Currencies

Highlights So What? Tariffs and currency depreciation will likely lead to military saber-rattling in Asia Pacific. Why? President Trump is not immune to the market’s reaction to his trade war escalation. Yet China’s currency depreciation is a major escalation and the near-term remains fraught with danger for investors. Military shows of force and provocations could crop up across Asia Pacific, further battering sentiment or delaying trade talks. Remain short CNY-USD, short the Hang Seng index, long JPY-USD, and long gold. Overweight the U.S. defense sector relative to global stocks. Feature The Osaka G20 tariff ceasefire has collapsed; U.S. President Donald Trump is threatening tariffs on all Chinese imports; the People’s Bank of China has allowed the renminbi to depreciate beneath the important 7.0 exchange rate to the dollar; and the United States has formally labeled China a “currency manipulator.” What a week! The spike in volatility is likely to be accompanied by a rise in credit risk, as measured by the TED spread (Chart 1). Safe havens like gold, treasuries, and the Japanese yen are rallying in a classic risk-off episode, while messengers of global growth like copper, the Australian dollar, and the CRB raw industrials index are stumbling (Chart 2). Only green shoots in Chinese trade and German manufacturing have kept the selloff in check this week by improving the cyclical outlook despite elevated near-term risks. Chart 1So Much For The Osaka G20 Tariff Ceasefire! Chart 2Key Risk-On/Risk-Off Indicators Breaking Down While we anticipated the re-escalation of U.S.-China tensions, now is the time to take stock and reassess. President Trump is a political animal. While he has demonstrated a voracious risk appetite throughout the year, he is ultimately focused on reelection in November 2020. The United States will survive without a trade deal by then, but Trump may not. Presumably, Trump’s reason for increasing pressure on China throughout 2019 is to secure a deal by the end of the year. This would be to see China’s concessions translate into trade perks for the U.S. markets and economy in 2020 by the time he hits the campaign trail. The experience of Q4 2018 suggests that Trump changed his negotiating tack after U.S. equities fell by only 4% from their peak – but we consider an equity correction a clear pain threshold (Chart 3). Trump is closely associated with the economic fortunes of the country, even more so than the average president. Bear markets tend to coincide with recessions. Trump – beset by controversy and scandal at home – must assume that a recession will be the coup de grâce. Chart 3Where Is President Trump's Pain Threshold? Chart 4Will Huawei Ban Hit The Tech Sectors? Investors will get some clarity next week when the Commerce Department decides whether to renew the general temporary license for American companies to trade with Chinese telecoms giant Huawei. A full denial of the license would signal that Trump is unconcerned with recession and reelection probabilities and focusing exclusively on the national security threat from China. It would send technology sectors and the broader equity market into a plunge on both sides of the Pacific (Chart 4) and could significantly increase the risk that the global economy begins a downturn. Positive signals are scarce as we go to press: New tariff is on track: The U.S. Trade Representative is preparing a final list of $300 billion in goods to fall under a new 10% tariff, despite reports that Trump overrode USTR Robert Lighthizer in announcing the new tariff. This does not guarantee that the tariff will go into effect on September 1 but it does make it more likely than not. Huawei is under pressure: Office of Management and Budget has disqualified Huawei from any U.S. government contracts as of August 13 – a ban to be extended to any third parties contracting Huawei as of the same date next year. This is not encouraging for Huawei but it is a separate and more limited determination from that of the Commerce Department. Still, we expect the Trump administration to take some moves to offset the ongoing trade escalation. While we are inclined to think the new tariff will take effect, Huawei will likely get a reprieve in the meantime. This will help to ensure that the September trade talks in Washington, DC go forward. The administration has an interest in keeping the trade negotiations alive. Furthermore, there is some evidence that President Trump is recognizing the need to calm other “trade wars” to mitigate the impact of the central China trade war. In September the administration will attempt ratification of the USMCA in Congress – we still think this is slightly favored to go through. We also expect a U.S.-Japan trade agreement to materialize rapidly – likely at the UN General Assembly from September 17-30. Another positive sign is that the European Union has agreed to expand beef imports from the United States. Real movement on agriculture, while China cancels U.S. ag imports, implies that President Trump is less likely to impose car tariffs on Europe for national security reasons on November 13-14.1 The problem is that the fallout from China’s currency depreciation and the new tariffs will hit the market before anything else, which means we remain tactically bearish. Heightened trade tensions are also likely to spill into the strategic sphere in the near term. Saber-rattling – military shows of force and provocations – will increase the geopolitical risk premium across the globe, especially in East Asia. A frightening U.S.-China clash may ultimately encourage real compromises in the trade negotiations, but the market would get the negative news first. If Washington does not make any reassuring moves but expands the current policy assault on China – including through a Huawei ban – then we will consider shifting to a defensive posture cyclically as well as tactically. Bottom Line: We recognize that President Trump may be forced by the risk of a recession to relax the trade pressure and accept some kind of China deal – we may upgrade this 40% chance if and when the U.S. veers toward an equity bear market. In the meantime we expect further negative fallout from the past week’s aggressive maneuvers by both sides. Currency War Assuming that an equity correction is inevitable at some point and that Trump goes crawling back to the Chinese for trade talks: How will they respond? Will Xi Jinping, the strongman general secretary of a resurgent Communist Party, return to talks and reassure global markets at Trump’s beck and call? Or will he refuse, let the market do what it will, and let Trump hang? By letting the currency drop … Beijing is expressing open defiance. The renminbi’s depreciation – through PBoC inaction on August 5, then through action on August 8 – is a warning that Trump is approaching the point of no return. His initial grievance has always been Chinese “currency manipulation” but until now he has refrained from formally leveling this accusation (only using it on Twitter). By letting the currency drop well beneath the level at which Trump was inaugurated (6.8 CNY-USD), and beyond the global psychological threshold, Beijing is expressing open defiance and threatening essentially to break off negotiations. Chart 5China Sends Warning Via Currency Depreciation The effect of continued depreciation would be to offset the effect of tariffs and ease financial conditions in China. This is fully in keeping with our view that China has opted for stimulus over reform this year. China is likely to follow up with further cuts to banks’ reserve requirement ratios and a cut to the benchmark policy interest rate (Chart 5). The July Politburo statement showed a greater willingness to stimulate the economy and it occurred prior to Trump’s new volley of tariffs. Currency appreciation is the surest way to rebalance China’s economy toward household consumption and obviate a strategic conflict with the United States. By contrast, yuan depreciation will exacerbate the U.S. trade deficit and give Trump’s Democratic rivals convenient evidence that the “Art of the Deal” is counterfeit. How far will the renminbi fall? Chart 6 updates our back-of-the-envelope calculation of the implication from different tariff scenarios assuming that the equilibrium bilateral exchange rate depreciation will equal the tariffs collected as a share of total exports to the United States. (10% tariff on $259 billion = $25.9 billion, which is 5% of $509 billion total.) The yuan is now approaching Scenario D, 25% tariffs on the first half of imports and 10% on the second half, which points toward 7.6 CNY-USD. There are reasons to believe that this simple framework won’t apply, at least in terms of the magnitude of the impact, but it gives an indication of considerable downward pressure. Chart 6The Yuan Will Fall, But Not Freely Chester Ntonifor of our Foreign Exchange Strategy sees the yuan falling to around 7.3-7.4 if the new tariffs are applied based on the fact that the 25% tariff on $250 billion worth of goods produced a roughly 10% decline in the bilateral exchange rate. Our Emerging Markets Strategy also expects about a 5% drop in the CNY-USD. Having tightened capital controls during the last bout of depreciation in 2015-16, China is probably capable of controlling the pace of depreciation, preventing capital outflows from becoming a torrent, by selling foreign exchange reserves, further tightening capital controls, or utilizing foreign currency forward swaps. But Asian currencies, global trade revenues in dollars, and EM currencies and risk assets will suffer – and they have more room to break down from current levels.2 Meanwhile even a modest drop in the renminbi – amid a return to dovish monetary policy in global central banks – has revived concerns about a global currency war. A rising dollar is anathema to President Trump, who aims to reduce the trade deficit, encourage the on-shoring of manufacturing, and maintain easy financial conditions for the U.S. economy. Table 1U.S. Demands On China In Trade Talks Chart 7U.S. Allies' Share Of Treasuries Rises Trump’s decision to slap a sweeping new tariff on China – reportedly at the objection of all of his trade advisers except the ultra-hawkish Peter Navarro (Table 1) – was at least partly driven by his desire to see the Fed cut rates beyond the 25 basis point cut on July 31 and weaken the dollar. Yet the escalation of the trade war weighs on global trade and growth, which will push the dollar up. This reinforces the above argument that Trump will probably seek to offset the recent trade war escalation with some mitigating moves. Beyond inducing the Fed to cut further, it is difficult for President Trump to drive the dollar down. The Treasury Department can intervene in foreign exchange markets, but direct intervention does not have a successful track record. Interventions usually have to be sterilized (expansion of the money supply externally must be addressed at home by mopping up the new liquidity), which in the context of free-moving global capital means that any depreciation will be short-lived. An unsterilized intervention would be extremely unorthodox and is unlikely short of a major crisis and breakdown in institutional independence. The U.S. could attempt to engineer an internationally coordinated currency intervention, as we have highlighted in the past. But it is highly unlikely to succeed this time around. The U.S. is less dominant of a military and economic power than it was when it orchestrated the Smithsonian Agreement of 1971 and the Plaza Accord of 1985. Neither the European nor the Japanese economies are in a position to tighten monetary policy or financial conditions through currency appreciation. While China weans itself off treasuries, U.S. allies and others fill the void. Indeed, after a long period in which American allies declined as a share total holders of treasuries – as China and emerging markets increased their forex reserves and treasury holdings momentously – allies are now taking a greater share (Chart 7). Chart 8China Diversifies While It Depreciates China is driving down the yuan not by buying more treasuries but by buying other things – diversifying away from the USD into alternative reserve currencies and hard assets, such as gold and resources tied to the Belt and Road Initiative (Chart 8). As trade, globalization, and global growth have slowed down, and as China’s growth model and the U.S.