuance would essentially fall to zero in the fourth quarter as the 2019 target would be hit by the end of September. Thus, the frontloading of next year’s bond issuance will only “fill the gap” between now and year-end. As special-purpose bond issuance only accounts for 15% of total funding for local governments’ infrastructure spending, the new measure alone is unlikely to meaningfully accelerate investment growth.3  We have noted in previous reports that in order for local governments to accelerate spending within the current fiscal budget framework, one of three things must occur: more direct funding from the central government, an acceptance by policymakers of more shadow bank lending, or a larger quota for bond issuance. So far we have not seen any of the above-mentioned shifts in policy. Chart 10Local Governments Tightening Belt This Year Local Governments Tightening Belt This Year Local Governments Tightening Belt This Year The only positive sign for local government spending has been a pickup in land sales in Q2, which makes up more than 70% of local government revenues. But, it is far from making up the shortfalls in local governments’ budgets (Chart 10). Local governments are facing considerable fiscal pressure as annual tax revenue growth has fallen to near zero. Critically, the government’s regulatory stance on local government budgets has continued to tighten: Local governments have been ordered by the Ministry of Finance to liquidate state-owned assets to fund their budget deficits this year.4 This austerity measure is also being met with explicit reiteration from the Ministry of Finance on the central government not bailing out local governments, and that local government officials are held responsible for their own borrowing and spending.5   Bottom Line: Optimism surrounding recent Chinese policy announcements is misguided. For now, Chinese policymakers are not upping the pace of stimulus, which underscores the risk to our forecast that growth will soon stabilize. A more meaningful shot of reflation will occur in early 2020 if the economy slows further in Q4, but policymakers will most likely continue their reactive approach rather than proactive. RMB Depreciation: A Plus Or Peril? The RMB’s renewed depreciation since August initially raised fears among global investors that an uncontrolled decline might occur, but these fears have subsided over the past several weeks. Even though the USD-CNY exchange rate has broken the psychological 7 threshold, it is not forming a linear downward trend. Unlike after the August 2015 devaluation, it appears that the PBoC can successfully enact countercyclical measures to guide the RMB’s value higher following each large depreciation (Chart 11). Chart 11PBoC Not Panicking Over RMB Depreciation PBoC Not Panicking Over RMB Depreciation PBoC Not Panicking Over RMB Depreciation Fears of uncontrolled capital outflows following the depreciation are also abating. We presented a dashboard for monitoring short-term capital outflows from China in our March 20 Special Report,6 and an update of these indicators suggests that China’s heightened capital controls are holding – i.e., outflows have not escalated as they did in 2015 (Chart 12). Chart 12No Major Capital Outflow No Major Capital Outflow No Major Capital Outflow Chart 13RMB Depreciation Partially Offsets Tariffs RMB Depreciation Partially Offsets Tariffs RMB Depreciation Partially Offsets Tariffs Thus, the conclusion is that Chinese policymakers appear to be in control of the currency. The reduced risk of an uncontrolled decline has allowed policymakers to (passively) provide meaningful stimulus to the domestic economy via depreciation. Indeed, the RMB has not only depreciated against the USD, but also against many Asian currencies including direct trade competitors such as Vietnam and Taiwan (Chart 13). This is helping offset the negative impact of U.S. tariffs on Chinese exporters. But currency devaluation can come with a price tag – in particular for corporations that have borrowed heavily in U.S. dollar-denominated debt. We estimate that $440 billion of U.S. dollar debt will be maturing over the coming two years, for Chinese companies and banks in the aggregate.7 A 12% depreciation in the RMB since April 2018 means that debt servicing costs will be 12% higher for unhedged debtors. This is particularly painful for real estate and financial services companies, two of the largest holders of U.S. dollar-denominated loans, and the weakest sectors in the current economic downturn. Most importantly, while currency devaluation ease the slowdown, it cannot be counted on to stabilize Chinese economic activity on its own. For example, while our earnings recession model suggests that the decline in the RMB since May has reduced the odds of a major decline in economic activity by roughly 20%, the model also shows that such an event is still highly probable (current odds are roughly at 70%). Bottom Line: Barring a successful (even if temporary) trade deal, we expect more weakness in the RMB as a passive source of reflation to aid the economy. But currency devaluation is a double-edged sword, and cannot be counted on to single-handedly stabilize China’s economy if a further slowdown occurs. An Update On Corporate Earnings Against a backdrop of what may turn out to be insufficient policy support, the earnings picture is providing one modest positive for equity investors. While the growth rate in investable earnings per share has slowed significantly over the past year (Chart 14), it has merely fallen to zero and not deeply into negative territory, as what seemingly occurred in 2015-2016. In our view, the risk of a similar collapse in earnings per share (EPS) has been an important factor weighing on Chinese investable equities’ relative performance since June 2018. In reality, a closer examination of MSCI China Index earnings reveals that a huge decline in EPS this year was never really a threat, because the apparent collapse in 2015-2016 did not actually transpire. Changes to the composition in the MSCI China Index that took effect in November 2015 and June 2016 had the effect of depressing index EPS, due to the sizeable inclusion of a set of richly valued stocks. Chart 15 presents BCA’s calculation of “break-adjusted” EPS for Chinese investable stocks, which shows that EPS growth bottomed out at -10% in late-2016, as opposed to the -28% implied by the unadjusted series. Chart 14Investable EPS Has Yet To Contract Meaningfully Investable EPS Has Yet To Contract Meaningfully Investable EPS Has Yet To Contract Meaningfully Chart 15The Potential Downside For Earnings Is Less Than Many Fear The Potential Downside For Earnings Is Less Than Many Fear The Potential Downside For Earnings Is Less Than Many Fear Chart 16A Cyclical Recovery In Earnings Has Not Yet Begun A Cyclical Recovery In Earnings Has Not Yet Begun A Cyclical Recovery In Earnings Has Not Yet Begun The existence of less downside potential for earnings is certainly positive for investable stocks at the margin, but it does