Currencies

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

Highlights Portfolio Strategy The trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. A tentative tick up in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Recent Changes Initiate a long S&P Industrials/short S&P Tech pair trade on a tactical three-to-six month time horizon, today. Initiate a long S&P Machinery/short S&P Semiconductors pair trade on a tactical three-to-six month time horizon, today. Follow The Profit Trail Follow The Profit Trail Feature The S&P 500 oscillated violently again last week, as the barrage of declining economic data, heightened trade war-related volatility and political upheaval dominated the news flow. While the Fed remains the backstop of last resort, we doubt additional interest rate cuts, which are already aggressively priced in the bond market, will boost lending and entice CEOs to invest in capital expenditure projects. Investors have to stay patient and disciplined, let this economic slowdown play out and allow for the natural healing of the economy. As a reminder, the ISM manufacturing index has been decelerating for twelve months and only been below the boom bust line for two. If history is an accurate guide, an additional three-to-six months of manufacturing pain are in store before a definitive bottom is in place (bottom panel, Chart 1). Such a macro backdrop, still warrants caution on the prospects of the broad equity market. Chart 1Allow Time For Economic Healing Allow Time For Economic Healing Allow Time For Economic Healing Beginning in August, a number of BCA publications became a tad more cautious on risk assets. Following our October editorial view meeting last week, this cautiousness was cemented with a tactical downgrade of global equities to neutral from previously overweight in the BCA House View matrix. While this marks a clear shift toward this publication’s less sanguine view of the U.S. equity market adopted during the summer, BCA's cyclical 12-month House View remains overweight global equities. Worryingly, the majority of the indicators we track continue to emit distress signals and warn that the SPX has further downside (Chart 2), especially absent profit growth. Importantly, we first correctly posited last May that the back half of the year global growth reacceleration was in jeopardy and would go on hiatus courtesy of rising policy uncertainty.1 Such a backdrop would boost the U.S. dollar and simultaneously take a bite out of SPX EPS.2 Chart 2Soft Data Red Flag Soft Data Red Flag Soft Data Red Flag Last week we highlighted that the U.S. dollar is the most important indicator to monitor given its global deflationary/reflationary properties. Were the greenback to maintain its year-to-date gains, it will continue to dent SPX profitability via P&L translation loss effects and likely sustain the profit recession into early 2020 (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 3). Chart 3Greenback Weighing On Profits Greenback Weighing On Profits Greenback Weighing On Profits U.S. Equity Strategy’s S&P 500 four-factor macro EPS growth model remains downbeat (middle panel, Chart 4). Were we to isolate the U.S. dollar as a single variable and re-run the regression it is clear that additional greenback appreciation will further weigh on SPX profit growth (bottom panel, Chart 4). Meanwhile, the easing in financial conditions and drubbing of the 10-year Treasury yield since the Christmas Eve lows is already reflected in the 23% jump in the forward PE multiple, which explains over 90% of the SPX’s rise since the Dec 24, 2018 trough (top & middle panels, Chart 5). In other words, for multiples to expand anew, financial conditions would have to further ease, which in our view is a tall order (bottom panel, Chart 5). Chart 4EPS Model Warrants Caution EPS Model Warrants Caution EPS Model Warrants Caution Chart 5Financial Conditions Are The Forward P/E Financial Conditions Are The Forward P/E Financial Conditions Are The Forward P/E This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe.  Thus, we would lean against the narrative that easy financial conditions are not fully reflected into stocks. In contrast, our worry is that junk spreads are on the verge of a breakout and such a backdrop would tighten financial conditions and aggravate an SPX drawdown (junk OAS shown inverted, Chart 6). Adding it all up, the trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe. Chart 6Watch Junk Spreads Watch Junk Spreads Watch Junk Spreads Initiate A Long Industrials/Short Tech Pair Trade… Ever since the Sino-American trade war started in March 2018, the market has punished industrials, but tech has escaped unscathed. While the global growth soft patch preceded the U.S./China trade spat, courtesy of the Fed’s tightening cycle and Chinese policymakers’ slamming on the brakes, the trade war has served as a catalyst to aggressively shed deep cyclical equities except for tech stocks (Chart 7). We think this misalignment presents a playable opportunity to generate alpha by going long industrials/short tech, irrespective of the trade war’s outcome. In other words, this market neutral trade will be in the black either because the trade spat gets resolved or because there will effectively be no “real” deal including intellectual property and the tech sector. If the two sides manage to iron out their differences and strike a deal, industrials stocks should benefit from a greater catch-up phase because they have been depressed over the past two years, while tech stocks are near relative all-time highs. In contrast, a “no deal” scenario, should also re-concentrate investors’ minds and lead to a relative selling in tech stocks versus their already beaten-down deep cyclical peers: industrials. Chart 7Bifurcated Deep Cyclicals Market Bifurcated Deep Cyclicals Market Bifurcated Deep Cyclicals Market Chart 8Lots Of Bad Trade War News Reflected In Prices Lots Of Bad Trade War News Reflected In Prices Lots Of Bad Trade War News Reflected In Prices Chart 8 shows the drubbing in relative share prices as three key macro drivers have felt the trade war’s wrath. In more detail, were a deal to get struck, growth expectations will reverse course and a bond market sell-off will almost immediately reflect such an improvement in the global macro backdrop. Rising interest rates on the back of a reflationary/inflationary impulse are a boon for industrials and a bane for high growth tech stocks (top panel, Chart 8). Similarly, the middle panel of Chart 8 highlights