Currencies

Highlights Investors ran for cover in December as they succumbed to a litany of worries regarding the outlook. The key question is whether the pessimism is overdone or an extended equity bear market is underway. Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. There are some tentative signs that the two U.S. weak spots, housing and capital spending, are bottoming out. However, our global leading economic indicators continue to herald a soft first half of 2019 outside of the U.S. The dollar thus has more upside in the near term. The political risks facing investors have not diminished either. In particular, we expect turbulence related to the U.S./China trade war to extend well beyond the 3-month “truce” period. The returns to stocks, corporate bonds and commodities historically have not been particularly attractive on average when the U.S. yield curve is this flat. Nonetheless, the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies back to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. The upgrade to stocks in the developed markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now, but be prepared to upgrade sometime in 2019. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil prices have overshot to the downside. Supply is adjusting and, given robust energy demand in 2019, we still expect prices to rise to $82. Feature Investors ran for cover in December as they succumbed to concerns regarding the U.S./China trade war, corporate leverage, global growth, rising U.S. interest rates and the shift toward quantitative tightening. Some equity indexes, such as the Russell 2000, reached bear market territory, having lost more than 20%. Losses have been even worse outside the U.S. Earnings revisions have plunged into the “net downgrade” zone. Implied volatility has spiked and corporate bond spreads are surging (Chart I-1). The key question is whether the pessimism is overdone or an extended equity bear market is underway. Chart I-1A Flight To Quality A Flight To Quality A Flight To Quality We laid out our economic view in detail in the BCA Outlook 2019 report, published in late November. Not enough has changed on the global economic front in the three weeks since then that would justify such a violent shift in investor sentiment. That said, our favorite global leading economic indicators continue to erode (Chart I-2). The only ray of hope is that the diffusion index constructed from our Global Leading Economic Indicator appears to have bottomed. Nonetheless, the actual LEI will keep falling until the diffusion index shifts into positive territory.   Chart I-2Global Leading Indicators Still Weak Global Leading Indicators Still Weak Global Leading Indicators Flashing Red Global Leading Indicators Still Weak Global Leading Indicators Flashing Red For China, a key source of investor angst, the latest retail sales and industrial production reports reinforced that economic momentum continues to recede. We will not be convinced that growth is bottoming until we see an upturn in our credit impulse indicator (Chart I-3). Its continued decline in November suggests that the outlook for emerging market assets and commodity prices is poor for at least the next quarter. Global industrial output appears headed for a mild contraction. The manufacturing troubles are centered in the emerging Asian economies, but Europe and Japan are also feeling the negative effects. Chart I-3China: No Bottom Yet China: No Bottom Yet China: No Bottom Yet In the U.S., November’s bounce in housing starts and permits is a hopeful sign that the soft patch in this sector is ending. However, it is not clear how the devastating wildfires on the west coast have affected the housing data (Chart I-4). The downdraft in capital goods orders may also be drawing to a close, based on the latest reading from the Fed’s survey of capital spending intentions. The U.S. leading economic indicator dipped slightly in November, but remains consistent with above-trend real GDP growth in the months ahead. Chart I-4U.S.: Some Hopeful Signs U.S.: Some Hopeful Signs U.S.: Some Hopeful Signs The bottom line is that our outlook for growth has not been significantly altered. We see little risk of a U.S. recession in 2019. The global economy continues to weaken, but we expect enough policy stimulus out of China to stabilize growth in that economy in the second half of the year. We highlighted in the BCA Outlook 2019 that, while the risks appeared elevated, we would consider shifting back to overweight in stocks if they cheapened sufficiently. Valuation has indeed improved in recent weeks and sentiment has turned more cautious. Global growth will likely continue to decelerate in the first half of 2019, but markets have largely discounted this outcome. In other words, the shift toward pessimism in financial markets appears overdone. The fact that the Fed has signaled a move away from regular quarter-point rate hikes adds to our confidence in playing what will likely be the last upleg in risk assets in this cycle. Fed: Rate Hikes No Longer On Autopilot The Fed lifted rates by a quarter point in December and signaled that