not alter the outlook for equity fundamentals over the coming year. We have shown in several previous reports that there is a strong and reliable link between investable EPS growth and China’s coincident economic activity,8 and the continued slowing in the latter does not suggest that a bottom in earnings is imminent. In addition, Chart 16 highlights that while net earnings revisions have recovered from their early-year lows, they remain in negative territory and have stopped rising over the past few weeks. Twelve-month forward EPS momentum, also presented on a break-adjusted basis, is modestly negative, and has recently weakened (panel 2). Bottom Line: The downside risk to earnings for Chinese investable equities is less than many investors fear. But absent stronger credit growth, it remains too early to confidently project a cyclical earnings recovery. Investment Conclusions The historical relationship between credit growth and economic activity suggests that the latter should soon stabilize, which is our base case view for the coming few months. Still, the risk of a further, meaningful deceleration in growth is elevated, given the unprecedented circumstances surrounding the ongoing slowdown. For equity investors, less potential downside risks to earnings than previously feared is a positive at the margin, but the fundamental outlook still hinges on a durable pickup in economic activity. Over a 6-12 month time horizon, this implies that one of two scenarios will unfold: The economy will stabilize in response to the easing that has already occurred (i.e. our base case view). The economy slows further in the near-term, prompting a more significant policy response that leads to an even sharper pickup in activity. Chart 17Investable Stocks: An Overshoot To The Downside? Investable Stocks: An Overshoot To The Downside? Investable Stocks: An Overshoot To The Downside? In the first scenario, investable stocks have probably overshot to the downside versus the global benchmark and thus will very likely outperform from current levels. Near-term performance is likely to be flat-to-down, as investors await hard evidence of a sequential improvement in growth (Chart 17). In the second scenario, investable stocks are at potentially acute near-term risk, but will likely eventually outperform global stocks once activity begins to pick up sharply. In this scenario, the outperformance of Chinese equities will commence later, but would likely still occur by the tail end of our cyclical investment horizon (6-12 months). As a final point, we are not ruling out the possibility of a temporary trade deal between the U.S. and China, as both sides have the incentive to avoid a further escalation and are now showing goodwill towards constructive negotiations. This may change our tactical view on Chinese stocks, but our cyclical view remains focused on China’s domestic policy and economic fundamentals.   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes   1      PBC Official: The RRR Cut Aims at Bolstering Real Economy, September 6, 2019 2      China to accelerate the issuance and use of special local government bonds to catalyze effective investment, China State Council, September 4, 2019 3      Please see Emerging Markets Strategy Special Report, “Chinese Infrastructure Investment: A Ramp-Up Ahead?”, dated August 1, 2019, available at ems.bcaresearch.com 4      China’s Local Governments Sell Assets to Make Up for Revenue Loss, Caixin, September 3, 2019 5      http://www.mof.gov.cn/zhengwuxinxi/caizhengxinwen/201909/t20190906_3382239.htm?mc_cid=eb2b199651&mc_eid=9da16a4859 6      Please see China Investment Strategy Special Report, “Monitoring Chinese Capital Outflows”, dated March 20, 2019, available at cis.bcaresearch.com 7      Please see Emerging Markets Strategy Special Report, “China’s Foreign Debt, And A Secret Weapon”, dated September 12, 2019, available at ems.bcaresearch.com 8      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2):Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com Cyclical Investment Stance Equity Sector Recommendations

Highlights Portfolio Strategy Intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. The transition from a virtuous to a vicious EPS-to capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating relative balance sheet (b/s) and relative operating metrics compel us to put the cyclicals/defensives portfolio bent on downgrade alert. Recent Changes The cyclicals/defensives portfolio bent is now on our downgrade watch list. Table 1 Capex Blues Capex Blues Feature The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes. Worrisomely, BCA’s Equity Selloff Indicator captures these dynamics and continues to emit a distress signal (Chart 1). Equities have been relatively resilient in the face of these headwinds. Investors are hoping not only for a U.S./China trade deal, but also that the Fed’s cutting cycle will save the day. Chart 1Mind The Gap Mind The Gap Mind The Gap What caught our attention from all the speeches at the recent Jackson Hole Symposium was RBA Governor Philip Lowe’s speech, especially the section titled “Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity”.1 Lowe highlighted that “When easing monetary policy, all central banks know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don't want to invest because of elevated uncertainty, we can't be confident that changes in monetary conditions will have the normal effect (stress ours).” The perception that the Fed is going to be the savior of the economy is a big risk, and when reality hits that President Trump’s tariffs are a shock to global final demand and presage profit contraction, volatility will skyrocket (please refer to Chart 3 from the August 19 Weekly Report). Importantly, the virtuous capex upcycle that has been in motion since the Trump inauguration when CEOs voted with their feet and started investing, has ground to a halt according to national accounts (Chart 2). U.S. non-residential fixed investment subtracted from GDP growth last quarter, and we doubt the Fed’s fresh interest rate cutting cycle will arrest the fall. Leading indicators of capital outlays point to additional pain in coming quarters (Chart 2). As a reminder, generationally low interest rates and a real fed funds rate near zero hardly restrict expansion plans. Chart 2Free Falling Free Falling Free Falling The shift from a virtuous to a vicious capex cycle is a theme that will start gaining traction as the year draws to a close. While pundits are dismissing the recent steep fall in capex as a one off, our indicators suggest otherwise. The middle panel of Chart 3 clearly depicts this emerging dynamic. Profit growth peaked in 2018 on the back of the massive fiscal easing package and capex is following suit, albeit with a slight lag. There are high odds that a looming profit contraction will further shatter frail animal spirits, sabotage the capex upcycle and tilt into a down cycle. Tack on the ongoing trade uncertainty, and CEOs are certain to, at least, postpone deploying