that the ISM manufacturing survey should climb above the boom/bust line and outshine the San Francisco Fed’s Tech Pulse Index (that comprises “coincident indicators of activity in the U.S. information technology sector”3) on news of a successful deal. Finally, relative capital expenditure outlays should also veer in favor of industrials as previously mothballed infrastructure projects will come out of hibernation (bottom panel, Chart 8). In contrast, tech capex has been resilient of late with analytics, security and cloud computing being the most defensive capex corner, leaving little room for additional relative capex gains. Taking the opposite side i.e. a “no deal”, we doubt the metrics we depict in Chart 8 would sink that much further. If anything we believe that there is an element of exhaustion and relative share prices would jump on news of a breakdown in trade talks as tech sector fire sales would trump the sell-off in already depressed industrials. Meanwhile, the U.S. dollar and relative share prices have been steeply diverging recently and this gap will likely narrow via a catch-up phase in the latter (top & middle panels, Chart 9). According to Factset’s latest data the S&P industrials sector garners 37% of its sales from abroad, whereas the S&P information technology sector’s foreign exposure stands at 57% of total revenues.4 Therefore, given this 20% delta, a rising greenback should be beneficial to the more domestically geared industrials stocks (bottom panel, Chart 9). On the operating front, industrials also have the upper hand. The relative wage bill is sinking like a stone (shown inverted, middle panel, Chart 10) at a time when relative selling price inflation is holding its own (top panel, Chart 10). The upshot is that a relative profit margin jump is in store in the coming months which should boost the relative share price ratio (bottom panel, Chart 10). Chart 9Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Chart 10Industrials Have The Upper Hand Industrials Have The Upper Hand Industrials Have The Upper Hand U.S. Equity Strategy’s proprietary relative Cyclical Macro Indicators and relative profit growth models capture all these drivers and both signal that an industrials versus tech earnings-led outperformance phase looms into year end (Chart 11). Chart 12 shows that the relative earnings breadth and relative net earnings revisions are both deep in negative territory. In terms of technicals, the relative percentage of groups trading with a positive 52-week rate of change has hit the lowest level in the past two decades (second panel, Chart 12) and our composite relative technical indicator is roughly one standard deviation below the historical mean (bottom panel, Chart 11). Chart 11Profit Models And...  Profit Models And...  Profit Models And...  Chart 12...Washed Out Breadth Say Buy Industrials At The Expense Of Tech ...Washed Out Breadth Say Buy Industrials At The Expense Of Tech ...Washed Out Breadth Say Buy Industrials At The Expense Of Tech Finally, relative valuations are also bombed out. Our relative valuation indicator has been in a six-year uninterrupted drop, falling from two standard deviations above the mean to one standard deviation below the mean (fourth panel, Chart 11). Such entrenched bearishness in relative value is unwarranted. Bottom Line:  Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. …And A Long Machinery/Short Semis Pair Trade A more speculative and higher octane vehicle to explore this trade war-related mispricing is via a long S&P machinery/short S&P semiconductors pair trade. Most of the drivers mentioned above also hold true in this subsector market-neutral trade. However, in this section we will drill deeper in the China/EM drivers. The Emerging Asia leading economic indicator (EALEI) has plummeted to levels last hit around the 1998 LTCM bailout (top panel, Chart 13). While more pain is likely in the coming months as global trade has ground to a halt, we doubt the carnage in the EALEI can continue indefinitely. In fact, a tentative trough in the Emerging Markets (EM) manufacturing PMI heralds a brighter outlook for relative share prices (bottom panel, Chart 13). Chart 13Same Trade War Theme, Different Vehicles To Play It Same Trade War Theme, Different Vehicles To Play It Same Trade War Theme, Different Vehicles To Play It Chart 14China...  China...  China...  Encouragingly, China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can spike 20% near the late-2018 highs (Chart 14).   Chinese money supply growth is showing some signs of life and capital committed to infrastructure spending is coming out of hibernation. Goldman Sachs’ China current activity indicator is on a similar upward trajectory, underscoring that the path of least resistance is higher for relative share prices (Chart 15). Chart 15...Holds The Key ...Holds The Key ...Holds The Key Chart 16Firming Final Demand... Firming Final Demand... Firming Final Demand... On the operating front, relative new orders and relative shipment growth have both ticked higher (top & middle panels, Chart 16). Importantly, our relative demand proxy suggests that the relative end-demand backdrop is also firming. Using Caterpillar’s global sales to dealers data compared with global chip sales reveals that a wide gap has formed between relative share prices and our relative demand gauge (bottom panel, Chart 16). If our thesis pans out in the upcoming three-to-six months then machinery will trounce semis. Finally, relative pricing power corroborates that machinery demand has the upper hand versus semiconductor final demand. The Commodity Research Bureau’s raw industrials index is climbing relative to Asian DRAM prices. The upshot is that the compellingly valued relative share price ratio will gain steam in the months ahead (Chart 17). In sum, a tentative up-tick in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Bottom Line: Initiate a long S&P machinery/short S&P semiconductors pair trade today. The ticker symbols for the stocks in the S&P machinery and S&P semis indexes are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS, and BLBG – S5SECO – INTC, TXN, NVDA, AVGO, QCOM, MU, ADI, AMD, XLNX, QRVO, MCHP, MXIM, SWKS, respectively. Chart 17...Is A Boon To Relative Pricing Power ...Is A Boon To Relative Pricing Power ...Is A Boon To Relative Pricing Power Key Risk To Monitor One important risk to both of our newly recommended market-neutral trades is China. We recently touched base with our ex-Chief Geopolitical Strategist and currently Chief Strategist at the Clocktower Group, Marko Papic. He warned us that all bets would be off because: “I think we will look back at the recession of 2020 and it will be known as the “China recession”. Basically, China just decided to stop playing, pick up its toys, and go home”. If Marko’s wise words were to ring true, then such a Chinese policy shift will truly be a game changer with negative global economic growth implications. With regard to our pair trades, they would both be offside.