any additional tightening will be data-dependent. The FOMC also trimmed the expected peak in the funds rate and its estimate of the long-run, or neutral, level. Policymakers were likely swayed by some disappointing U.S. economic data, the pullback in core PCE inflation, and the sharp tightening in financial conditions (Chart I-5). Chart I-5Financial Conditions Have Tightened Financial Conditions Have Tightened Financial Conditions Have Tightened Monetary conditions are not tight by historical yardsticks, such as the level of real interest rates. The problem is that investors fear that the neutral level of the fed funds rate, the so-called R-star, remains very depressed. If true, it could mean that the Fed is already outright restrictive, which would signal that the monetary backdrop has turned hostile for risk assets. The OIS curve signals that the consensus believes that the Fed is pretty much done the tightening cycle (Chart I-6) Chart I-6Investors Believe The Fed Is Done! Investors Believe The Fed Is Done! Investors Believe The Fed Is Done! We believe that R-star is higher than the current policy setting and is rising, as the growth headwinds related to the Great Financial Crisis fade with the passage of time. The problem is that nobody knows the level of the neutral rate. Thus, we need to watch for signs that the fed funds rate has surpassed that level, such as an inverted yield curve. The 10-year/3-month T-bill spread is still in positive territory, but barely so. Meanwhile, our R-star indicator is also flashing yellow as it sits on the zero line (Chart I-7). It is a composite of monetary indicators that in the past have been useful in signaling that monetary policy had become outright restrictive, leading to slower growth and trouble for risk assets. The lead time of this indicator relative to economic activity and risk asset prices has been quite variable historically, but a breakdown below zero would send a powerful bearish signal for risk assets if confirmed by an inverted yield curve. Chart I-7Worrying Signs Of Tight Money Worrying Signs Of Tight Money Worrying Signs Of Tight Money The Implications Of Four Fed Scenarios It is not surprising that investors are struggling with a number of different possible scenarios on how the R-star/Fed policy nexus will play out. We can perhaps boil down discussion of the Fed and the implications for financial markets to a matrix of four main outcomes, based on combinations related to the level of R-Star (high or low) and the pace of Fed rate hikes in 2019 (pause or continue increasing rates by 25 basis points per quarter). Policy Mistake #1: R-star is still very low, but policymakers do not realize this and the FOMC continues to tighten into restrictive territory in 2019. By definition, the economy begins to suffer in this scenario, inflation and inflation expectations decline and long-bond yields are flat-to-lower. The yield curve inverts. However, current real rates are still so low that the fed funds rate cannot be very far above R-Star, which means it would represent only a small policy mistake. As long as the Fed recognizes the economic slowdown early enough and truncates the rate hike cycle, then there is a good chance that a recession would be avoided. Investors would initially fear a recession, however, which means that risk assets would be hit hard in absolute terms and relative to bonds and cash until recession fears fade. The direction of the dollar is perhaps trickiest part because there are so many potential cross currents. To keep things simple we will assume that global growth follows our base-case view and remains lackluster in the first half of 2019, followed by a modest re-acceleration. We believe the dollar would likely rally a little as the Fed continues tightening, but then would fall back as the FOMC is forced to turn dovish in the face of a U.S. growth scare. Policy Mistake #2: R-Star is high and rising but the Fed fails to hike rates fast enough to keep up. The economy accelerates in this scenario because monetary policy remains stimulative through 2019, at a time when the 2018 fiscal stimulus will still be providing a demand tailwind. Core PCE inflation moves above 2% and long-term inflation expectations shift up, signaling to investors that the Fed has fallen behind the inflation curve. Risk assets rip for a while and the yield curve bear-steepens as the 10-year Treasury yield moves gradually higher at first. Belatedly, the FOMC realizes it has underestimated the neutral rate and signals a hawkish policy shift. A 50-basis point rate hike at one FOMC meeting causes risk assets to buckle on the back of surging Treasury yields. The yield curve begins to bear-flatten. Eventually the curve inverts and the economy enters recession. The dollar weakens at first because higher inflation lowers U.S. real interest rates relative to the rest of the world. Global growth prospects would initially get a boost from the acceleration in U.S. growth, which is also dollar-bearish. However, in the end the dollar would likely rise as global financial markets turn risk-off. Fed Gets It Right (1): R-star is high and rising. The Fed