-China special relationship expire, global dollar liquidity is shrinking. Dollar liquidity is the lifeblood of the global financial system and the consequence is to tighten financial conditions, including via equity markets (Chart 9). The solution would be a trade deal in which China agrees to reforms to pacify the U.S., including an appreciation renminbi, while the U.S. abandons tariffs, enabling global trade, growth, commodity prices, and dollar liquidity to recover. Yet China was never likely to agree to a new Plaza Accord because it is delaying reform to its economy in order to maintain overall political stability – and the financial turmoil of 2015-16 only hardened this position. Chart 9Dollar Liquidity A Risk To Global Equities Moreover Japan in 1985 was already a subordinate ally and had a security guarantee from the United States that was not in question. By contrast, China today is asserting its “equality” as a nation with the U.S., and has no guarantee that Americans are not demanding economic reforms so as to debilitate China’s political stability and strategic capability. After tariffs and currency war comes saber-rattling. Comparing China to Japan in the decades leading up to the Plaza Accord shows how remote of a possibility this solution is: China’s currency has been moving in precisely the opposite direction (Chart 10). Chart 10So Much For Plaza Accord 2.0 The Plaza Accord is a useful analogy for another reason: it marked the peak in Japanese market share in the U.S. economy. In Japan’s case, currency appreciation was the primary mover, while Japan also relocated production to the United States. Chart 11The Real Analogy With The Plaza Accord In China’s case, if currency appreciation is ruled out and production is not relocated due to a failure to secure a trade agreement, then U.S. protectionism will remain the primary means of capping China’s share of the market (Chart 11). The dollar will remain strong and this will continue to weigh on global markets. Bottom Line: China’s recent currency depreciation is a warning signal to the U.S. that the trade negotiations could be broken off. There is further downside if the U.S. implements the new tariffs or hikes tariff rates further. The renminbi is unlikely to enter a freefall, however, because China maintains tight capital controls and is stimulating its economy. It is doubtful that the Trump administration can engineer a depreciation of the dollar through a multilateral agreement. It lacks the geopolitical heft of the 1970s-80s, and it does not have a strategic understanding with China that would enable Beijing to make the same degree of concessions that Tokyo made in 1985. Saber-Rattling After tariffs and currency depreciation, the next likeliest manifestation of strategic tensions lies in the military sphere. While the U.S. threatens to cut off Chinese tech companies like Huawei, Beijing has signaled that countermeasures would include an embargo on U.S. imports of rare earth elements and products.3 When China implemented a partial rare earth export ban on Japan (Chart 12), the context was a maritime-territorial dispute in the East China Sea in which military and strategic tensions were also escalating. The threat to industry only amplified these tensions. There are several locations in East Asia where conditions are ripe for clashes and incidents that could add to negative global sentiment. Indeed, saber-rattling has already begun in Hong Kong, Taiwan, the Koreas, and the East and South China Seas. The following areas are the most likely to darken the outlook for U.S.-China negotiations: Direct U.S.-China tensions: The U.S. and China have experienced several minor clashes since the beginning of the Trump administration. The near-collision of a Chinese warship with the USS Decatur occurred in October 2018, after the implementation of the first sweeping tariff on $200 billion worth of goods – a period of tensions very similar to that of today.4 October 1 marks the 70th anniversary of the People’s Republic of China, an event that will be marked by outpourings of nationalism and a flamboyant military parade displaying advanced new weapons. The government in Beijing will be extremely sensitive in the lead-up to this anniversary, leading to tight domestic controls of news and media, hawkish rhetoric, and the potential for provocations on the high seas. Hong Kong and Taiwan: Chinese officials, including the People’s Liberation Army garrison commander in Hong Kong, the director of the Office of Hong Kong and Macao Affairs, and the city’s embattled Chief Executive Carrie Lam have warned in various ways that if unrest spirals out of control, it could result in mainland China’s intervention. A large-scale police exercise in Shenzhen, Guangdong, just across the water, has highlighted Beijing’s willingness to take forceful action. The deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries that would have common cause on this issue. The Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions (Chart 13). Hong Kong is obviously a much smaller share of total exports to China these days, but when combined with Taiwan – where there could also be a hit to sentiment from Hong Kong unrest and possibly separate economic sanctions – the impact could be substantial (Chart 14). Chart 13Mainland Intervention In Hong Kong Could Prompt Sanctions Chart 14HK/Taiwan A Significant Share Of Greater China Trade Why would Taiwan get worse as a result of Hong Kong? Unrest in Hong Kong has already galvanized opposition to the mainland’s policies in Taiwan, where the presidential election polling has shifted in incumbent President Tsai Ing-wen’s favor (Chart 15). Beijing has imposed new travel restrictions and held a number of intimidating military exercises, while the U.S. has increased freedom of navigation operations in the Taiwan Strait. These trends could worsen over the next year. Japan and the East China Sea: Japan’s top military official – General Koji Yamazaki – recently warned that Chinese military intrusions are increasing around the disputed Senkaku (Diaoyu) islands in the East China Sea. He called particular attention to China’s change of the Coast Guard from civilian to military control, which he said posed new risks of escalation in disputed waters. Japan itself may have an interest in a more confrontational stance over the coming year. The Japanese government has seen a rise in public opposition to its plan to revise the constitution to enshrine the Self-Defense Forces and thus move toward a more “normal” Japanese military and security posture (Chart 16). A revival of trouble in the South China Sea: China has not reduced its assertive foreign policy in order to win regional allies amid its conflict with the United States. On the contrary, it has continued asserting itself to the point of alienating governments that have largely sought to warm up to the Xi administration, including both Vietnam and the Philippines. The Vietnamese have engaged in a month-long standoff over alleged Chinese encroachments in its Exclusive Economic Zone. And a clash near Sandy Cay in the Spratly Islands is forcing Philippine President Rodrigo Duterte, who has otherwise avoided confrontation with China, to address President Xi over the international court decision in 2016 that ruled out China’s claims of sovereignty over the disputed islands. The South China Sea is important because it is a vital supply line for all of the countries in the region. Even if the United States washed its hands of Beijing’s efforts to control the sea lanes, U.S. allies would still face a security threat that would drive tensions in these waters. This is a formidable group of Asian nations that China fears will seek to undermine it (Chart 17). And of course the Americans are not washing their hands of the region but actually reasserting their interest in maintaining a western Pacific defense perimeter. The Korean peninsula: North Korea has resumed testing short-range missiles, causing another hiccup in U.S. attempts at diplomacy (Chart 18). These tensions have the potential to flare as the U.S.-China trade talks deteriorate, since Beijing has offered cooperation on North Korea’s missile and nuclear program as a concession. Chart 17U.S. Asian Allies Formidable Chart 18North Korean Provocations Still Low-Level Ultimately North Korea needs to be part of the U.S.-China solution, so as long as tensions rise it sends a negative signal regarding the status of talks. And vice versa. South Korea is another case in which China is not reducing its foreign policy aggressiveness in order to win friends. On July 23, a combined Russo-Chinese bomber exercise over the disputed Dokdo (Takeshima) islands in the Sea of Japan led to interception by both Korean and Japanese fighter jets and the firing of hundreds of warning shots. The incident reveals that South Korean President Moon Jae-in is not seeing an improvement in relations with these countries despite his more pro-China orientation and his attempt to engage with North Korea. It also shows that while South Korea’s trade spat with Japan can persist for some time, it may take a back seat to these rising security challenges. As long as North Korean tensions rise it sends a negative signal regarding U.S.-China talks. Chart 19Russia May Need To Distract From Domestic Unrest Russia, like China, is feeling immense domestic political pressure, including large protests, that may result in greater foreign policy aggression (Chart 19). And as China and Russia tighten their informal alliance in the face of a more aggressive U.S., American allies face new operational pressures and the potential for geopolitical crises will rise. Bottom Line: The whole panoply of East Asian geopolitical risks is heating up as U.S.-China tensions escalate. While the U.S. and China may engage in direct provocations or miscalculations, their East Asian neighbors are implicated in the breakdown of the regional strategic order. A crisis in any of these hotspots could jeopardize the already unfavorable context for any U.S.-China trade deal over the next year, especially during rough patches like the very near term. Investment Implications Chart 20A Strategic Investment The potential for saber-rattling in the near term – on top of a series of critical U.S. decisions that could mitigate or exacerbate the increase in tensions surrounding the new tariff hike – argues strongly against altering our tactically defensive positioning at the moment. In this environment we advise clients to stick with our two strategic defense plays – long the BCA global defense basket in absolute terms, and long S&P500 Aerospace and Defense equities relative to global equities. The U.S. Congress’s newly agreed bipartisan budget deal provides a substantially improved fiscal backdrop for American defense stocks, which are already breaking out amid positive fundamentals. A host of non-negligible geopolitical risks speaks to the long-term nature of this trade (Chart 20). Our U.S. Equity Strategy recently reaffirmed its bullish position on this sector. We maintain that the U.S. and China have a 40% chance of concluding a trade agreement by November 2020. Note, however, that even a “no deal” scenario does not entail endless escalation. Presidents Trump and Xi could agree to another tariff ceasefire; negotiations could even lead to some tariff rollback in 2020. That would be, after all, Trump’s easiest way to “ease” trade policy amid recession risks. Nevertheless, our highest conviction call is not about whether there will be a deal, but that any trade truce that is reached will be shallow – an attempt to mitigate the trade war’s damage, save face, and bide time for the next round in U.S.-China conflict. We give only a 5% chance of a “Grand Compromise” by November 2020 that greatly expands the U.S.-China economic and corporate earnings outlook over the long haul. In this sense the ultimate trade deal will be a disappointment for markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 At the signing ceremony President Trump reminded his European interlocutors that the risk of car tariffs is not yet off the table. He concluded the celebration saying, “Congratulations. And we’re working on deal where the European Union will agree to pay a 25 percent tariff on all Mercedes-Benz’s, BMWs, coming into our nation. So, we appreciate that. I’m only kidding. (Laughter.) They started to get a little bit worried. They started — thank you. Congratulations. Best beef in the world. Thank you very much.” 2 See Emerging Markets Strategy Weekly Report, “EM: Into A Liquidation Phase?” August 8, 2019, ems.bcaresearch.com. 3 The national rare earth association holding a special working meeting and pledging to support any countermeasures China should take against U.S. tariffs. See Tom Daly, “China Rare Earths Group Supports Counter-Measures Against U.S. ‘Bullying,’” Reuters, August 7, 2019. 4 Military tensions are already heating up as Beijing criticizes the U.S. over the new Defense Secretary Mark Esper’s claim during his Senate confirmation hearings that new missile defense may be installed in the region in the coming years. This comes in the wake of the U.S. withdrawal from the 1987 Intermediate-Range Nuclear Forces Treaty, partly due to China’s not being a signatory of the agreement. Missile defense is a long-term issue but these developments feed into the current negative atmosphere.