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Consolidation” dated May 21, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “On Edge” dated May 13, 2019, available at uses.bcaresearch.com. 3      https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 4      https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_100419A.pdf Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The world remains mired in a manufacturing recession. This has historically not been bullish for pro-cyclical currencies. The velocity of money in the euro area will need to rise vis-à-vis the U.S. to confirm a bottom in EUR/USD. Watch the gold/silver ratio in timing this shift. Feature The view on the dollar has hardly ever been more polarized. In the bullish camp are those who believe expected returns are currently highest in the U.S., whether in the bond, equity, or real estate markets. As such, deployment of fresh capital will naturally gravitate towards the U.S. Meanwhile, the bearish side has to contend with the fact that the dollar is expensive, the Federal Reserve is about to expand dollar liquidity, and central banks keep diversifying out of their dollar holdings at a rampant pace. Both camps make quite strong arguments. However, there is little discussion about how these trends will affect relative prices between the U.S. and its trading partners. Exchange rates constantly oscillate to equate prices between any two nations. And the most important of those prices is that of money or interest rates. Forecasting relative interest rates can be an arduous task, but at a minimum, one can observe whether they are in equilibrium or not. In this report, we do it via one lens: the velocity of money, with specific application to the EUR/USD exchange rate.    EUR/USD And The Velocity Of Money The velocity of money (V) is a difficult concept to define, but can be summarized by Irving Fisher’s classical equation MV=PQ, where P is the price level in the economy, Q is output, and M is the money supply. In other words, V=PQ/M. Classical monetarists believe that the velocity of money should exhibit a high degree of stability, allowing central banks to control prices by simply altering the money supply. However, over the past few decades, there has been no correlation between prices and money supply, at least in the U.S., which seems to suggest V has a life of its own.  Chart I-1Money Velocity And Interest Rates Money Velocity And Interest Rates Money Velocity And Interest Rates There are many debates on how to interpret the velocity of money, but it is generally accepted that it is related to interest rates. If money supply is expanding faster than output, then it must be that interest rates are falling, assuming the latter are the price of money. Ergo, one way to regard V is as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables, while long rates are priced in the financial arena. Put another way, once economic agents start to increase the turnover of money in the system, it is an endogenous sign that the economy requires higher rates, similar to the signal from rising inflation. Ever since the European debt crisis, the velocity of money in the euro area has collapsed relative to that in the U.S. In the financial world, relative long bond yields have followed suit in tight correlation (Chart I-1). In a nutshell, the relative demand for holding money, perhaps precautionary demand, has been extremely high in the euro area, such that all the increase in relative money supply has been absorbed by falling relative velocity. Put another way, the neutral rate of interest in the euro area has been falling relative to that in the U.S. The velocity of money is observed ex-post, meaning it is not very useful as a forecasting tool. However, if we accept the premise that it measures the underlying neutral rate of interest in an economy, then observing it offers powerful insight into the underlying fundamental trends for any economy. One conclusion from this could be that outgoing European Central Bank President Mario Draghi might be justified in his delivery of powerful monetary stimulus last month, despite the rising chorus of dissent from the governing council. Chart I-2Structural Slowdown In European Growth Structural Slowdown In European Growth Structural Slowdown In European Growth Chart I-2 plots the relative growth performance of the euro area versus the U.S. superimposed with the exchange rate. The result is very evident: The collapse in the euro since the financial crisis has been driven by falling growth differentials between the Eurozone and the U.S. There is little the central bank can do about deteriorating demographic trends, but it can do something about falling productivity. One of those things is to lower the cost of capital in the entire Eurozone, such that it makes sense even for the less productive peripheral countries to borrow and invest. Of course, dynamics in the euro area are much more complex than this simple analogy, since rates do little to boost total factor productivity, and the capital stock in the euro area is quite high. But the fact that the biggest increase in investment since the end of the European debt crisis has been in the periphery is non-negligible evidence. A weaker exchange rate also helps. Global trade growth peaked in 2011, which means that since then, one of the few ways for countries to expand their trade pie has been via a “beggar thy neighbor” policy. Both the Germans and the Japanese are automobile geniuses. So, at the margin, the decision for an indifferent buyer comes down to cost. Chart I-3 shows that ever since the European debt crisis, the relative exchange rate between Japan and the euro area has followed the relative balance sheet expansion and contraction of both central banks. Until now, the Bank of Japan’s balance sheet was slated to expand much faster than that of the ECB. This would have been a powerful and unnecessary upward force on the EUR/JPY exchange rate, in the face of a trade war. Ever since the European debt crisis, the