longer-term oriented capital. Worryingly, this transition from a virtuous to a vicious capex cycle is not limited to a few cyclical sectors as we would have expected on the back of the re-escalating Sino-American trade tussle. In fact, basic resources’ and non-capital goods producers’ capital outlays are decelerating, warning that corporate America is in the early stages of retrenchment (bottom panel, Chart 3). Chart 3EPS-To-Capex Down Cycle EPS-To-Capex Down Cycle EPS-To-Capex Down Cycle Chart 4Capex… Capex… Capex… Charts 4, 5 & 6 break down sectorial capex growth using financial statement reported data from Refinitiv. Seven out of eleven sectors are steeply decelerating from near 20%/annum growth to half that; given that these sectors comprise more than 72% of the total capex pie, they will continue to weigh on overall stock market reported investment. Chart 5…Per… …Per… …Per… Chart 6…Sector …Sector …Sector Similarly, the news on the cyclicals versus defensives capex profile is grim. Trade uncertainty and the global growth soft patch has dealt a blow to deep cyclical expansion plans and leading indicators signal that the cyclicals/defensives capex will flirt with the contraction zone in the coming quarters (Chart 7). In sum, intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. Chart 7Relative Capex Blues Relative Capex Blues Relative Capex Blues This week we update our cyclicals versus defensives bias (we are currently neutral) and are compelled to put this portfolio bent on our downgrade watch list. Put The Cyclical/Defensive Tilt On Downgrade Alert Roughly two years ago, when nobody was talking about the brewing capex upcycle, we penned a report titled “Underappreciated Capex” and posited that: “It would be unprecedented if the current business cycle ended without a visible capex upcycle. Since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming.” Fast forward to today and as historical empirical evidence had suggested, capex growth peaked near the 20%/annum mark (Chart 3 above). If our assessment is accurate that capex has now likely hit a wall and the virtuous EPS-to-capex cycle reverses to a vicious down cycle as EPS are now contracting, then deep cyclical high-operating leverage sectors are in for a rough ride. This will especially be true if the global recession warnings also morph into an actual recession on the back of the re-escalating Sino-American trade war. More specifically, our capex indicators are firing warning shots. Capex intentions according to a plethora of regional Fed surveys are sinking steadily, which bodes ill for cyclicals versus defensives (Chart 8). One key driver of the capex cycle is China and the emerging markets (EM). News on both fronts is grim. Our real-time indicator that gauges China’s reflation efforts (monetary and fiscal) turning into actual economic activity is Chinese excavator sales that remain in the doldrums (top panel, Chart 9). Chart 8Drop In Capex Will Weigh On Relative Profits Drop In Capex Will Weigh On Relative Profits Drop In Capex Will Weigh On Relative Profits Chart 9Elusive Global Growth Elusive Global Growth Elusive Global Growth Granted, global growth remains elusive as we highlighted last week and while softening Chinese economic activity is weighing on global growth, European and Japanese GDP growth is also decelerating with a number of economies already in the contraction zone (bottom panel, Chart 9). Melting global bond yields reflect these growth fears and warn that the relative share price ratio has more downside (middle panel, Chart 9). Export growth is an important indicator that closely tracks the ebbs and flows of global trade. When the trade-weighted U.S. dollar appreciates it dampens trade, the opposite is also true. Currently the Fed’s trade-weighted greenback based on goods has vaulted to cyclical highs, warning that the path of least resistance is lower for trade, thus a net negative for relative export and profit prospects (Chart 10). Similarly, EM capital outflows exacerbate the ongoing global growth blues and put additional strain on EM economies as depreciating currencies sap consumer purchasing power (top panel, Chart 10). The implication is that EM final demand is in retreat. The rising U.S. dollar not only deals a blow to basic resource exports via making them less competitive and leading to market share losses, but it also undermines cyclical sectors' pricing power. The top panel of Chart 11 shows that deflating commodity prices are exerting downward pull on relative share prices. The ISM manufacturing survey’s prices paid subcomponent corroborates this deflationary backdrop. Keep in mind that operating leverage cuts both ways, and now that the pendulum is swinging the opposite way revenue contraction in these high fixed costs industries will fall straight off the bottom line (Chart 11). Chart 10Rising Dollar Dollar Dampens Trade And… Rising Dollar Dollar Dampens Trade And… Rising Dollar Dollar Dampens Trade And… Chart 11…Saps Pricing Power …Saps Pricing Power …Saps Pricing Power Our macro-based cyclicals/defensives EPS growth models do an excellent job in capturing all these moving parts and signal that defensives have the upper hand in the coming quarters (bottom panel, Chart 8). Turning to operating metrics, the inventory buildup in the past few quarters coupled with a softness in overall business sales underscore that relative share prices will continue to trend lower (top panel, Chart 12). On the balance sheet front, relative net debt-to-EBITDA has troughed and widening junk spreads and the inverted yield curve warn that a further relative b/s degrading looms (second & third panels, Chart 12). If our thesis pans out in the coming months, then cash flow growth will come under pressure as the vicious capex cycle flexes its muscles foreshadowing a rise in bankruptcy filings. Already, the news on the profit margin front is disconcerting. Historically, the ISM manufacturing index and relative operating profit margins have been joined at the hip and the recent flirting of the former with the boom/bust line points toward an ominous relative margin squeeze (bottom panel, Chart 12). Chart 12Poor Financial & Operating Backdrop… Poor Financial & Operating Backdrop… Poor Financial & Operating Backdrop… Chart 13…But Excellent Valuations And Technicals …But Excellent Valuations And Technicals …But Excellent Valuations And Technicals Finally, soft versus hard data surprise oscillations have an excellent track record in forecasting relative share price movements. The current message is to expect additional weakness in relative share prices (second panel, Chart 13). While most of the indicators we track signal that the time is ripe to downgrade this portfolio bent to an underweight stance, bombed out relative valuations, and oversold technicals keep us at bay, at least for the time being (third & bottom panels, Chart 13). However, we are compelled to put the cyclicals/defensives ratio on downgrade alert to reflect the transition from a virtuous to a vicious EPS-to-capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating b/s and operating metrics. The way we will execute this downgrade will be via a downgrade of the S&P tech sector (for additional details on the S&P tech sector's downgrade mechanics please refer to last Friday’s U.S. Equity Strategy Insight Report). Bottom Line: Stay on the sidelines in the S&P cyclicals/S&P defensives ratio, but put it on downgrade alert.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1      https://www.rba.gov.au/speeches/2019/sp-gov-2019-08-25.html Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps

Feature According to the official reported growth rate, Chinese industrial profit growth ticked slightly back into positive territory in July, after having fallen into modestly negative territory earlier this year. However, market participants have increasingly noted the gaping difference between the reported year-over-year (YoY) growth rate and the YoY growth rate of the reported level, with the latter having shown a much weaker profile over the past two years (Chart I-1). Chart I-1Will The Real Profit Trend Please Stand Up? Will The Real Profit Trend Please Stand Up? Will The Real Profit Trend Please Stand Up? The profile in the growth of overall earnings per share of listed companies does not match that of the reported level of industrial profit growth (either in the domestic or investable markets), and it remains unclear whether this is due to changes in shares outstanding or other factors. But the divergence between the two series shown in Chart I-1 has certainly focused investor attention on China’s profit outlook, which has deteriorated over the past year regardless of the data series used. This deterioration in earnings has raised the risk of a bullish cyclical position towards Chinese stocks for two reasons: 1) it makes an eventual uptrend in stock prices conditional on a rebound in EPS and, 2) it had led to a deterioration in corporate health in what has become a highly-leveraged economy. The latter is particularly notable, given the backdrop of serious investor concern over rising (although still low) onshore corporate defaults. To investigate the impact of declining/decelerating profit growth on Chinese corporate health, this week we are updating our China Industry Watch thematic chartpack. The charts shown on pages 6 - 27 present our corporate health monitor (CHM) and its components across multiple industries (see below for our CHM methodology).1 Several observations are noteworthy: Although our aggregate CHM for all industrials hasn’t yet fallen back to levels seen in 2008 or during the early-2000s, the deceleration in profit growth has clearly caused a meaningful deterioration in corporate health (Chart I-2). To underscore the point, our aggregate CHM suggests that Chinese industrial sector health is presently the worst that it has been since the global financial crisis (Chart I-3). While we acknowledge that Chinese authorities remain reluctant to prompt a large rise in the macro leverage ratio, this core finding of our report raises the stakes for policymakers in terms of their ability to tolerate significant further weakness in economic activity. Chart I-2In China, Profit Growth Drives Corporate Health In China, Profit Growth Drives Corporate Health In China, Profit Growth Drives Corporate Health Chart I-3Chinese Corporate Health Now The Worst Since the Global Financial Crisis Chinese Corporate Health Now The Worst Since the Global Financial Crisis Chinese Corporate Health Now The Worst Since the Global Financial Crisis Our sub-industry CHMs shed some light on what has driven the deterioration in our overall CHM. The monitors show a particularly marked decline in corporate health for the steel, non-ferrous metals, construction materials, autos, and information technology sectors. Three of these sectors (steel, non-ferrous metals, and IT) are particularly sensitive to exports, suggesting that the trade war with the U.S. is at least partially responsible for the worsening corporate health of industrial enterprises. However, the auto and construction materials sectors tend to be domestically-oriented, underscoring that some of the weakness in these sectors is purely homegrown. Corporate health for energy-related sub-industries (oil & gas and coal) continues to improve from a poor starting point, and the incredible two-decade improvement in health for the food & beverage sector has continued, which shows that Chinese demand for consumer staples remains robust. Measured either by debt-to-assets or interest coverage, China’s industrial enterprises have experienced a broad-based worsening of leverage. To the extent that “deleveraging” has happened, it has occurred in some of China’s “old industries” such as coal, steel, and non-ferrous metals. On the efficiency front, coal and steel have been the only sectors experiencing an improvement in inventory turnover due to China’s capacity reduction campaign; besides this, inventory, asset, and receivable turnover has deteriorated in nearly every other sub-industry. Similarly, profit growth has decelerated and/or fallen into negative territory broadly across sub-industries along with a meaningful deceleration in revenue growth. Utilities and food & beverage are the notable outliers, where profit growth has moderately recovered due to a combination of positive revenue growth and wider margins. Chart I-4Non-SOE Profits: A Leading Indicator For Overall Profit Growth? Non-SOE Profits: A Leading Indicator For Overall Profit Growth? Non-SOE Profits: A Leading Indicator For Overall Profit Growth? Finally, Chart I-4 provides an interesting perspective about overall profit growth. A breakdown of profit growth by ownership (state-owned vs. non-state-owned enterprises), shows that non-SOE industrial profits led the decline in overall profit growth in 2017-2018. While it has not yet occurred, a significant pickup in non-SOE profit growth may herald a durable bottom for industrial sector profits, which could act as a meaningful outperformance catalyst for Chinese stocks over the coming 6-12 months. To us, the significant decline in corporate health noted in this report reinforces both our tactically bearish and cyclically bullish recommendations towards Chinese stocks. In the near-term, the risks facing Chinese stocks are high, as the combination of the reluctance of policymakers to stimulate aggressively, weaker corporate health, and the likelihood of negative near-term economic and profit momentum is a perfect storm for stock prices. We recommend an underweight position relative to global stocks for the remainder of the year. However, over the cyclical time horizon (i.e. 6-12 month), these circumstances also suggest high odds in favor of Chinese policymakers soon accepting the need to ease meaningfully further. Barring a major episode of earnings dilution among publicly-listed stocks, significant further easing along with controlled currency depreciation makes a strong case for an overweight stance towards Chinese stocks versus the global benchmark in local currency terms.2 We recommend that investors who are not yet invested in Chinese assets to remain on the sidelines until clearer signs of materially stronger stimulus emerge. However, intermediate-term investors who are already positioned in favor of Chinese equities should stay long, as the relative performance trend of Chinese stocks will likely be higher a year from now than it is today.   