Analysis on India is available below. Highlights Moderate RMB depreciation is consistent with the economic as well as political objectives of Chinese authorities. Yet, this is bad news for EM currencies and risk assets. As EM currencies depreciate, driven by a weaker RMB and lower commodities prices, foreign investors will head for the exit and EM risk assets will plummet. Meanwhile, there are tell-tale signs of an incipient EM breakdown. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We also remain structurally short the RMB. Feature In our May 23 report titled The RMB: Depreciation Time? , we argued that the odds of an RMB depreciation were rising and that the currency would likely depreciate by some 6-8% versus the dollar. We contended that this would be bad news not only for EM currencies but also for all EM risk assets. EM fundamentals have been poor – both exports and cyclical domestic sectors have been contracting for some time. We illustrated the weak domestic demand conditions experienced by the majority of developing economies in our recent report, Domestic Demand In Individual EM Countries. Nevertheless, many investors have been ignoring the growing evidence of deteriorating growth conditions. The recent breakdown in the CNY/USD cross has reminded investors of the 2015 episode, when global risk assets – particularly in EM – tumbled following the yuan’s depreciation. We expect the RMB to depreciate by another 5-6% or so. We expect the RMB to depreciate by another 5-6% or so (Chart I-1). This will likely trigger a full-scale breakdown in EM risk assets. With respect to investor positioning, sentiment on EM was buoyant up until last week. Chart I-2 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures was elevated as of Friday August 2. Chart I-1More Downside In RMB Chart I-2Investor Sentiment On EM Was Positive As Of Last Week With negative news proliferating on many fronts – the U.S.-China confrontation, slumping global trade, shrinking EM profits, tumbling commodities prices and RMB depreciation – the risk of a portfolio capital exodus from EM is rising, and a liquidation phase is highly probable. Implications Of RMB Depreciation It is impossible to know whether the recent RMB depreciation was market-driven or engineered by the PBoC. Our best guess is that the latest RMB depreciation was driven by both market pressures as well as the authorities’ increased tolerance of a weaker RMB.  The mainland economy requires a weaker currency to counteract accumulating deflationary pressures from deteriorating domestic and foreign demand, as well as to offset rising U.S. import tariffs. The Chinese leadership likely regards RMB depreciation as an economic and political response to U.S. import tariffs. That said, the Chinese authorities have significant latitude to control the exchange rate, not only via selling the central bank’s foreign currency reserves and tightening capital controls but also by utilizing foreign currency forward swaps. Therefore, the RMB depreciation will run further but will unlikely spiral out of control. Regardless of the cause of the depreciation, a weaker RMB will affect the rest of the world in general and EM in particular. Regardless of the cause of the depreciation, a weaker RMB will affect the rest of the world in general and EM in particular via the following two channels: Escalating competitive devaluation: The RMB is causing a breakdown in other Asian currencies, especially those exposed to manufacturing exports (Chart I-3). Critically, falling export prices herald currency depreciation not only in China but also in other Asian economies such as Korea, Singapore and Taiwan (Chart I-4). Chart I-3Breakdown In Emerging Asian Currencies Chart I-4Lower Export Prices Warrant Currency Depreciation Less Chinese imports = a drag on global trade: An RMB devaluation reduces Chinese importers’ purchasing power in U.S. dollar terms. The same amount of credit and fiscal stimulus in yuan when converted into U.S. dollars can be used to procure less goods and commodities. In brief, the gap between mainland imports in yuan and in dollars will widen (Chart I-5). Chart I-5Chinese Imports In Dollars Will Continue Shrinking Chinese imports in dollar terms will continue contracting. Many EM and some DM currencies will be negatively affected, since China is a major source of demand for these economies. Bottom Line: Moderate RMB depreciation is consistent with the economic as well as political objectives of Chinese authorities. Yet, this is bad news for EM currencies and risk assets. An EM Breakdown Is In The Making There are a number of financial markets and individual share prices that have been forewarning of potential breakdowns in EM/China plays and global pro-cyclical assets. In particular: Having failed to break above its 200-day moving average, the Risk-On vs. Safe-Haven currency ratio1 has dropped below its three-year moving average (Chart I-6, top panel). This indicator has had a very high correlation with EM stocks and global materials equities. Hence, its breakdown heralds a gap down in EM share prices as well as global materials stocks (Chart I-6, middle and bottom panels). Chart I-6Beware Of Breakdowns The rationale for using the 400-day (18-month), 800-day (three-year) and other long-term moving averages is similar to why investors utilize the 200-day (nine-month) moving average. When a market fails to punch below or above any of its long-term moving averages, odds are that it will make a new high or low, respectively. We discussed these technical indicators and have offered empirical examples of how these signals have historically worked in principal markets such as the S&P 500 and U.S. bond yields in our past reports.   Base metals (including copper) and oil prices as well as global steel stocks have broken below their three-year moving averages (Chart I-7). Commodities prices have been exhibiting a very bearish chart formation, and will likely plunge further. BCA’s Emerging Markets Strategy team remains bearish on commodities prices, even though BCA’s house view is bullish. The primary basis for this divergence in view has been and remains the Chinese growth outlook. Chart I-7Commodities Are In A Trouble Spot Chart I-8Canary In A Coal Mine For Commodities Share price of Glencore – a major player in the commodities space – has plunged below its three-year moving average, which has served as a support a couple of times in recent years2 (Chart I-8). Crucially, this stock has exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads the U.S. manufacturing cycles and has formed a similar configuration as Glencore’s (Chart I-9). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Finally, the relative performance of S&P 500 global cyclical stocks versus global defensives3 has resumed its downtrend after failing to break above its 200-day moving average (Chart I-10). This foreshadows a poor global growth outlook and serves as a downbeat signal for global cyclical plays. Chart I-9Canary In A Coal Mine For U.S. Industrials Chart I-10A Message From S&P 500 Industry Groups Does all of the above imply that the global growth slowdown is already priced into global financial markets? Not necessarily. These breakdowns have occurred on the fringes of markets. As the average investor heeds to these signals and as these breakdowns move from the periphery to the center, there will be more damage to global risk assets in general and EM in particular. Importantly, there are cyclical segments of global and EM financial markets that have not adjusted and remain vulnerable. For example, global semiconductor stocks and global industrial share prices remain elevated despite the enduring global manufacturing recession (Chart I-11). Chart I-11Mind The Gaps The wide gap between share prices and revenues of these cyclical sectors implies that investors have been pricing an imminent business cycle recovery. Odds are that the current global manufacturing downturn will last longer or that a bottoming-out phase will be more extended than in 2012 and 2015. We have elaborated on the rationale for a more extended downturn in our past reports, and our conclusions still stand: A lack of aggressive stimulus in China, a lower propensity to spend among Chinese households and companies, as well as the ongoing trade war will continue to dampen business sentiment worldwide. Consequently, the current gap between share prices of these cyclical sectors and their underlying revenues will likely be closed via lower stock prices. As to non-cyclical equity sectors, they are less vulnerable to a profit downturn but their valuations are very expensive, and investor positioning is heavy. Further, EM local currency bonds as well as EM sovereign and corporate credit markets have been buoyant because of falling U.S. interest rates. Yet EM currencies are at risk from both RMB devaluation and falling commodities prices. EM currency depreciation will in turn undermine returns on EM local currency bonds and spur an investor exodus from high-yielding domestic bonds. Chart I-12Which Way These Gaps Will Close? Excess returns on EM sovereign and corporate credit have historically correlated with EM currencies and commodities prices as well as with equity returns (Chart I-12). Commodities prices, EM currencies and share prices are all poised to weaken further. It will be very surprising if sovereign and corporate spreads do not widen from their current tight levels. Bottom Line: There are a number of tell-tale signs of an incipient EM breakdown. As EM currencies depreciate driven by a weaker RMB and lower commodities prices, foreign investors will head for the exit and all EM risk assets will plummet. Investment Recommendations We are reiterating our negative stance on EM currencies and risk assets both in absolute terms and relative to their DM counterparts. Our recommended country overweights and underweights for EM equity, sovereign credit and local currency bond portfolios are always available at the end of our reports (please refer to pages 18 and 19 ). As to exchange rates, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We also remain structurally short the RMB. In a nutshell, EM currency depreciation will -- for now -- overwhelm the positive impact of lower domestic interest rates on EM equities and in some cases will prevent developing nations’ central banks from reducing rates further. Finally, we recommended a long gold / short oil and copper trade on July 11 and this has panned out nicely (Chart I-13). Gold has made a structural breakout versus the rest of commodities complex and investors should hold into this position. We recommended a long gold / short oil and copper trade on July 11 and this has panned out nicely. Chart I-13A Structural Breakout In Gold Versus Oil And Copper Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indian Stocks: Poor Profit Outlook Amid Rich Valuation Indian stocks have failed to break out above their highs, in both local currency and U.S. dollar terms, and have rolled over decisively (Chart 1, top panel). Chart II-1Indian Stocks Failed To Break Major Resistance Levels Relative to the EM equity benchmark, Indian share prices have recently been underperforming despite collapsing oil prices and plunging U.S. interest rates. Furthermore, this bourse’s relative performance against the global equity index in common currency terms has bounced lower from a major structural technical resistance (Chart II-1, bottom panel). India’s recent underwhelming equity dynamics have transpired despite ongoing monetary policy easing by the country's central bank. In a nutshell, the roots of this poor equity performance trace back to lackluster profitability, rich equity valuations and overcrowded positioning. We recommend investors continue avoiding Indian equities for now as more downside is likely. Domestic Growth/Corporate Earnings Slump Indian domestic demand growth has been nosediving with no clear end in sight: Sales of passenger cars, two-wheelers, three-wheelers, tractors as well as medium & heavy commercial trucks are all contracting at double-digit rates (Chart II-2). Similarly, real gross fixed capital formation growth has decelerated, the number of capex projects underway are falling, capital goods imports and production are contracting and cement production growth has plummeted (Chart II-3). Chart II-2Domestic Demand Is Very Weak Chart II-3Capex And Infrastructure Are Heading South Some cracks are also appearing in India’s real estate sector. Chart II-4 shows nationwide housing