relative exchange rate between Japan and the euro area has followed the relative balance sheet expansion and contraction of both central banks. EUR/USD could face some near-term downside, judging from the spread between German bunds and Treasury yields (Chart I-4). Admittedly, hedged yields still favor the Eurozone over the U.S., especially in the periphery, but that advantage is fading rapidly. More importantly, yields across the periphery are converging rapidly towards those in Germany, solving a critical dilemma that has always plagued the Eurozone in general, and the euro in particular. In simple terms, ECB policy has historically always been too easy for some member countries while too stimulative for others. This has traditionally led to internal friction for the currency. However, with 10-year government bond yields in France, Spain, and even Portugal now at -26 basis points, 15 basis points and 14 basis points, respectively, this dilemma is slowly fading. Chart I-3ECB Action May Have Stalled A Euro Overshoot ECB Action May Have Stalled A Euro Overshoot ECB Action May Have Stalled A Euro Overshoot Chart I-4EUR/USD And ##br##Interest Rates EUR/USD And Interest Rates EUR/USD And Interest Rates The drop in the neutral rate of interest for the Eurozone versus the U.S. might have to do with internal dynamics in the euro area, but part of the reason may also lie in the performance of the manufacturing sector versus the services industry over the past few years. The end of the commodity bull market earlier this decade, the peak in global trade – partly driven by  China’s deliberate efforts to shift its economy more towards services, and the proliferation of “capital-lite” firms has decimated the manufacturing sector around the world. This maybe explains the underperformance of the Eurozone versus the U.S. It is clear that part of this shift is structural, but there has also been a cyclical component. Together with a lot of our leading indicators, one way to time the reversal will be to watch relative money velocity trends – between the U.S., the euro area, and China, for example. This brings us to the ratio of gold prices versus silver. Bottom Line: The world remains mired in a manufacturing recession. This has historically not been bullish for pro-cyclical currencies. The velocity of money in the euro area will need to rise vis-à-vis the U.S. to confirm a bottom in EUR/USD. Gold Versus Silver Chart I-5GSR At A Speculative Extreme GSR At A Speculative Extreme GSR At A Speculative Extreme The gold/silver ratio (GSR) was in a race towards major overhead resistance at 100 this summer, but finally hit a three-decade high of 93.3 and is now showing tentative signs of a reversal. The history of these reversals is that they tend to be powerful, quick, and extremely volatile (Chart I-5). This not only paves the way for an excellent entry point to short gold versus silver, but provides important information on the battleground between easing financial conditions and a pick-up in economic (or manufacturing) activity. In short, it provides insight on when to buy pro-cyclical currencies. Just like gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for currency wars and fiat money debasement. However, the gold/silver ratio tends to rally ahead of an economic slowdown, but then peaks when growth is still weak but liquidity conditions are plentiful enough to affect the outlook for future global growth. Of course, a key assumption is that the global economy fends off a recession, which could otherwise sustain a high and rising GSR. The ratio of the velocity of money between the U.S. and China has tended to track the gold/silver ratio in a tight embrace. The ratio of the velocity of money between the U.S. and China has tended to track the gold/silver ratio in a tight embrace (Chart I-6). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the U.S. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses (Chart I-7).  Chart I-6Falling GSR = Rising Manufacturing Activity Falling GSR = Rising Manufacturing Activity Falling GSR = Rising Manufacturing Activity Chart I-7No Recession = Buy Silver No Recession = Buy Silver No Recession = Buy Silver A falling dollar also tends to benefit silver more than gold, because silver generally rises faster than gold during precious metal bull markets. Part of the reason is that the silver market is thinner and more volatile, with futures open interest that is about one-third that of gold. Put another way, volatility in silver has always been historically higher than gold (Chart I-8), just as manufacturing and exports tend to be the most volatile part of any economy. Chart I-8Silver Is More Volatile Than Gold Silver Is More Volatile Than Gold Silver Is More Volatile Than Gold This brings us to the sweet spot for silver (and procyclical currencies). Even if global growth remains tepid over the next few months, a lot of the bad news is already reflected in a high GSR, meaning the potential for upside will have to be nothing short of a deep recession. Relative speculative positioning hit a high of 36% of open interest and has been rolling over since. Relative sentiment hit a high of 33% and is also rolling over. More often than not, confirmation from both these indicators has led to a selloff in the GSR (Chart I-9). Chart I-9Tentative Signs Of A Top Tentative Signs Of A Top Tentative Signs Of A Top If global growth bottoms, then the rise in silver prices could be explosive. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” industry that are capturing the new manufacturing landscape (Chart I-10). Meanwhile, we are entering a window where any pickup in demand could lead to a sizeable increase in the silver physical deficit. The sharp fall in silver scrap supply is an indication that the supply bottleneck is becoming acute (Chart I-11). Chart I-10Silver Fabrication Demand Uptrend Silver Fabrication Demand Uptrend Silver Fabrication Demand Uptrend Chart I-11Physical Silver Is In Deficit Physical Silver Is In Deficit Physical Silver Is In Deficit As for speculators, ETF demand for silver has just started to pick up, meaning the prospect for a speculative buying frenzy is significant. Similarly, in Shanghai, turnover in both gold and silver has been muted – fitting evidence that there has been a dearth of Asian physical demand, from Hong Kong to India (Chart I-12). We are following this turnover closely as it could be a good indication of a turnaround. Chart I-12Silver Turnover Is Low In Asia Silver Turnover Is Low In Asia Silver Turnover Is Low In Asia Bottom Line: A falling GSR provides important information about the battleground between easing financial conditions and a pickup in economic activity. We remain bullish on both gold and silver, but a trading opportunity has opened up for a short GSR position. Place a limit sell at 90.