Qingyun Xu, CFA, Senior Analyst qingyunx@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   BCA's China Industry Watch The BCA China Industry Watch includes four categories of financial ratios to monitor a sector’s leverage, profitability, growth and efficiency, respectively. Some of these ratios, as shown in Table 1, are slightly tweaked from conventional definitions due to data availability. The financial data in our exercise are from the official statistics on overall industrial firms, of which the listed companies are a subset, but most financial ratios based on the two sets of data are very similar, especially for the heavy industries that dominate the Chinese stock markets - both onshore and offshore. The financial ratios on leverage, growth and profitability are almost identical for some sectors, while some other sectors that are not well represented in the stock market, such as technology, healthcare and consumer sectors, show notable divergences. As the Chinese equity universe continues to expand, we expect that the two sets of data will increasingly converge. Chart I- Appendix: China Industry Watch All Firms Chart II-1Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Non-Financial Firms: Stock Price & Valuation Indicators Chart II-2Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Non-Financial Firms: Relative Performance Of Valuation Indicators Chart II-3Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Non-Financial Firms: Leverage Indicators Chart II-4Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Non-Financial Firms: Growth Indicators Chart II-5Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Non-Financial Firms: Profitability Indicators Chart II-6Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Non-Financial Firms: Efficiency Indicators Oil & Gas Sector Chart II-7Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Oil&Gas Sector: Stock Price & Valuation Indicators Chart II-8Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Oil&Gas Sector: Relative Performance Of Valuation Indicators Chart II-9Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Oil&Gas Sector: Leverage Indicators Chart II-10Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Oil&Gas Sector: Growth Indicators Chart II-11Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Oil&Gas Sector: Profitability Indicators Chart II-12Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators Oil&Gas Sector: Efficiency Indicators   Coal Sector Chart II-13Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Coal Sector: Stock Price & Valuation Indicators Chart II-14Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Coal Sector: Relative Performance Of Valuation Indicators Chart II-15Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Coal Sector: Leverage Indicators Chart II-16Coal Sector: Growth Indicators Coal Sector: Growth Indicators Coal Sector: Growth Indicators Chart II-17Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Coal Sector: Profitability Indicators Chart II-18Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Coal Sector: Efficiency Indicators Steel Sector Chart II-19Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Steel Sector: Stock Price & Valuation Indicators Chart II-20Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Steel Sector: Relative Performance Of Valuation Indicators Chart II-21Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Steel Sector: Leverage Indicators Chart II-22Steel Sector: Growth Indicators Steel Sector: Growth Indicators Steel Sector: Growth Indicators Chart II-23Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Steel Sector: Profitability Indicators Chart II-24Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Steel Sector: Efficiency Indicators Non Ferrous Metals Sector Chart II-25Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Non Ferrous Metals Sector: Stock Price & Valuation Indicators Chart II-26Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Non Ferrous Metals Sector: Relative Performance Of Valuation Indicators Chart II-27Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Non Ferrous Metals Sector: Leverage Indicators Chart II-28Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Non Ferrous Metals Sector: Growth Indicators Chart II-29Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Non Ferrous Metals Sector: Profitability Indicators Chart II-30Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Non Ferrous Metals Sector: Efficiency Indicators Construction Material Sector Chart II-31Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Construction Material Sector: Stock Price & Valuation Indicators Chart II-32Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Construction Material Sector: Relative Performance Of Valuation Indicators Chart II-33Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Construction Material Sector: Leverage Indicators Chart II-34Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Construction Material Sector: Growth Indicators Chart II-35Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Construction Material Sector: Profitability Indicators Chart II-36Efficiency Indicators Construction Material Sector: Efficiency Indicators Construction Material Sector: Efficiency Indicators Machinery Sector Chart III-37Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Machinery Sector: Stock Price & Valuation Indicators Chart III-38Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Machinery Sector: Relative Performance Of Valuation Indicators Chart III-39Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Machinery Sector: Leverage Indicators Chart III-40Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Machinery Sector: Growth Indicators Chart III-41Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Machinery Sector: Profitability Indicators Chart III-42Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Machinery Sector: Efficiency Indicators Automobile Sector Chart III-43Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Automobile Sector: Stock Price & Valuation Indicators Chart III-44Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Automobile Sector: Relative Performance Of Valuation Indicators Chart III-45Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Automobile Sector: Leverage Indicators Chart III-46Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Automobile Sector: Growth Indicators Chart III-47Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Automobile Sector: Profitability Indicators Chart III-48Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Automobile Sector: Efficiency Indicators Food & Beverage Sector Chart