price growth is decelerating in nominal terms and deflating in real (inflation-adjusted) terms. Chart II-4House Prices Are Contracting In Real Terms Typically, share prices become extremely sensitive to business cycles slowdowns when valuations are elevated. This is currently the case for the Indian bourse. In fact, India’s latest corporate earnings season was lackluster and many companies across various sectors have warned about slowing growth. More visibility on an ameliorating profit outlook as well as lower valuation multiples are needed for share prices to reach a sustainable bottom. India Is Joining The “Kick The Can Down Road” Club Banks have been the star performers within the Indian bourse with non-financials generating underwhelming returns. This warrants particular attention to bank stocks’ fundamentals and valuations. Recent media reports have been highlighting that India’s NPL cycle has finally turned for the better – marking an end to the country’s bad asset cycle that started in 2013. Chart II-5Poor Debt Servicing Ability Among Indian Corporate Borrowers However, scratching below the surface, the recent reduction in India’s NPLs ratio has not occurred due to organic improvement in India’s corporate borrowers’ ability to service debt. For instance, the EBITDA-to-interest expense ratio for the country’s non-financial publically-listed companies has not improved at all (Chart II-5). Rather, what seems to be driving the NPLs ratio lower is a regulatory forbearance: The new Governor of the RBI – Shaktikanta Das – issued a new circular on NPL recognition in June. It essentially provides commercial banks with much more flexibility in the way they can deal with their bad assets and permits them to delay their NPL recognition. The central bank also allowed India’s manufacturing and infrastructure corporates in default to borrow via the External Commercial Borrowing route in order to pay down their domestic loans under a one-off settlement. Furthermore, the RBI permitted commercial banks to restructure loans of micro-, small-, and medium-sized businesses before they turn bad - allowing banks to delay the proper recognition of such types of loans as well. Finally, the RBI reduced the risk weight of consumer credit from 125% to 100% in its monetary policy meeting yesterday. The objective of this measure is to accelerate consumer credit growth even though the latter has been booming in the past ten years. All in all, these regulatory measures reverse banks and corporate sector restructuring efforts and thereby are negative from a structural perspective. In the past, we were positive on the Indian banking system structurally because the central bank was promoting critical reforms.   Under the new leadership of the RBI, India is now joining the “kick the can down the road” club. This warrants somewhat lower equity multiples for banks than before. Financials Stocks Are Still Expensive Despite the selloff, Indian bank stocks are not yet cheap. For Indian public banks we focused our analysis on the State Bank of India (SBI) as it is the largest and only public bank that has performed reasonably well. This bank presently trades at a price-to-book value (PBV) ratio of 1.15.  Our analysis shows that at a more realistic 12% NPL ratio4 and assuming a 30% recovery ratio, 25% of its equity would be impaired. This would move its adjusted PBV ratio to 1.5. Assuming a fair-value PBV ratio of 1.3, the SBI appears to be overvalued by 15-17%. As to private banks,5 they are also expensive. For instance, if their NPLs rise to 6% from around 3% currently, they would seem overvalued by at least 12% (Table II-1). The analysis assumes a generous recovery ratio of 50% and a very high fair-value PBV ratio of 3.3.  Finally, a comment on non-bank financial companies (NBFCs) is warranted. Their liquidity situation is extremely grim. Chart II-6 shows that our proxy for liquidity, measured as short-term investments (including cash) minus short-term borrowing for the 11 large NBFCs we assessed,6 is in a deep negative territory. In other words, these companies have a substantial maturity mismatch. Chart II-6Major Asset-Liability Mismatches In Non-Bank Finance Sector Remarkably, these non-bank organizations grew their assets at a 20% annual compounded growth rate since 2009. Odds are they have misallocated capital to a large extent and their NPL ratio is probably in the double-digits. According to the RBI, non-bank financials’ gross NPLs ratio stood at 6.6% as of March 2019. By comparison the NPLs ratio of Indian banks peaked at 11.2%. Meanwhile, their valuations are not cheap at all. For instance, the NBFCs included in the MSCI India equity index carry a PBV ratio of 3.5 for consumer finance focused companies and a PBV ratio of 3 for thrift & mortgage finance focused companies. Bottom Line: Share prices of banks and non-bank financials are far from being cheap and remain at risk of further decline. Investment Recommendations In absolute U.S. dollar terms, Indian stocks have meaningful downside. This is confirmed by some precarious technical signals: the equal-weighted stocks index has dropped by 28% from its top in January 2018 and small-cap stocks are breaking down (Chart II-7). Finally, while the RBI cut rates yesterday, share prices still closed lower. Chart II-7Ominous Signals From The Indian Broader Equity Market In terms of our relative strategy, we continue to recommend that dedicated EM equity investors keep underweighting Indian stocks for now, but our conviction level is lower than it was in May. The basis is that ongoing fiscal and monetary easing, coupled with very low U.S. bonds yields and oil prices, might help Indian equities to outpace their EM peers at some point. For now, we will wait for a better entry point to upgrade. Our strongest conviction is that Indian stocks will underperform the global equity index in common currency terms (please see Chart II-1 on page 11). As for the currency, lingering problems in the NBFC sector will force the RBI to keep liquidity in the banking system abundant. Excessive liquidity expansion amid the ongoing selloff in EM currencies will hurt the rupee. Fixed-income investors should play a yield curve steepening trade as lower short rates and rupee deprecation could generate a yield curve steepening. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      The drop occurred well before the latest negative profit report. 3      These indexes are based on U.S. S&P 500 industry groups and published by Goldman Sachs. The Bloomberg tickers for S&P 500's global cyclicals and global defensives indexes are GSSBGCYC and GSSBGDEF, respectively. 4      Instead of the 7.5% ratio it reported last week. 5      We analyzed the six largest private banks: HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, IDFC First Bank and Kotak Mahindra Bank 6      Six of which are listed in the MSCI India equity index and account for 12% of MSCI total market cap. Equity Recommendations Fixed-Income, Credit And Currency Recommendations  

Highlights Chinese economic growth slowed in June & July, but at a more moderate pace than had been the case earlier this year. The housing market is a notable exception, which appeared in June to slow in a broad-based fashion. The near-term (0-3 month) outlook is bearish for China-related assets, and investors should bet on further weakness in the RMB. However, investors should remain cyclically bullish (i.e., over a 6-12 month time horizon) in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the intensifying drag from weak external demand. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident measures of economic activity suggest that China’s economy experienced “controlled weakness” in June and July: growth continued to slow, but at a more moderate pace than had been the case in late-2018 and early-2019. The housing market appeared to be the exception to this relative stability; all 10 of the core housing indicators that we track decelerated in June, suggesting that a moderation in housing-related activity was broad-based. This implies that a further slowdown in construction is likely over the coming months, barring a meaningful pickup in sales. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, all of the key developments have occurred over the past several trading days, in response to President Trump’s threat last week to further hike U.S. import tariffs at the beginning of September. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark, as have Hong Kong stocks in response to intensifying protests in the city. A sharp decline in the RMB and the U.S. designation of China as a currency manipulator have unnerved Chinese and global investors, and our bias is to expect even further weakness in the yuan. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Otherwise stated, we expect Chinese relative performance to trend lower in the near-term, but to be higher 12-months from today. Investors should also continue to hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks with a long USD-CNH position. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Our leading indicator for the Li Keqiang Index is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth. Chart 1Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Chart 2Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator The Li Keqiang index (LKI) rose moderately in June after a significant decline in May, but remains in a downtrend (Chart 1). The June increase was driven entirely by a pickup in electricity production (which had nearly contracted in May); bank loan growth and rail cargo volume both decelerated. The takeaway for investors is that while the Chinese economy did not slow meaningfully further in June, the pace of growth remained tepid, suggesting the economic activity remains vulnerable to a further increase in U.S. import tariffs. Our leading indicator for the LKI is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth (Chart 2). However, the magnitude of the rise in the indicator is being held back by growth in the money supply, which has only slightly accelerated over the past few months, as well as a “half strength” recovery in credit. Our view is that Chinese policymakers are likely to wait for further economic weakness before allowing money & credit growth to significantly overshoot, which increases the odds of a continued market riot in the short-term. Chart 3Decelerating House Price Appreciation Is Coming All 10 of the housing indicators shown in Table 1 decelerated in June, suggesting that a moderation in housing-related activity was broad-based. Our BCA 70-city diffusion index for (YoY) house prices has an excellent track record at leading inflection points in overall price growth (Chart 3), and is currently suggesting that house price appreciation is at risk of falling back to mid-2018 levels (which would imply a 5-6 percentage point deceleration). Continued weakness in floor space sold continues to suggest that the ongoing pace of housing construction is unsustainable; we expect a further moderation in floor space started over the coming several months barring a meaningful pickup in sales. Both the Caixin and official manufacturing PMI for China rose in July, including the official new export orders component (which we have been closely following). However, the survey was taken prior to President Trump’s renewed tariff threat last week, and we expect the July gains to reverse in August barring a major de-escalation in the conflict. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark over the past week due to President Trump’s threat to impose tariffs on all remaining imports from China. We noted in our May 29 weekly report that a financial market riot point remained likely over the coming few months,1 and we explicitly recommend an underweight position in Chinese stocks for the remainder of 2019 in last week’s report.2 Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Investors who are already positioned in favor of Chinese stocks should stay long, despite the likelihood of further near-term losses. ​​​​​​​Investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Chart 4Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance The MSCI Hong Kong index has also significantly underperformed the global benchmark since late-July, in response to intensifying protests in the city (Chart 4). The protests have been driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. However, Hong Kong has no real alternative to Beijing’s sovereignty, and the unrest should gradually die down as long as the imposition of martial law is avoided. Nonetheless, Hong Kong’s stock market is likely to remain under pressure in the interim; for now, we recommend that investors stay underweight versus China and Taiwan.