continues to tighten in line with the increase in the neutral rate. Treasurys sell off hard and the yield curve shifts higher, but remains fairly flat (parallel shift). The curve could mildly invert temporarily, but market worries about a recession eventually recede as economic momentum remains robust, allowing the curve to subsequently trade in the 0-50 basis point range. As discussed below, risk assets tend to outperform Treasurys and cash when the yield curve is in this range, but not by much. The Treasury market would suffer significant losses. This is the most dollar-bullish of the four scenarios, given our global growth view (tepid) and the fact that the market is not even priced for a full quarter-point rate hike in 2019. Fed Gets It Right (2): R-Star is actually still quite low, but the Fed correctly sees recent economic data disappointments and the tightening in financial conditions as signs that policy is close to neutral. The Fed pauses the rate hike cycle, followed by a slower and more data-dependent pace of tightening. The yield curve stays fairly flat and flirts with inversion as investors try to figure out if the Fed has overdone it. Risk assets are volatile and deliver little return over cash. Treasurys rally a bit as the chance of any further rate hikes is priced out of the market, but the rally is limited unless the economy falls into recession (which is not part of this scenario because we are assuming the Fed “gets it right”). The dollar fluctuates, but delivers no real trend since U.S. yield differentials versus the rest of the world do not change much. As we go to press, financial markets are moving in a way that is consistent the Policy Mistake #1; the consensus appears to believe that the Fed has already lifted the fed funds rate too far, causing financial conditions to tighten. But if U.S. real GDP growth remains above-trend as we expect, then the market view could eventually transition to a belief in Mistake #2; the Fed falls behind the inflation curve. The curve would re-steepen and risk assets could have one last hurrah before the Fed gets hawkish again and the 2020 recession arrives. The transition from Mistake #1 to Mistake #2 is essentially our base-case outlook. Nonetheless, obviously the risks around this central scenario are high, especially given how late it is in the U.S. economic and policy cycle. Asset Returns And The Yield Curve Our 2018 late-cycle investing theme focussed on historical asset return and policy dynamics after the U.S. unemployment rate fell below the full-employment level in past cycles. We found that risk assets tend to run into trouble once the U.S. S&P 500 operating margin peaks. As we highlighted in the BCA Outlook 2019, our margin proxies are still not heralding that a peak is at hand. Given the recent investor obsession with the U.S. yield curve, this month we look at historical asset returns at different levels of the 10-year/3-month T-bill yield curve slope: Phase I, when the slope is above 50 basis points; Phase II, when the curve is between 0 and 50 basis points; and Phase III, when the curve is inverted (Table I-1). The data are presented as (not annualized) monthly average returns. It may be surprising that risk asset returns are for the most part positive even in when the curve is inverted. However, keep in mind that we are focussing on the curve, not on recession periods. The curve can be inverted for a long time before the subsequent recession occurs. Risk asset returns often remain positive during this period. The broad conclusions are as follows: Unsurprisingly, risk assets perform their best, in absolute terms and relative to government bonds and cash, in Phase I when the yield curve is steep. Returns tend to deteriorate as the curve flattens. This includes equities, corporate bonds and commodities. Small caps underperform large caps when the curve is between 0 and 50 basis points, but the reverse is true when the curve is flatter or steeper than that range. The ratio of cyclical stocks to defensives has not revealed a consistent pattern with respect to the yield curve, although this may reflect the short historical period available. Value stocks shine versus growth when the curve is inverted. Hedge fund and private equity returns have not varied greatly across the three yield curve environments. Structured product, such as CMBS and ABS, have enjoyed their best performance when the curve is inverted. Timberland and Farmland have also rewarded investors during Phase III. We suspected that asset returns when the curve is in the 0-50 basis point range would vary importantly with the direction of the curve. In Table I-I we split Phase II into two parts: when the curve is steepening after being inverted, and when the curve is flattening after being steep. In other words, when the consensus is either transitioning from quite bullish to very bearish, or vice-versa. Chart I- Risk assets such as equities (U.S. and Global) and U.S. investment-grade corporate bonds indeed perform much better in absolute terms when the curve is flat but is steepening rather than flattening. The same is true for U.S. structured product. In