III-49Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Food&Beverage Sector: Stock Price & Valuation Indicators Chart III-50Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Food&Beverage Sector: Relative Performance Of Valuation Indicators Chart III-51Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Food&Beverage Sector: Leverage Indicators Chart III-52Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Food&Beverage Sector: Growth Indicators Chart III-53Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Food&Beverage Sector: Profitability Indicators Chart III-54Food & Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Food&Beverage Sector: Efficiency Indicators Information Technology Sector Chart III-55Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Information Technology Sector: Stock Price & Valuation Indicators Chart III-56Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Information Technology Sector: Relative Performance Of Valuation Indicators Chart III-57Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Information Technology Sector: Leverage Indicators Chart III-58Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Information Technology Sector: Growth Indicators Chart III-59Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Information Technology Sector: Profitability Indicators Chart III-60Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Information Technology Sector: Efficiency Indicators Utilities Sector Chart III-61Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Utilities Sector: Stock Price & Valuation Indicators Chart III-62Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Utilities Sector: Relative Performance Of Valuation Indicators Chart III-63Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Utilities Sector: Leverage Indicators Chart III-64Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Utilities Sector: Growth Indicators Chart III-65Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Utilities Sector: Profitability Indicators Chart III-66Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators Utilities Sector: Efficiency Indicators   Footnotes 1      Please see China Investment Strategy Special Report, “Introducing The BCA China Industry Watch”, dated February 10, 2016, available at cis.bcaresearch.com. 2      We continue to recommend that investors hedge the currency exposure of a long Chinese equity position by being long USD-CNH. Cyclical Investment Stance Equity Sector Recommendations

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Chart II-1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Chart II-5 Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart II-7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II)   Chart II-14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart II-15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Chart II-19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps Chart II-21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets   Chart II-22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Chart II- Chart II-25 We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II)   The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds   Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… Image …And The Bears Image Footnotes 1       To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5     France is a good proxy for the euro area. 6     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1 The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 Chart 1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart 1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart 2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart 2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart 3). Chart 3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart 4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart 4 (PETER)Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. Chart 5 I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart 5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4 Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart 6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart 6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart 7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S. Chart 7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart 8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart 8, bottom panel). The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart 9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart 8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Chart 9 (ARTHUR)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones   On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production. Chart 10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart 10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart 11). The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth. Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart 12). Chart 11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Chart 12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart 13). Chart 13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Chart 13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart 14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates.   Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart 15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart 15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart 16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart 17). Chart 16 (DOUG)Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Chart 17 (DOUG)...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart 18). The recent divergence is unprecedented. Chart 18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart 19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6 Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart 20). Chart 19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting Chart 20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart 21). This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart 22). Chart 21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets Chart 22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care   Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart 23). Chart 23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart 24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart 24 (DOUG)Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table 1). Bull markets tend to sprint to the finish line (Chart 25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Table 1 (DOUG)The S&P 500 Doesn’t Peak Until Six Months Before A Recession … What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open Chart 25 We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 26). One should favor stocks over bonds when the ERP is high. Chart 26A (PETER)Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart 26B (PETER)Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. Chart 27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart 27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade. Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart 28). Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. Chart 28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp.   Summary Of Views And Recommendations What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Peter Berezin Chief Global Strategist peterb@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Doug Peta Chief U.S. Investment Strategist dougp@bcaresearch.com Robert Robis Chief Fixed Income Strategist rrobis@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   Footnotes 1 To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5 France is a good proxy for the euro area. 6 Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com. Strategy & Market Trends* MacroQuant Model And Current Subjective Scores Image Tactical Trades Strategic Recommendations Closed Trades