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly negative: Average hourly earnings growth fell from 3.2% year-on-year to 2.9% in September. Nonfarm payrolls decreased to 136,000, while the unemployment rate fell to a 50-year low of 3.5%. The trade deficit marginally widened to $54.9 billion in August. The NFIB’s business optimism index fell to 101.8 in September, down from 103.1 in August. Producer prices for final demand fell by 0.3% month-on-month in September. Services decreased by 0.2% while goods fell by 0.4%.  Initial jobless claims fell to 210,000 for the week ended October 4th. Both headline and core inflation were unchanged at 1.7% and 2.4% year-on-year in September. The DXY index increased by 0.1% this week. Fed chair Jerome Powell said in a speech on Tuesday that the Fed will begin increasing its securities holdings to maintain an appropriate level of reserves in order to avoid another cash supply shock. Balance sheet expansion may eventually help weaken the greenback. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have continued to disappoint: The Sentix confidence index in the euro area fell further to -16.8 in October.  German factory orders contracted by 6.7% year-on-year in August, while industrial production fell by 4% year-on-year. The trade surplus narrowed by roughly €2 billion to €18 billion in August. In France, the trade deficit widened by €0.5 billion to €5 billion in August. Industrial output fell by 0.9% month-on-month in August.  The EUR/USD increased by 0.4% this week. The incoming data are sending the same old message: that while services and domestic demand are holding up, manufacturing and exports continue to underperform. In an interview this week, European Central Bank Vice President Luis de Guindos stated that the ECB still has further headroom to ease policy.  Report Links: A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Both the coincident index and leading index fell to 99.3 and 91.7 in August. Labor cash earnings contracted by 0.2% year-on-year in August. The current account balance also widened to a surplus of ¥2.2 trillion in August. The ECO Watchers Survey shows an improvement of the current situation to 46.7 in September. However, the outlook index fell further to 36.9. Preliminary machine tool orders contracted by 35.5% year-on-year in September. The USD/JPY increased by 0.6% this week. The Bank of Japan is likely to introduce additional stimulus via stronger forward guidance. But the path of least resistance for the yen before then is down. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been dismal: Halifax house prices contracted by 0.4% month-on-month in September. Retail sales decreased by 1.7% year-on-year in September. Industrial production continued to fall by 1.8% year-on-year in August. Manufacturing production also decreased by 1.7% year-on-year. GDP fell by 0.1% month-on-month in August. The GBP/USD fell by 0.8% this week, weighed by Brexit uncertainties and weaker incoming data. Moreover, the FPC meeting minutes released this Wednesday highlighted the downside risks associated with a disorderly Brexit, including material debt vulnerabilities, structural illiquidity, and reduced space for monetary policy. The pound is extremely cheap, but volatility will persist in the near term. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: The NAB’s business conditions index increased to 2 from 1 in September. However, the NAB confidence index fell to zero. The Westpac consumer confidence reading also plunged by 5.5% to 92.8 in October, its lowest since mid-2016.  Home loans grew by 1.8% month-on-month in August, following a monthly increase of 5% in July. The AUD/USD has been flat this week. Our bias remains pro-cyclical and we are constructive on the Aussie dollar from a contrarian perspective, especially against the kiwi. As an export-oriented economy, the Australian dollar is likely to respond well to positive U.S.-China trade talks. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There is scant data from New Zealand this week: The Inflation gauge was unchanged at 0.3% month-on-month in September. The NZD/USD has been flat this week. As a small, open economy, New Zealand is highly tied to global growth, and heavily weighed down by the U.S.-China trade war. We continue to be long AUD/NZD however as a play on relative valuation. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been relatively strong: Exports and imports both increased in August. However, the trade deficit narrowed to C$0.96 billion in August from C$1.38 billion in July. The Ivey PMI fell to 48.7 in September, down from 60.6 in August. Building permits grew by 6.1% month-on-month in August. New housing prices contracted by 0.3% year-on-year in August. The USD/CAD fell by 0.1% this week, as Canada is gearing up for a federal election on October 21st. The latest opinion polls show the Liberal Party still ahead with 34.2% of votes, followed by the Conservative Party, closely behind. Our colleagues in Commodity & Energy Strategy point out that the most positive outcome for the Canadian energy sector is a Conservative majority. Our baseline scenario remains a second Trudeau term, producing a status quo result that does not materially change our energy sector outlook. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The unemployment rate came in at 2.3% in September, the lowest over the past 18 years. USD/CHF has been more or less flat this week. As we argued in last week’s report, the Swiss domestic economy is holding up well. However, due to the highly export-driven nature of the Swiss economy, the Swiss National Bank is likely to weaponize its currency to keep tradeable goods prices in a favorable range. We will go long EUR/CHF at 1.06. Stay tuned.   Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mostly negative: Manufacturing output contracted by 1.1% month-on-month in August. Headline inflation slowed to 1.5% year-on-year in September. Core inflation, however, increased to 2.2% year-on-year. The producer price index increased by 3.6% month-on-month in September. The Norwegian krone continues to trade offside against the U.S. dollar, due to broad dollar resilience and weak oil prices. The USD/NOK increased by 0.2% this week. The EIA posted an increase of 2.9 million barrels in crude oil stocks this week, following an increase of 3.1 million barrels last week, much higher than expected. The increase in oil supply, together with a quick recovery of Saudi oil facilities are viewed as near-term bearish for oil prices. But if demand is able to recover, this will be positive. Remain long petrocurrencies for now. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden continue to disappoint: Industrial production grew by 2.5% year-on-year in August, following yearly growth of 3.1% the previous month. Total manufacturing new orders contracted by 1.1% year-on-year on a seasonally-adjusted basis in August. Headline inflation increased to 1.5% year-on-year in September. The Swedish krona has been the worst-performing G-10 currency this week, losing 1.1% against the U.S. dollar. Year-to-date, the USD/SEK has appreciated by a total of 12.3%. Swedish manufacturing new orders, a key indicator we watch in gauging the direction of the global economy, continued to deteriorate this week. Among sub-sectors, the largest decrease was recorded in the mines and quarries sector. We are watching Swedish data closely.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Analysis on Turkey is available below. Highlights A dovish Fed or robust U.S. growth does not constitute sufficient conditions for a bull market in EM. China’s business and credit cycles are much more important factors for EM than those of the U.S. A recovery in the Chinese economy and global manufacturing is not imminent. The common signal reverberating from various financial markets is that the risks to the global business cycle are still skewed to the downside. Feature Current investor perceptions of emerging markets are mixed. Some expect EM to benefit greatly from low U.S. interest rates. These investors view even a partial trade deal between the U.S. and China as sufficient for EM to embark on a bull market. BCA’s Emerging Markets Strategy team disagrees with this narrative. We deliberated the significance of the U.S.-China confrontation to EM in our September 19 report; therefore, we will not go over this subject here. Rather, in this report we discuss some of the more common misconceptions surrounding EM currently, and infer what these mean for investment strategies. Perception 1: The share of resource sectors (materials and energy) in the EM equity benchmark has declined substantially. This along with the expanded role of consumers and consumer stocks (Alibaba, Tencent and Baidu) in EM economies and equity markets has made their share prices less exposed to the global trade cycle and commodities prices. Reality: It is true that in many EM bourses, the weight of consumer stocks has been growing. Nevertheless, their financial markets in general, and equity markets in particular, remain very sensitive to the global trade cycle and commodities prices. Chart I-1 illustrates that the aggregate EM equity index has historically been and continues to be strongly correlated with the global basic materials stock index. The latter includes mining, steel and chemical companies. Global materials stocks also exhibit a very strong correlation with Chinese banks’ share prices. Moreover, global materials stocks also exhibit a very strong correlation with Chinese banks’ share prices (Chart I-2). The rationale for the high correlation is that both mainland banks’ profits and global demand for basic materials are driven by a common factor: China’s business cycle. Chart I-1EM And Global Materials Stocks Move Together EM And Global Materials Stocks Move Together EM And Global Materials Stocks Move Together Chart I-2Chinese Bank And Global Materials Share Prices Are Highly Correlated Chinese Bank And Global Materials Share Prices Are Highly Correlated Chinese Bank And Global Materials Share Prices Are Highly Correlated For example, construction in China is contracting (Chart I-3), which entails both higher NPLs for Chinese banks and lower demand for basic materials. China accounts for about 50% of global consumption of industrial metals, cement and many other basic materials. Finally, EM ex-China bank stocks also correlate strongly with global basic materials share prices. The basis is as follows: Many emerging economies export raw materials, and commodities price fluctuations impact their business cycle, exports and exchange rates. Chart I-3China: Construction Activity Is Contracting China: Construction Activity Is Contracting China: Construction Activity Is Contracting Chart I-4High-Yielding EM: Currencies And Local Bond Yields High-Yielding EM: Currencies And Local Bond Yields High-Yielding EM: Currencies And Local Bond Yields Historically, in high-yielding EM markets, currency depreciation has led to higher interest rates and lower bank share prices, and vice versa (Chart I-4). Lately, EM bond yields have not risen in response to EM currency depreciation. However, we believe this correlation will soon be re-established if EM currencies continue drifting lower.  In short, China’s money/credit cycles drive not only the mainland’s business cycle, banking profits and NPLs, but also global trade and commodities prices. The latter two - via their impact on exchange rates and in turn interest rates - have historically explained credit and domestic demand cycles in high-yielding EM. Perception 2:  EM stocks are a high-beta play on the S&P 500, i.e., EM equities outperform when the S&P 500 rallies, and vice versa. Reality: Since 2012, the beta for EM equity versus the S&P 500 has often been below one (Chart I-5). Furthermore, since 2012, EM share prices often failed to outpace their DM peers during global equity rallies. Indeed, EM relative equity performance versus DM, as well as the EM ex-China currency total return index, have been closely tracking the relative performance of global cyclicals versus global defensive stocks (Chart I-6). Chart I-5EM Equities Beta To The S&P 500 EM Equities Beta To The S&P 500 EM Equities Beta To The S&P 500 Chart I-6Global Cyclicals-To-Defensives Equity Ratio And EM Global Cyclicals-To-Defensives Equity Ratio And EM Global Cyclicals-To-Defensives Equity Ratio And EM   In short, EM equities and currencies have been, and will remain, sensitive to the global business cycle rather than the S&P 500. Since 2012, the latter has - on several occasions - decoupled from the global manufacturing and trade cycles. Perception 3:  EM stocks, currencies and fixed-income markets are very sensitive to U.S. interest rates. Hence, a dovish Fed will lead to EM currency appreciation.  