terms of excess returns relative to government issues, both U.S. IG and HY corporates have tended to underperform when the curve is in the 0-50 basis point range. Surprisingly, the underperformance is worse when the curve is steepening than when it is flattening. This appears to reflect an anomalous period in early 2006 when the curve was flattening but corporate bonds enjoyed strong excess returns. Emerging market equities show very strong returns in all three curve phases. This reflects the inclusion of the pre-2000 period in the mean calculations, a time when EM equities were much less correlated with U.S. financial conditions. EM equity returns have been significantly lower on average since 2000 when the curve is in the 0-50 basis point range (and especially when the curve is flattening) The bottom line is that risk assets can still reward investors with positive returns during periods when the yield curve is flat. However, it is a dangerous time, especially when the global economy is up to its eyeballs in debt. This month’s Special Report beginning on page 17 argues that, although regulation has made the global financial system more resilient to shocks compared to the pre-Lehman years, the number of potentially destabilizing shocks has increased. Moreover, the trade war and Brexit risks make the investment backdrop all the more precarious. No Quick End To The Trade War The honeymoon following the trade ceasefire between the U.S. and China, agreed at the G20 summit in early December, did not last long. The arrest of the chief financial officer of Chinese telecom maker Huawei and continuing hawkish tweets from the U.S. president dampened hopes that a trade agreement can be negotiated by March. Even news that China intended to cut tariffs on U.S. auto imports did not help much. We highlighted in the BCA Outlook 2019 that negotiations will prove to be protracted and testy. It will take a lot more than some token market-opening action on the part of China to placate the U.S. Our geopolitical team emphasizes that “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance.1 For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart I-8). While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Chart I-8R&D Expenditure By Country R&D Expenditure By Country R&D Expenditure By Country U.S. demands will also be hard for China to swallow. Most importantly, the U.S. is requesting that China rein in its hacking and spying, shift its direct investment to less tech-sensitive sectors, adjust its “Made in China” targets to allow for more foreign competition, and lower foreign investment equity restrictions. These stumbling blocks will make it difficult to strike a deal on trade. We continue to believe that a final trade deal between the U.S. and China will not arrive in the 90-day timeframe of the ceasefire. Thus, global risk assets will be subject to swings in sentiment regarding the likelihood of a trade deal well beyond March. Meanwhile, as previously discussed, Chinese policy stimulus has not yet become aggressive enough to spark animal spirits in the private sector. The Chinese authorities are proceeding cautiously so as to avoid adding significantly to private- and public-sector’s debt mountain. This month’s Special Report also discusses the risks that the surge in debt over the past decade poses for the global financial system, including escalating risk in China’s shadow banking system. Brexit Pain Continues Politics surrounding the torturous Brexit process will also remain a source of volatility for global markets in 2019. Prime Minister May survived a leadership challenge, but this is hardly confidence-inspiring. The question is whether any deal can get through Westminster. The votes appear to be in place for the softest of soft Brexits, the so-called Norway+ option, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to essentially pay for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election (which may usher the even less pro-Brexit Labour Party into power), or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the failure of the Tories to endorse May’s proposed agreement means that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear; the median voter is turning forcefully towards Bremain (Chart I-9). It will soon become untenable to delay the second referendum. The bottom line is that, while a soft Brexit is the most likely outcome, the path from here to the end result will be punishing. We do not recommend Brexit-related bets on the pound, despite the fact that it is cheap. Chart I-9A Shift Toward Bremain A Shift Toward Bremain A Shift Toward Bremain 2019: A Tale Of Two Halves For EM, Commodities And The Dollar One of our key themes in the BCA Outlook 2019 is that the growth divergence between China and the U.S. will persist at least for the first half of 2019. The result will be weak EM asset prices and currencies, little upside for base metals and a strong U.S. dollar. We expect the Chinese authorities will do enough to stabilize growth by mid-year, providing the impetus for a playable bounce in EM and commodity prices in the second half of 2019, coinciding with