​​​​​​​ The sector performance within China’s investable and domestically-listed equity markets over the past month has largely been along cyclical / defensive lines. In the investable market, consumer staples, health care, financials, information technology, communication services, and utilities have all outperformed, in contrast to energy, materials, industrials, consumer discretionary, and real estate stocks. The pattern has been similar in the domestic market, with two exceptions: modest staples underperformance, and material underperformance of comm services. Real estate stocks have been among the worst performers in both markets over the past month, possibly in response to the deteriorating housing market data that we highlighted above. China’s 3-month repo rate has fallen approximately 20 bps over the past month, and is now back close to its one-year low. We continue to believe that a cut to the benchmark lending rate is unlikely in the near-term, but could occur in Q4 if economic conditions in China weaken materially further.​​​​​​​ Chinese onshore corporate spreads increased modestly over the past month, but have not yet risen to a new high for the year. The uptrend in spreads that began in late-May does reflect renewed risks to the Chinese economy from a further increase in U.S. import tariffs, but annualizing the most recent pace of onshore corporate defaults suggests that onshore bond spreads are still much too high. Our long China onshore corporate bond trade continues to register gains in local currency terms (Chart 5), and we recommend that investors stick with a long/overweight currency-hedged stance. ​​​​​​​Our bias is to bet on further RMB weakness until policymakers aggressively ramp up their reflationary efforts. The yuan weakened sharply this week, with the U.S. dollar breaking above 7 versus both the onshore and offshore RMB (Chart 6). This is the weakest level for the currency since the global financial crisis, and the decline has clearly occurred in response to last week’s tariff threat. We noted in our May 15 report that a meaningful decline in the exchange rate would likely be required in order to stabilize the outlook for earnings & the economy,3 and we recommended at that time that investors should hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. It is difficult to forecast how much further the RMB is likely to fall, but our bias is to bet on further weakness until policymakers aggressively ramp up their reflationary efforts. Stay tuned. Chart 5Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Chart 6Weakest RMB In A Decade, And Further Declines Are Likely   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com 1      Please see China Investment Strategy Weekly Report, “Waiting For The Pain,” dated May 29, 2019. 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?” dated July 24, 2019. 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019.   Cyclical Investment Stance Equity Sector Recommendations

Highlights The Federal Reserve’s 25-basis-point interest rate cut might have disappointed market participants, but Trump’s additional tariffs is a far bigger slap. Our bias is that this is not an escalation in trade tensions. To gauge the dollar’s future path, investors should focus less on what central banks are going to do and more on what will happen to the global manufacturing cycle. The pro-Brexit rhetoric by U.K. Prime Minister Boris Johnson is knocking the pound towards a very compelling buy zone. Sell EUR/GBP at 0.94. Stale longs are currently being flushed out of the gold rally. Trump’s weaponization of the dollar allows investors who missed the first up-leg to accumulate bullion on weakness. Remain short USD/JPY. In the central bank battle towards lower rates, short USD/JPY positions are in an enviable “heads I win, tails I do not lose too much” position. Market volatility is triggering a few stop losses. Stand aside on short CAD/NOK and long AUD/USD. Feature We had the privilege of meeting a few sophisticated investors in South America last week. The general sentiment was cautious in light of the fact that a few end-of-cycle indicators were beginning to flash green. Discussions circled around growth developments in the U.S., the eurozone and China. Even those who have been cautiously optimistic on global growth for some time now are beginning to feel they are waiting for Godot, given the duration of the manufacturing slowdown. South American economies are closely knitted to the Chinese industrial cycle, and so the rising trepidation given credit injections in China should have turned things around by now was both rational and justified. The latest tweets by Trump have done little to alleviate this fear. Our general thesis that a pro-cyclical stance for developed market currencies made sense over the next few months was received with skepticism. The overarching consensus was that the U.S. (and the rest of the world, for that matter) will not go into a recession over the next six-to-12 months, but the dollar will remain in a bull market regardless. We were in agreement that some emerging markets warranted lower currencies versus the dollar, but spent most of our time making the case for a trend reversal in the dollar versus its G10 counterparts. Below is a synopsis of some of our dialogue. Global Growth Remains Weak, But… It is quite remarkable that most investors do not expect a recession in the next six-to-12 months, but expect manufacturing data to keep weakening. If the German manufacturing PMI falls much lower from current levels, Germany will be in deep recession (Chart I-1). What is clear is that this cognitive dissonance is squarely rooted in the recent history of data disappointments, including an escalating trade war. Manufacturing slowdowns have tended to last 18 months peak-to-trough, the final months of which are characterized by fatigue and capitulation. However, unless major imbalances exist (our contention is that so far they do not), mid cycle slowdowns sow the seeds of their own recovery via accumulated savings and pent-up demand. Chart I-1A German Recession? Chart I-2Some Yield Curves Are Steepening The U.S. 10-year versus 3-month curve inverted in March, which has typically heralded a recession over the coming six-to-18 months. The key difference today is that the term premium (compensation that investors receive for holding a long-duration asset) is severely depressed in 10-year notes, making an apples-to-apples comparison with the past more difficult. The two- or five-year Treasury notes, which have both seen similar compression in term premiums, offer more insight, and those curves have not yet inverted (Chart I-2). The recovery could be more L-shaped than V-shaped because of knock-on effects from the trade war and a falling marginal propensity to consume in China.  A pick up in Chinese demand will be critical for a recovery in the global manufacturing cycle. China embarked on massive credit stimulus in March of this year, a development that has been clearly reflected in official loan numbers. If past is prologue, about now is the time that the credit injection should begin to impact underlying data, as the lag is typically six to nine months (Chart I-3). Moreover, the fact that the July manufacturing data were so weak almost guarantees that the next few months will see more aggressive stimulus by the Chinese authorities, and might also explain why China appears so nonchalant to the latest tariffs from the U.S. Chart I-3Chinese Stimulus Works With A Lag A constant pushback we received was that credit stimulus will be much less than in the past, because of structural reform concerns. Also, the recovery could be more L-shaped than V-shaped because of knock-on effects from the trade war and a falling marginal propensity to consume in China. These are obviously very valid concerns. Standard economic theory tells us that unless the trade war degenerates from current levels, the exchange rate should have already adjusted for impending price differentials. Ever since the U.S. began to threaten to impose tariffs on $200 billion worth of goods, the USD/CNY has risen by around 10%. This more than accounts for the notional amount of Chinese exports affected, and is now in the rear-view mirror. The marginal propensity question for China is more difficult to answer because it is only observable ex-post. Think about an economy in recession. The central bank has no idea what proportion of companies are in a liquidity versus a solvency crisis. This is why it keeps injecting stimulus until a few rational players stop deleveraging and start borrowing to invest. Until the cost of capital is lowered to the point where it makes sense for these rational players to invest, the marginal propensity to consume (or invest) will fall. Chart I-4The Euro Zone Manufacturing Recession##br## Is Over We all know that the euro area exports a lot to China. So at times, it is instructive to focus less on what’s happening in China and more on what’s happening to economies highly sensitive to the Chinese pulse. Sweden’s manufacturing new orders-to-inventories ratio is a neat series to track for two reasons. First, Sweden is one of the most export-oriented economies in Europe, selling both to the euro area and outside it. This makes it highly sensitive to the global manufacturing pulse. Second, there are no Chinese credit variables in Sweden’s data, and so it falls outside the judgement call of Chinese reflationary efforts. More importantly, it leads the European PMI tick-for-tick by five months, and so we would be surprised if the eurozone manufacturing recession did not end by the fourth quarter this year (Chart I-4). With new tariffs underway, it will be interesting to see how the balance of forces play out. Bottom Line: In the press conference after the Fed’s rate cut announcement, Fed Chairman Jerome Powell’s delivery was underwhelming, but manufacturing is a small portion of the U.S. economy, suggesting a rate cut was not entirely justified. Going forward, if the Fed delivers less interest rate cuts than is priced in by the market, it is because manufacturing has picked up, which will favor non-U.S. interest rates either way. We are fading the current strength in the dollar as the last hurrah before the ultimate drop. …A Few Tectonic Shifts Are Underway Interest rate differentials have been dictating currency market trends of late, but a few underlying forces that are critical for exchange rates are sending a warning signal for the dollar. Investors are constantly evaluating how to allocate funds, and will rationally deploy capital towards projects that have the highest returns. We know from both the wealth of seminal work that has been done on value investing and from the simple premise that the entry point in any trade could be as important as your entire thesis for that investment, that starting points matter. The starting point for the U.S. is an equity market that is one of the most overvalued, dictating that subsequent returns will pale by historical comparison. The 2017 Trump tax cuts allowed a huge repatriation of capital back to the U.S., to the tune of $400 billion, but that cash is beginning to slowly seep out as high-return projects become more and more difficult to come by (Chart I-5). This may explain why foreigners are stampeding out of U.S. equities, to the tune of about $200 billion a year, not exactly an environment that is conducive for U.S. dollar strength. The reality is that the ebb and flow of U.S. repatriation/outflows have generally captured all the major turning points in the dollar, and there is no reason to believe this time will be different. The ebb and flow of U.S. repatriation/outflows have generally captured all the major turning points in the dollar, and there is no reason to believe this time will be different. The Fed may have delivered a hawkish surprise, and Trump may appear victorious, but confidence in the dollar is fraying at the edges. This can be observed in a falling bond-to-gold ratio. Ever since the end of the Bretton Woods agreement broke the gold/dollar link in the early 1970s, bullion has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick-for-tick. U.S. yields might be the only game in town today, but portfolio outflows and a deteriorating balance of