Reality: Chart I-7 reveals that EM currencies, total returns on EM local currency bonds in U.S. dollar terms and EM sovereign credit spreads do not exhibit a strong relationship with U.S. Treasury yields. U.S. interest rate expectations have a much smaller impact on EM financial markets than commonly perceived by the investment community.  Overall, U.S. interest rate expectations have a much smaller impact on EM financial markets than commonly perceived by the investment community.  Chart I-7EM And U.S. Bond Yields: No Stable Correlation bca.ems_wr_2019_10_10_s1_c7 bca.ems_wr_2019_10_10_s1_c7 Chart I-8China Cycle And EM Stocks Led U.S. Bond Yields China Cycle And EM Stocks Led U.S. Bond Yields China Cycle And EM Stocks Led U.S. Bond Yields On the contrary, the declines in U.S. bond yields in both 2015/16 and in 2018/19 were due to the growth slowdown that emanated from China/EM. The top panel of Chart I-8 illustrates that Chinese import growth rolled over in December 2017, yet U.S. bond yields rolled over in October 2018. What is more, EM share prices have been leading U.S. bond yields in recent years, not the other way around (Chart I-8, bottom panel). Perception 4:  If the U.S. avoids a recession, EM risk assets will recover. Chart I-9EM Profits Are Driven By Chinese Not U.S. Business Cycle EM Profits Are Driven By Chinese Not U.S. Business Cycle EM Profits Are Driven By Chinese Not U.S. Business Cycle Reality: EM per-share earnings contracted in 2012-2014 and in 2019, despite reasonably robust growth in U.S. final demand (Chart I-9, top panel). This suggests that even if the U.S. economy avoids a recession, that will not be a sufficient condition to be bullish on EM. EM corporate profits are highly driven by China’s business cycle. The bottom panel of Chart I-9 illustrates that mainland domestic industrial orders have been the key driver of EM corporate profit cycles since 2008. Perception 5:  EM equities, fixed-income markets and currencies are cheap. Reality: EM stocks are not cheap. They are fairly valued. Equity sectors with very poor fundamentals have very low multiples. Hence, they are “cheap” for a reason. These include Chinese banks, state-owned enterprises in various countries and resource companies. Equity segments with robust fundamentals are overpriced. Given that Chinese banks, state-owned enterprises in various countries, resource companies, and cyclical businesses have very large market caps, EM market-cap based equity valuation ratios are low – i.e., they appear cheap.  To remove the impact of these large market cap segments, we constructed and have been publishing the following valuation ratios: median, 20% trimmed mean and equal-sub-sector weighted (Chart I-10). Each of these is calculated based on the average of trailing and forward P/E ratios, price-to-book value, price-to-cash earnings and price-to-dividend ratios. EM equities relative to DM are not cheap either. Chart I-11 demonstrates the same ratios – median, 20% trimmed-mean and equal-sub-sector weighted values for EM versus DM. Chart I-10EM Equities Are Not Cheap bca.ems_wr_2019_10_10_s1_c10 bca.ems_wr_2019_10_10_s1_c10 Chart I-11Relative To DM EM Stocks Are Not Cheap bca.ems_wr_2019_10_10_s1_c11 bca.ems_wr_2019_10_10_s1_c11 Further, when valuations are not at extremes as in the case of EM equities at the moment, the profit cycle holds the key to share price performance over a 6 to 12-month horizon. EM earnings are presently contracting in absolute terms, and underperforming DM EPS. Two currencies that offer value are the Mexican peso and Russian ruble. Chart I-12EM Local Yields Are Low In Absolute Terms And Relative To U.S. EM Local Yields Are Low In Absolute Terms And Relative To U.S. EM Local Yields Are Low In Absolute Terms And Relative To U.S. In the fixed-income space, EM local bond yields are very low in absolute terms and relative to U.S. Treasury yields (Chart I-12). EM sovereign and corporate spreads are not wide either. As to exchange rates, the cheapest currencies are those with the worst fundamentals, such as the Argentine peso, Turkish lira and South African rand. The majority of other EM currencies are not very cheap. Two currencies that offer value are the Mexican peso and Russian ruble. Yet foreign investors are very long these currencies, and a combination of lower oil prices and portfolio outflows from broader EM will weigh on these exchange rates as well. Takeaways And Investment Strategy Chart I-13EM Currencies And Industrial Metals Prices bca.ems_wr_2019_10_10_s1_c13 bca.ems_wr_2019_10_10_s1_c13 EM risk assets and currencies exhibit the strongest correlation with global trade and commodities prices. Chart I-13 indicates that the EM ex-China currency total return index closely tracks commodities prices. This corroborates the messages from Chart I-1 on page 1 and Chart I-6 on page 4.  China’s business and credit cycles are much more important for EM than those of the U.S. A dovish Fed or strong U.S. growth are not sufficient reasons to bet on an EM bull market. A recovery in the Chinese economy and global manufacturing is not imminent. Individual EM countries’ domestic fundamentals such as return on capital, inflation, banking system health, competitiveness and politics drive individual EM performance. On these accounts, the outlook varies among EM. Readers can find analyses on specific EM economies in our Countries In-Depth page. Asset allocators should continue underweighting EM stocks, credit and currencies versus their DM counterparts.  