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 Chart 1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart 1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart 2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart 2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart 3). Chart 3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart 4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart 4 (PETER)Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. Chart 5 I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart 5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart 6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart 6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart 7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart 7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart 8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart 8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart 9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart 8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Chart 9 (ARTHUR)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones   On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  Chart 10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart 10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart 11). The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart 12). Chart 11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Chart 12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart 13). Chart 13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Chart 13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart 14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates.   Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart 15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart 15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart 16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart 17). Chart 16 (DOUG)Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Chart 17 (DOUG)...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart 18). The recent divergence is unprecedented. Chart 18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart 19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart 20). Chart 19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting Chart 20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart 21). This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart 22). Chart 21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets Chart 22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care   Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart 23). Chart 23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart 24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart 24 (DOUG)Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table 1). Bull markets tend to sprint to the finish line (Chart 25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Table 1 (DOUG)The S&P 500 Doesn’t Peak Until Six Months Before A Recession … What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open Chart 25 We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 26). One should favor stocks over bonds when the ERP is high. Chart 26A (PETER)Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart 26B (PETER)Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. Chart 27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart 27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart 28). Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. Chart 28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp.   Summary Of Views And Recommendations What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Peter Berezin Chief Global Strategist peterb@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Doug Peta Chief U.S. Investment Strategist dougp@bcaresearch.com Robert Robis Chief Fixed Income Strategist rrobis@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   Footnotes 1      To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4      Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5      France is a good proxy for the euro area. 6      Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1 The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 Chart 1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart 1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart 2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart 2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart 3). Chart 3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart 4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart 4 (PETER)Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. Chart 5 I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart 5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4 Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart 6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart 6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart 7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S. Chart 7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart 8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart 8, bottom panel). The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart 9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart 8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Chart 9 (ARTHUR)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones   On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production. Chart 10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart 10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart 11). The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth. Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart 12). Chart 11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Chart 12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart 13). Chart 13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Chart 13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart 14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates.   Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart 15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart 15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart 16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart 17). Chart 16 (DOUG)Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Chart 17 (DOUG)...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart 18). The recent divergence is unprecedented. Chart 18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart 19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6 Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart 20). Chart 19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting Chart 20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart 21). This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart 22). Chart 21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets Chart 22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care   Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart 23). Chart 23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart 24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart 24 (DOUG)Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table 1). Bull markets tend to sprint to the finish line (Chart 25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Table 1 (DOUG)The S&P 500 Doesn’t Peak Until Six Months Before A Recession … What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open Chart 25 We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 26). One should favor stocks over bonds when the ERP is high. Chart 26A (PETER)Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart 26B (PETER)Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. Chart 27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart 27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade. Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart 28). Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. Chart 28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp.   Summary Of Views And Recommendations What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Peter Berezin Chief Global Strategist peterb@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Doug Peta Chief U.S. Investment Strategist dougp@bcaresearch.com Robert Robis Chief Fixed Income Strategist rrobis@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   Footnotes 1 To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2 Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3 Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5 France is a good proxy for the euro area. 6 Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 Chart 1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart 1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart 2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart 2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart 3). Chart 3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart 4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart 4 (PETER)Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. Chart 5 I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart 5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart 6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart 6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart 7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart 7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart 8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart 8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart 9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart 8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Chart 9 (ARTHUR)Chinese Households Are More Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones   On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  Chart 10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart 10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart 11). The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart 12). Chart 11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Chart 12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart 13). Chart 13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Chart 13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II) Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart 14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. Chart 14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates.   Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart 15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart 15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart 16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart 17). Chart 16 (DOUG)Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Chart 17 (DOUG)...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart 18). The recent divergence is unprecedented. Chart 18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart 19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart 20). Chart 19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting Chart 20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart 21). This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart 22). Chart 21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets Chart 22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care   Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart 23). Chart 23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart 24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart 24 (DOUG)Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table 1). Bull markets tend to sprint to the finish line (Chart 25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Table 1 (DOUG)The S&P 500 Doesn’t Peak Until Six Months Before A Recession … What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open Chart 25 We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart 26). One should favor stocks over bonds when the ERP is high. Chart 26A (PETER)Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart 26B (PETER)Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. Chart 27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart 27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart 28). Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. Chart 28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp.   Summary Of Views And Recommendations What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open What Goes On Between Those Walls? BCA’s Diverging Views In The Open   Anastasios Avgeriou U.S. Equity Strategist anastasios@bcaresearch.com Peter Berezin Chief Global Strategist peterb@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Doug Peta Chief U.S. Investment Strategist dougp@bcaresearch.com Robert Robis Chief Fixed Income Strategist rrobis@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   Footnotes 1      To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4      Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5      France is a good proxy for the euro area. 6      Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.