payments backdrop will keep longer-term investors on the sidelines (Chart I-6). Chart I-5Investors Are Stampeding Out Of U.S. Assets Chart I-6Confidence In The Dollar##br## Is Falling Data from the World Gold Council this week showed that central banks continued to load up on gold through the first six months of this year. In fact, both China and Russia have been indiscriminate buyers of bullion, irrespective of price, over the past decade. As the amount of negative-yielding debt keeps rising and confidence in the dollar keeps falling, the conditions for a gold bull market become ever-fervent (Chart I-7). Not to mention that many gold buyers have geopolitical concerns against holding dollar liabilities. Finally, long-dollar bets are a much-crowded trade (Chart I-8). In cyclical markets, you are either a contrarian or a victim. One often-asked question on our trip was: For how long have you had a contrarian view on the dollar? The answer is quite simple: As soon as Charts I-1 to I-8 began showing signs of a reversal, which was around a few months ago. Chart I-7Bullion Tailwinds Chart I-8A Crowded Trade Bottom Line: The dollar bull market is late. Watch the AUD/JPY cross, specifically the 72-74 cent zone, for signs of a reversal. A break below will signal we are entering a deflationary bust, while a bounce could be a prelude to a reflationary rally. Housekeeping The stop-loss on our short CAD/NOK position was triggered at 6.65. Two fundamental reasons triggered the stop. First, the U.S. economy has been surprising to the upside relative to that of the euro area. This favors the CAD over the NOK, and the U.S. dollar in general (Chart I-9). Second, oil price differentials have favored the CAD over the NOK, with the WCS-Brent differential narrowing from -$30/Bbl to -$20/Bbl. We are standing aside for now, but will look to put this trade back on in the future. The pro-Brexit rhetoric by U.K. Prime Minister Boris Johnson is knocking the pound towards a very compelling buy zone. Sell EUR/GBP at 0.94. The EUR/GBP is approaching a sell zone (Chart I-10). We will be discussing the pound in an upcoming report, but in the interim please refer to our July 5th bulletin1 for an analysis on cable. Chart I-9Stand Aside On CAD/NOK Chart I-10Sell EUR/GBP At 0.94   Finally, Trump’s rhetoric to step up the trade war in a very nonchalant fashion has nudged us out of our long AUD/USD position. The loss is meaningful, but manageable given the tight stop loss. Stay long AUD/NZD. We will be looking to put back on outright AUD longs soon.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Portfolio Tweaks Into Thin Summer Trading,” dated July 5, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed:  GDP growth fell to 2.1% quarter-on-quarter in Q2, but was stronger than expected. Both headline and core PCE both increased to 2.3% and 1.8% quarter-on-quarter in Q2. Dallas Fed manufacturing business index improved from -12.1 in June to -6.3 in July; Chicago Fed purchasing managers’ index fell to 44.4 in July.  Pending home sales increased by 1.6% year-on-year in June. 156 thousand jobs were created in July according to the ADP report. However, initial jobless claims rose to 215 thousand. Markit manufacturing PMI increased to 50.4 in July, while ISM manufacturing PMI fell to 51.2. It was worrisome that the prices paid index fell from 49.6 to 45.1. DXY index surged by 0.5% this week, the highest since the beginning of the year. The Fed cut interest rates by 25 bps this Wednesday, mainly due to the global downside risks and below-trend inflation. However, his delivery towards further interest rate cuts, should the economy warrant it, was underwhelming. As long as the slowdown in manufacturing does not infect services, this might be a one and done but the insurance guarantee the markets needed from the Fed was poorly telegraphed. Report Links: Global Growth And The Dollar - July 19, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Battle Of The Central Banks - June 21, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been negative: Confidence remains low in July. Consumer confidence came in at -6.6; Services sentiment fell to 10.6; Industrial confidence decreased to -7.4; Business climate fell to -0.12. Q2 GDP growth fell to 1.1% year-on-year. On a quarter-on-quarter basis, it fell from 0.4% to 0.2%. Unemployment rate was steady at 7.5% in June. Headline and core CPI both decreased to 1.1% and 0.9% year-on-year respectively. Markit manufacturing PMI increased slightly to 46.5 in July. EUR/USD plunged by 0.6% this week. The euro area economy expanded by only 0.2% quarter-on-quarter in Q2. Among the European nations, Spain had the highest quarterly GDP growth rate in Q2 at 0.5%, while Italian economy stagnated in Q2. In its meeting last week, the ECB suggested that it stands ready to cut interest rates further and restart its asset purchase program, should the economy warrant it. This is hugely reflationary. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Retail trade yearly growth fell from 1.3% in May to 0.5% in June. The jobs-to-applicants ratio fell slightly to 1.61 in June, while the unemployment rate nudged lower to 2.3% in June. Industrial production contracted by 4.1% year-on-year in June. Housing starts grew by 0.3% year-on-year in June. Consumer confidence fell to 37.8 in July. Nikkei manufacturing PMI fell to 49.4 in July. USD/JPY fell by 1.3% this week. On Tuesday, the Bank of Japan kept interest rates unchanged at -0.1%. In its quarterly outlook, the BoJ cut its inflation forecasts and warned against downside risks to the economy. Kuroda highlighted that additional easing might be required due to increasing exogenous risks: “If Fed moves trigger yen rises, the BOJ could either strengthen forward guidance, allow 10-year bond yields to move in a wider band, or do both.” Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been positive: Mortgage approvals increased to 66.4 thousand in June. Consumer confidence increased from -13 to -11 in July. Nationwide housing prices grew by 0.3% year-on-year in July. Markit manufacturing PMI was unchanged at 48 in July. GBP/USD plunged by 2.6% this week.  On Thursday, the BoE’s Monetary Policy Committee voted unanimously to keep rates unchanged at the current level of 0.75%. Growth forecasts were also cut due to Brexit and global trade blues. With Prime Minister Boris Johnson now in power and his commitment to take Britain out of the European Union, markets are seeing increasing risks of a no-deal Brexit in October. Fortunately, this is knocking cable to compelling buy levels. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been positive: Building permits contracted by 25.6% year-on-year in June, but on a chart looks like a lengthy bottoming process. Headline inflation increased to 1.6% year-on-year in Q2. Australian Industry Group (AiG) manufacturing index increased to 51.3 in July. Terms of trade remain a tailwind for the AUD. Export prices rose by 3.8% in Q2 versus expectations for a 2.8% increase. AUD/USD fell by 1.9% this week. This stands in stark contrast to the Australian equity ASX 200 index that reached a new high this week. An accommodative central bank, skyrocketing iron ore prices and a subtle shift in external demand conditions are fuel for the Australian economy, thus the Aussie dollar. 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 Chart II-12NZD Technicals 2 There was scant data out of New Zealand this week: Building permits contracted by 3.9% month-on-month in June. The RBNZ activity outlook fell to 5 in July. Business confidence fell to -44.3 in July from -38.1 in June. NZD/USD fell by 1.4% this week. New Zealand remains vulnerable to exogenous downside risks. The RBNZ is lagging the RBA, in a domestic situation that will eventually culminate into the downturn we have witnessed in Australia. Stay long AUD/NZD. . Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been negative: Bloomberg Nanos weekly confidence index fell slightly to 58.2 for the week ending July 26. Industrial product price contracted by 1.4% month-on-month in June. Raw material prices decreased by 5.9% month-on-month in June. GDP growth fell from 1.5% year-on-year in April to 1.4% year-on-year in May. Markit manufacturing PMI increased to 50.2 in July. USD/CAD increased by 0.1% this week. Canadian data was disappointing, but not as much as elsewhere. The First-Time Home Buyers Incentive, scheduled to be launched this September, will allow the government to own 10% equity of the purchased homes in a range of qualified buyers. In the near term, this will cement the floor under CAD. We were stopped out of our short CAD/NOK position this week and are standing aside for now.  Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There was scant data out of Switzerland this week: KOF leading indicator increased to 97.1 in July. USD/CHF fell by 0.4% this week. We remain positive on the Swiss franc due to the rising market volatility. EUR/CHF has been weakening of late, a trend that might finally catalyze the SNB towards more unconventional policies. In the past, Swiss central bankers have made sizeable gains by de-swaying market participants. With the large euro short positions currently at stake, we will err on the side of caution. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There was little data out of Norway this week:  Retail sales contracted by 0.4% in June. USD/NOK rose by 1.8% this week. Oil prices remain volatile as markets await a demand revival. On the supply side, U.S. has posted the seventh consecutive drawdown in inventory. The combination of supply hurdles (Iran and Venezuela production) and rising demand (a pickup in global growth) should underpin the energy market and by extension the Norwegian krone later this year. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Retail sales increased by 3.8% year-on-year in June. Trade balance narrowed to SEK 2.9 billion in June. Non-manual workers’ wages grew by 2.4% in May. GDP growth fell from 2.1% year-on-year in Q1 to 1.4% year-on-year in Q2. Manufacturing PMI was unchanged at 52 in July. USD/SEK increased by 1.7% this week. In June, the Swedish exports decreased to SEK 123 billion from SEK 137 billion in May. The imports also fell from SEK 129 billion in May to SEK 120 billion in June. This further reflects the slowdown in global trading activities. The good news is that the Swedish manufacturing new orders to inventory ratio ticked up in July. Going forward, we will closely monitor the Chinese stimulus, trade talk progresses, and global trade for the direction of the krona. 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

Feature The global manufacturing cycle looks dire at the moment. Around the world, manufacturing PMIs have fallen, profit growth has slowed, and capex has been reined back (Chart 1). This is clearly a risky moment for the economic expansion (and the equity bull market) which began in 2009. We hear that many clients are having vigorous debates on their investment committees about what to do – and indeed, at BCA, the views of our strategists are unusually divided.1 Recommendations Chart 1Heading Downhill Fast       Global Asset Allocation veers towards the optimistic camp. In brief, we expect the services and consumer sectors of major economies to remain robust, and that manufacturing will bottom out in the coming months, partly as a result of easier financial conditions, including the dovish turn by central banks and monetary stimulus in China. But we recognize the risks currently and have constructed our portfolio accordingly. We remain overweight equities versus bonds, but leaven that with an overweight on the most defensive equity market, the U.S. The global economy is a wonderful self-organizing system. The disparity between manufacturing and services is stark everywhere. Both the soft data, such as PMIs (Chart 2), and hard data, such as industrial production and retail sales (Chart 3), show that manufacturing almost everywhere is in recession (the U.S. is not yet, but is perhaps headed that way), but that services growth remains robust. Services have been held up by decent wage growth (even in the manufacturing-heavy eurozone) and generally easier fiscal policy (in the eurozone and China, in particular), which have allowed consumers to continue spending. (In the U.S., the risk of tighter fiscal policy next year has been alleviated by last month’s budget agreement which will produce a small positive fiscal thrust in 2020 – see Chart 4.) Chart 2Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data   