Absolute-return investors should outright avoid EM, or trade them on the short side. Within the EM equity space, our overweights are Mexico, Russia, Central Europe, Korea ex-tech, Thailand and the UAE. Our underweights are South Africa, Indonesia, Philippines, Hong Kong, Turkey and Colombia. The path of least resistance for the U.S. dollar is up. Continue shorting the following basket of EM currencies versus the dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We are also short the CNY versus the greenback. As always, the list of our country allocations for local currency bonds and sovereign credit markets is available at the end of our reports – please refer to page 16. Take Cues From These Markets We suggest investors take cues from the following financial market signals. They are unequivocally sending a downbeat message for global growth and risk assets: The ratio between Sweden and Swiss non-financial stocks in common currency terms is heading south (Chart I-14). Swedish non-financials include many companies leveraged to the global industrial cycle, while Swiss non-financials are dominated by defensive stocks. Hence, the persistent decline in this ratio presages a continued deterioration in the global industrial sector. Where is the next defense line for this ratio? To reach its 2002 and 2008 nadirs, it will need to drop by another 10%. In the interim, investors should maintain a defensive posture. Chart I-14A Message From Swedish And Swiss Equities A Message From Swedish And Swiss Equities A Message From Swedish And Swiss Equities Chart I-15A Breakdown In The Making? A Breakdown In The Making? A Breakdown In The Making? U.S. FAANG stocks appear to be cracking below their 200-day moving average. The relative performance of global cyclical versus global defensive stocks is relapsing below the three-year moving average that served as a support last December (Chart I-15). U.S. FAANG stocks appear to be cracking below their 200-day moving average (Chart I-16). If this support gives, the next one will be about 17% below current levels. Finally, U.S. high-beta share prices are on the verge of a breakdown (Chart I-17). The next technical support is 10% below current levels. Chart I-16FAANG Are On The Support Line FAANG Are On The Support Line FAANG Are On The Support Line Chart I-17U.S. High-Beta Stocks Are On The Edge U.S. High-Beta Stocks Are On The Edge U.S. High-Beta Stocks Are On The Edge Bottom Line: The common message reverberating from these financial markets corroborates our fundamental analysis that a global business cycle recovery is not imminent, and that global risk assets in general, and EM financial markets in particular, are at risk of selling off further. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Turkey: Is The Mean-Reversion Rally Over? Turkish financial markets have rebounded to their respective falling trend lines (Chart II-1). Are they set to break out or is a setback looming? Chart II-1Back To Falling Trend Back To Falling Trend Back To Falling Trend Chart II-2TRY Is Cheap TRY Is Cheap TRY Is Cheap Pros The economy has undergone a considerable real adjustment and many excesses have been purged: The current account balance has turned positive as imports have collapsed. Going forward, lower oil prices are likely to help the nation’s current account dynamics. The lira has become cheap (Chart II-2).  According to the real effective exchange rate based on unit labor costs, the currency is one standard deviation below its fair value. Core and headline inflation have fallen, allowing the central bank to cut interest rates aggressively. However, the exchange rate still holds the key: if the currency depreciates anew, local bonds yields will rise and the ability of the central bank to reduce borrowing costs further will diminish. Finally, private credit and broad money growth have decelerated substantially and are contracting in inflation-adjusted terms (Chart II-3). Chart II-3Money & Credit Have Bottomed Money & Credit Have Bottomed Money & Credit Have Bottomed Chart II-4Banks Have Been Aggressively Buying Government Bonds Banks Have Been Aggressively Buying Government Bonds Banks Have Been Aggressively Buying Government Bonds The recent gap between broad money and private credit growth has been due to commercial banks buying government bonds (Chart II-4). When a commercial bank purchases a security from non-banks, a new deposit/new unit of money supply is created. Banks’ purchases of government bonds en masse have capped domestic bond yields. However, if pursued aggressively, such monetary expansion could weigh on the currency’s value.   Cons Presently, potential sources of macro vulnerability in Turkey are: Foreign debt obligations (FDOs) – which are calculated as the sum of short-term claims, interest payments and amortization over the next 12 months – are at $168 billion, which is sizable. The annual current account surplus has reached only $4 billion and is sufficient to cover only 2.5% of FDOs, assuming the capital and financial account balance will be zero. Clearly, Turkey needs to both roll over most of its foreign debt coming due and attract foreign capital to finance a potential expansion in its imports if its domestic demand is to recover. Critically, $20 billion of net FX reserves, excluding gold, swap lines with foreign central banks and net of domestic banking and non-banking corporations’ foreign exchange deposits, are not adequate either to cover foreign debt obligations. Even though headline and core inflation measures have fallen, wage inflation remains rampant (Chart II-5). If wage inflation does not drop substantially very soon, rapidly rising unit labor costs will feed into inflation leading to negative ramifications for the exchange rate. This is especially crucial in Turkey given President Erdogan has undermined the central bank’s credibility and is resorting to populist measures to revive his popularity. Finally, Turkish banks remain under-provisioned. Currently, the banking regulator is requiring banks to boost their non-performing loans (NPL) ratio to 6.3% of total loans.This a far cry from the 2001 episode when the NPL ratio shot up to 25% (Chart II-6).   Even though interest rates rose much more in 2001 than last year, the private credit penetration in the economy was very low in the early 2000s. A higher credit penetration usually implies weaker borrowers have borrowed money and heralds a higher NPL ratio. Typically, following a credit boom and bust, it is natural for the NPL ratio to exceed 10%. We do not think Turkish banks stocks, having rallied a lot from their lows, are pricing in such a scenario. Chart II-5Surging Wages Are A Risk Surging Wages Are A Risk Surging Wages Are A Risk Chart II-6NPL Ratio Is Unrealistic NPL Ratio Is Unrealistic NPL Ratio Is Unrealistic Investment Recommendation We recommend both absolute-return investors and asset allocators not to chase Turkish financial markets higher. Renewed market volatility lies ahead. Given we expect foreign capital outflows from EM, Turkish companies and banks will encounter difficulties in rolling over their external debt and attracting foreign capital into domestic markets. This will produce a new downleg in the exchange rate. In turn, currency depreciation will weigh on performance of local bonds as well as sovereign and corporate credit. Stay underweight.   Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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.