Chart 5China Is The Root Cause   The manufacturing recession was clearly triggered by China – it is notable, for instance, that large exporting countries have seen no slowdown in sales to the U.S. but a big drop in those to China (Chart 5). In 2017-18, China slowed as a result of its tighter monetary policy and clamp-down on shadow banking. The countries that have been most affected by the slowdown over the past 18 months are, unsurprisingly then, those which have the largest manufacturing sectors, notably Korea, Germany and Japan (Chart 6). But the global economy is a wonderful self-organizing system. Historically, intra-expansion industrial cycles have typically lasted around 18 months from peak to trough, and 18 months from trough to peak (Chart 7). Lower commodity prices, easier financial conditions, and pent-up demand mean that, after a period of slowdown, demand and risk appetite build up. This self-equilibrating cycle breaks only if there is a major structural imbalance, usually excess debt or rising inflation. As we have argued previously, we do not see clear signs currently that either of these usual structural triggers of recession is present (Chart 8). Chart 7Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased The Fed cut rates on July 31 as a risk management measure, “a mid-cycle adjustment to policy,” as Chair Powell put it in his post-FOMC press conference. With the stock market close to a record high and unemployment at a 50-year low, there is no obvious need for the Fed to implement a full-out easing campaign. But with inflation well below its 2% target, and a risk that the manufacturing slowdown could spill over into consumption (perhaps if companies start to lay off workers – something there is little sign of yet), an “insurance” cut seemed prudent. Financial conditions have eased significantly in the U.S. this year, and somewhat in Europe (Chart 9), and this should soon start to positively affect growth. China’s stimulus remains key. So far it has been half-hearted (Chart 10). This is because Chinese growth has to a degree stabilized, trade negotiations with the U.S. continue, and because the authorities have not abandoned their wish to delever the economy – it is notable that shadow-bank credit creation has not rebounded (Chart 11). Both fiscal and monetary stimulus will need to be ramped up in the second half if we are to see a repeat of 2016’s China-driven risk rally. Investors should see this as a put option – if Chinese growth slows again, and the trade talks break down (both of which are likely), the authorities will roll out a stimulus on the scale of their previous efforts. Chart 10China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? What is the biggest risk to our sanguine view? With global stocks up 16% and U.S. stocks 20% year-to-date, the bottoming-out of the manufacturing cycle and greater monetary easing may already be priced in. Chart 12 shows that year-on-year stock market moves typically follow the manufacturing PMIs closely. Even if stock prices remain only at their current level to year-end, they are already discounting a sharp bounce in the PMIs. Fixed Income: If we are right about the macro environment, U.S. Treasury bond yields should rise from their current 2%. Yields usually move in line with consensus GDP forecasts (Chart 13). Economists have cut their 2020 forecast to only 1.8% (from 2.5% for this year). If the 2020 number is revised up, as we expect, Treasury yields have some room to move back up. Moreover, the Fed is unlikely to cut rates twice more by year-end as the futures market implies. Therefore, we stay underweight duration. We have a neutral stance on credit, but this asset class should produce reasonable excess returns over coming quarters given current spreads (Chart 14). U.S. high yield (especially B and below) and eurozone investment grade bonds (which the ECB may start buying again) look attractive. Chart 13Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Equities: Given the uncertainties over the timing and strength of Chinese stimulus, we remain cautious on Emerging Markets and euro area stocks, the most obvious beneficiaries of this. Both regions have structural headwinds (excess foreign-currency debt in the case of EM, the fragile banking system and flattening yield curve for Europe) which mean that, even when Chinese stimulus comes, their outperformance may prove short-lived. For now, we prefer U.S. equities, although we recognize that upside for this year is limited. The key will be whether earnings can surprise analysts’ (over cautious) forecast of only 3% EPS growth in 2019. This seems likely since the Q2 earnings season, with almost half of companies having reported, is coming in at close to 80% beats on the bottom line. To hedge against the upside risk of Chinese stimulus, we continue to recommend building a position in Australian equities and in the Industrials sector. China’s stimulus remains key, but so far it has been half-hearted. Currencies: The U.S. dollar is a counter-cyclical currency and should start to depreciate once signs of a manufacturing recovery become apparent. Moreover, the Fed’s dovish move – and the fact that it has significantly more room to ease than other large DM central banks – should also prove to be dollar bearish eventually (Chart 15). One key cross to watch for signs that the global cycle is bottoming is AUD/JPY, since the Australian dollar is a very cyclical, and the Japanese yen a very defensive, currency (Chart 16). Chart 15Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Commodities: We continue to have a bullish outlook for oil. Although developed-world demand growth has slowed slightly this year, OPEC supply constraints mean that inventories should draw down further (Chart 17). We expect Brent crude to average $74 a barrel in 2H2019 (from $65 today). Gold has performed well this year, up 11%. Our colleagues in BCA’s Foreign Exchange Strategy and Commodity & Energy Strategy services conclude that this has largely been because of monetary and financial factors, mostly lower real rates (Chart 18).2 In the coming months, while rates may rise, gold should be helped by a weaker USD. We are neutral on the metal and see it more as an insurance asset. Our FX and Commodity strategists concur with GAA’s long-standing view that gold is a useful portfolio diversification tool to protect against financial, geopolitical, and inflation risks. Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see BCA’s Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open,” dated 19 July 2019, available at www.bcaresearch.com. 2      Please see Commodity & Energy Strategy Special Report, “All That Glitters…And Then Some,” dated 25 July 2019, available at ces.bcaresearch.com.   GAA Asset Allocation  

Special Report

Highlights From time immemorial, gold has been a medium of exchange, a store of value, and a safe haven to hedge portfolios. In modern times, the market in which it trades has evolved into an important filter of information and expectations re monetary policy, inflation expectations, and geopolitical risk. At any moment in time, one or all of these factors can drive gold prices. At present, we believe the precious metal is pricing to all three of them. However, as we show below, one group of factors – monetary and financial aggregates – holds sway over the evolution of gold prices at present (Chart of the Week). Feature We view gold primarily as a financial asset – almost a currency, but not quite, since it has non-monetary value as well as being a medium of exchange (e.g., in electronics applications). We separate the factors to which gold prices are responsive into three groups of fundamentals: Demand for inflation hedges; Monetary and financial aggregates; and, Demand for portfolio-diversification assets, including safe-haven demand. In modeling gold prices, we also pay attention to a group of tactical indicators that complements our fundamental analysis using sentiment, positioning and technical indicators (Table 1).1 Table 1Fundamental And Technical Gold-Price Drivers As important as real rates are to the evolution of gold prices, technical factors – chiefly sentiment and positioning – also played a large role in gold’s recent breakout (Chart 2). Our tactical composite indicator moved from oversold to overbought territory. Sentiment often is a thin reed on which to place too much conviction, and, over the near term, this could weigh on prices, as market participants try to anticipate when sentiment will change.2 Tracking these variables allows us to generate a “fair value” for gold, which represents the equilibrium at which all of these diverse forces meet (Chart 3). Chart 2Technical Indicators Play A Role In Price Formation Chart 3Gold Fair Value Model Captures Upward Trajectory For Gold Below, we discuss each group of fundamentals driving gold prices, using this analysis to draw investment conclusions. Inflation Hedging Demand Hedging against inflation historically has been one of the key drivers of gold demand. For most of the 21st century, inflationary pressures in the U.S. have remained subdued (Chart 4). For the most part, the recent fall in realized inflation is due to transitory factors like the sharp decline in financial-services costs inflation following last December’s market sell-off (Chart 5). However, it also reflects a larger-than-expected slowdown in the U.S. and global economy, as well as falling inflation expectations (Chart 6). Low realized and expected inflation will, we believe, make it easier for the Fed to cut rates at its upcoming end-July meeting.   Chart 4Inflation Pressures Remain Subdued Our research shows inflation-hedging demand for gold only supports the metal’s price in periods of “high” inflation – i.e., realized and expected inflation rates running above 4.5% p.a. Chart 5Transitory Factors Push Realized Inflation Lower Chart 6Inflation Expectations Also Are Subdued Over the short term – i.e., the next 3 months or so – this means demand for an inflation hedge will not be the primary driver of gold prices. All the same, markets might be getting out ahead of themselves on this score: The Fed’s recent dovish turn signals inflation could surprise to the upside, and likely will move above target next year. As our U.S. Bond strategists note, the Fed’s new battleground is between inflation expectations and financial conditions.3 Indeed, the upcoming “insurance cut” from the Fed at its end-July meeting largely reflects the Fed’s goal of reviving inflation expectations.4 Our research shows inflation-hedging demand for gold only supports the metal’s price in periods of “high” inflation – i.e., realized and expected inflation rates running above 4.5% p.a. We expect inflation to trend higher later in 2020.5 Ordinarily, during inflationary periods, store-of-value assets like gold are bid up as demand exceeds relatively inelastic supply.6 Bottom Line: For now, even though realized and expected inflation remains subdued, it can exceed the Fed’s and other systematically important central banks’ policy rates. This produces low inflation-adjusted interest rates – real rates, in the vernacular – which are bullish for gold prices. We explore this further below. Monetary And Financial Aggregates In the current low-interest-rate environment, inflation rates do not have to rise far above central-bank targets to trigger a flight to gold. Indeed, real rates can quickly turn negative as inflation rises, which diminishes the real return of holding bonds. Since 2014, gold’s price has correlated well with negative yields in global debt markets (Chart 7). The recent dovish turn by systematically important central banks will reinforce this tendency. At present, the monetary and financial aggregates we follow are the most important determinants of gold prices. From an explanatory perspective – vis-à-vis modeling gold prices – these are the most robust group of variables in our analytical framework, as shown in the price decomposition in Chart 1. These variables are important because they focus on the opportunity cost of holding gold, which, in and of itself, generates no yield, and the impact of the U.S. dollar on gold demand, via its price and wealth effects on consumers ex U.S. Chart 7Gold Correlations Rise With Negative-Yielding Debt Chart 8Gold Correlations Also Higher Versus Real Rates U.S. real rates: As a non-yielding asset, gold’s opportunity cost increases with real interest rates. This makes investment demand for gold negatively correlated with real rates (Chart 8). As mentioned previously, the recent dovish turn by major central banks – notably the Fed – supported gold’s 10.8% return YTD, and will continue to do so as we approach the July FOMC meeting. Nonetheless, the positive effect of monetary easing could diminish going into 2H19. Our U.S. Bond strategists’ recent research shows yields rise, on average, following a mid-cycle “insurance rate” cut (Chart 9).7 A second “insurance cut” in 2H19 would delay a rise in yields further into 2H19 or 2020. Because of this, markets will be focused on the Fed’s forward guidance, following it FOMC’s end-July meeting. U.S. Dollar: One of the most stable and powerful relationships with gold prices is its inverse correlation to the U.S. dollar (USD). Chart 10 illustrates this relationship, which has held since the 1990s and before, and has been even more profound than that of oil and copper with the greenback. For one, gold, like oil and copper, is quoted in U.S. dollars, so a drop in the greenback is manifested through higher gold prices because of the numeraire effect. But the powerful relationship between the dollar and gold is at the heart of the function of gold as a medium of exchange, from time immemorial. Chart 10Gold's Relationship With USD Is Long-Standing Gold continues to outperform Treasurys today, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the Bretton Woods agreement broke the gold/dollar link in the early ‘70s, bullion has stood as a viable barometer of dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick for tick. With the Federal Reserve’s dovish shift, we may just have triggered one of the necessary catalysts for a selloff in the U.S. dollar. A pick-up in global and Chinese growth amidst ample liquidity conditions will be supportive of gold. The rationale is pretty simple. Investors who are worried about U.S. twin deficits – fiscal and trade – and the crowded trade of being long Treasurys will shift into gold, since pretty much every other major bond market (Germany, Switzerland, Japan) has negative yields. That favors gold at the expense of the dollar. The reverse is true if investors consider Treasurys more of a safe haven. The bond-to-gold ratio and dollar tend to move tick for tick, so a breakout in one can be a signal for what will happen to the other (Chart 11). Given interest rates, portfolio flows, balance-of-payments dynamics and growth differentials are moving against the U.S. dollar, a breakdown will be a powerful catalyst for higher gold prices. Meanwhile, a fall in the dollar improves the purchasing power of many emerging-market countries as their currencies appreciate. These countries, especially China, Russia and India tend to be the marginal buyers of gold. Chart 12 shows that there is a pretty strong and consistent relationship between the performance of EM relative to DM equities and the gold price. The important takeaway is that the rise in the gold price has not yet been supported by the normal wealth-effect channels from emerging markets, suggesting we are just in the early stages of the rally. Chart 11As Is The USD's Relationship With The Bond/Gold Ratio Chart 12Gold's Second Leg Up Likely Comes From EM Demand Gold tends to be a “Giffen Good,” meaning physical demand increases as prices rise. Ever since the gold bubble burst in 2011, both financial and jewelry demand have evaporated. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different, if, as we expect, incomes continue to rise in these markets (Chart 13). This is especially important since less than 28% of gold demand is investment related, with the balance being consumer and industrial. Ergo, a pick-up in global and Chinese growth amidst ample liquidity conditions will be supportive of gold. Consumer and industrial demand for gold is vividly captured in our GIA index (Chart 14). As a weighted average of select country trade data, currencies, industrial production and a few Chinese manufacturing sector variables, it captures the ebb and flow of the global production cycle. More important for the gold price is the trend in this index rather that the amplitude. The upturn remains tentative, but will be another catalyst that cements the gold bull market. Bottom Line: Given interest rates, portfolio flows, balance-of-payment dynamics and growth differentials are moving against the U.S. dollar, a breakdown will be a powerful catalyst for higher gold prices. Higher EM income growth will also be supportive. Chart 14Rebound in EM Industrial Activity Will Boost EM Wealth, Gold Demand Gold As A Portfolio-Diversification Asset Safe-haven assets provide an essential source of returns for investors in times of crisis. Gold remains one of the best safe-haven assets to protect portfolios against drawdowns arising from financial, geopolitical and political crises. Our analysis shows gold performs better than most alternative safe-haven assets – i.e. U.S., Japanese and Swiss bonds and currencies (Chart 15, Top Panel). Importantly, gold is unique because of the non-linearity in its hedging ability: In times of crisis, gold beats most other safe-havens, while also being the top performer among the group in periods of economic and equity market expansion (Chart 16).8 This makes gold a less risky safe-haven asset to own defensively in late cycles. Critically, gold’s performance during periods of heightened geopolitical risk is formidable. Not to put too fine a point on it, but we believe geopolitical risks will remain elevated in 2H19. Three ongoing developments remain important to monitor: Iran-U.S. conflict and the heightened probability of an oil shock. We believe markets are underestimating the likelihood of a military conflict between Iran and the U.S. in the Persian Gulf. While both sides to this standoff in the Gulf have professed their desire to avoid war, the real risk is an inadvertent escalation in hostilities arising from routine operations, as has happened in the past. An escalation of hostilities in the Gulf almost surely would rally oil and gold prices, as Chart 15, Middle Panel – Performance During Geopolitical Crises – shows.9 EM central banks’ de-dollarization. Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. At the same time, foreign central banks have been amassing gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 17, Bottom Panel). The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is fading. Escalating Sino-U.S. trade tensions. The effects on gold prices from an escalation in Sino-U.S. trade tensions are difficult to model. On the one hand, such an escalation would positively impact gold prices, because it increases the probability of more rate cuts from central banks – including the Fed and PBOC – and likely would lead to an increase in equity volatility. It also could impact gold prices negatively, because it likely would diminish EM GDP growth more than U.S. growth, which, over the short-to-medium term, would be negative for gold and commodities generally. This likely also would rally the dollar, which is negative for gold, and commodities generally. About the only thing we can venture at this point is such an escalation would increase the safe-haven demand for gold, as investors rush for cover. Chart 17Central Banks Are Absorbing Most Gold Production Chart 18Gold Becomes More Appealing As Recession Fears Grow Each factor influencing gold is time-varying. The safe-haven component of gold’s price is a modest driver of its price in ordinary times. However, as an economic expansion reaches its limit, gold benefits from mounting recession fears, as these worries usually are exacerbated by the Fed‘s tightening cycles (Chart 18). In these periods, gold’s correlation with real rates diminishes and the inflation and recession/equity-correction risks dominate. This contributed to gold’s outperformance since 4Q18. We continue to recommend gold as a portfolio hedge, given its performance during periods of financial, monetary and geopolitical stress. For the present, however, the dovish turn by systematically important central banks – combined with fiscal stimulus earlier this year, and monetary stimulus later this year in China – implies the expansion will last longer than previously expected, pushing portfolio-diversification demand lower in the ranking of gold’s drivers until the hiking cycle restarts some time in the future.10 Bottom Line: We continue to recommend gold as a portfolio hedge, given its performance during periods of financial, monetary and geopolitical stress, as shown above. Risks remain elevated in all of these dimensions, which will keep gold well supported over the short and medium terms.     Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      The supply of gold is relatively fixed over the short and long term – every ounce of gold ever produced still is in circulation in one form or another (e.g., as jewelry or as an electronic component).Please see the World Gold Council’s Supply and Demand Statistics, which show these data to 1Q19. 2      Please see The Gold Trifecta published June 27, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see The New Battleground For Monetary Policy, published by BCA Research’s U.S. Bond Strategy March 26, 2019.It is available at usbs.bcaresearch.com. 4      This expression was used by Fed Chair Jay Powell in his March congressional testimony: “In our thinking, inflation expectations are now the most important driver of actual inflation.”Please see Fed Puts Inflation Expectations at Heart of Major Policy Review, published by Bloomberg.com March 15, 2019. 5      For more details on gold – and other assets – performance during different inflation regimes, please see BCA Research’s Global Asset Allocation’s Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises, published May 22, 2019.It is available at gaa.bcaresearch.com. 6      Gold’s inelastic supply is important. Gold is regularly treated as a currency; however, it lacks a central bank that can increase its supply via turning up the printing press. This makes the precious metal a so-called "hard currency," and endows it with the ability to maintain its purchasing power during periods of inflation. In addition, it is an asset that is accepted as collateral to support bank lending and margining by the Bank for International Settlements (BIS), and numerous commercial and private banks. 7      Please see The Long Awkward Middle Phase published by BCA Research’s U.S. Bond Strategy July 2, 2019.It is available at usbs.bcaresearch.com. 8      Gold’s performance across the spectrum of bear-to-bull equity markets shows it is, in some respects, similar to a long option position with puts protecting the downside and calls protecting the upside. Its value increases as equities and other asset classes are falling, and it also appreciates as these other assets are rising, albeit not as much at times. 9      Please see Supply – Demand Balances Consistent With Higher Oil Prices, published by BCA Research’s Commodity & Energy Strategy June 20, 2019, for further discussion.See also The Emerging Crisis in the Persian Gulf by Richard Nephew, published by Columbia University's Center on Global Energy Policy July 19, 2019. 10     Please see “Third Quarter 2019 Strategy Outlook: The Long Hurrah” published by BCA Research’s Global Investment Strategy June 28, 2019, for a discussion of U.S. and Chinese stimulus.It is available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2   Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Special Report

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 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 Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart II-7 (ARTHUR)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 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 On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I)   Chart II-14 (PETER)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 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 ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Chart II-19 (ARTHUR)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 Chart II-21 (ANASTASIOS)Buy Hypermarkets   Chart II-22 (ANASTASIOS)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 Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (I) Chart II-26B (PETER)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 Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds   Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… …And The Bears 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.