a peak in the U.S. dollar. Nonetheless, the dollar still has some upside potential in broad trade-weighted terms in the first half of 2019. Our Central Bank Monitors continue to show a greater need for policy tightening in the U.S. than in the rest of the major countries. The dollar has usually strengthened when this has been the case historically. In particular, the ECB’s Central Bank Monitor has slipped back into “easy money required” territory, reflecting moderating economic momentum and still-depressed consumer price inflation (Chart I-10). Chart I-10Our CB Monitors Support A Stronger Dollar Our CB Monitors Support A Stronger Dollar Our CB Monitors Support A Stronger Dollar The ECB announced the well-anticipated end of its asset purchase program in December. The central bank will now focus on forward guidance as its main policy tool outside of setting short-term interest rates. Lending via targeted LTROs will also be considered under certain circumstances. Policymakers retained the latest forward guidance after the December MPC meeting, that rates are on hold “through the summer of 2019”. The latest reading from our ECB Monitor suggests that the central bank could be on hold for longer than that. We expect Eurozone growth to improve somewhat through the year, but we still believe that interest rate differentials will move further in favor of the dollar relative to the euro and the other major currencies. Periods of slow global growth also tend to favor the greenback. The bottom line is that, while a correction is possible in the very near term, investors with at least a six-month horizon should remain long the dollar. Investment Conclusions: Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. The risks facing investors have not diminished either, especially given the precarious nature of late-cycle investing and the uncertainty regarding the neutral level of the fed funds rate. Historically, the returns to stocks, corporate bonds and commodities have not been particularly attractive on average when the yield curve is this flat. Nonetheless, we believe that the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. Despite our more positive view on equities, we remain cautious on credit. Spreads have widened recently to more attractive levels, but we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009. Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019.  Credit is an asset class that is likely to perform particularly poorly in the next recession. Our upgrade to stocks in the advanced markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil markets are still in the process of re-adjusting to an extraordinary policy reversal by the Trump Administration on its Iranian oil-export sanctions in November, as last-minute waivers were granted to Iran’s largest oil importers. We believe that oil prices have overshot to the downside. Following OPEC 2.0’s decision to cut 1.2mm b/d of production to re-balance markets in the first half of the year, we continue to expect prices to recover on the back of solid global energy demand. Canada also mandated energy firms to trim production. Our energy experts expect oil prices to reach $82/bbl in 2019. We also like gold as long as the fed funds rate remains below its neutral level. Mark McClellan Senior Vice President The Bank Credit Analyst December 21, 2018 Next Report: January 31, 2019 II. (Part II) The Long Shadow Of The Financial Crisis This is the second of a two-part Special Report on the structural changes that have occurred as a result of the Great Recession and financial crisis. We look at three issues: asset correlation, the safety of the financial system, and the level of global debt. First, correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. Some believe that the underlying level of correlation among risk assets has shifted permanently higher for two main reasons: (1) trading factors such as the increased use of exchange-traded funds and algorithms; and (2) the risk-on/risk-off environment in which trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. We have sympathy for the second explanation. The equity risk premium (ERP) was forced higher on a sustained basis by the financial crisis, driven by fears that the advanced economies had entered a ‘secular stagnation’. Elevated correlation among risk assets was a result of a higher-than-normal ERP. The ERP should decline as fears of secular stagnation fade, leading to a lower average level of risk asset correlation than has been the case over the last decade. Second, regulators have been working hard to ensure that the financial crisis never happens again. But is the financial system really any safer today? Undoubtedly, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. The propensity for contagion among banks has diminished and there has been a dramatic decline in the volume of complex structured credit securities. The bad news is that the level of global debt has increased at an alarming pace. The third part of this report highlights that elevated levels of debt could cause instability in the global financial system. Choking debt levels boost the vulnerability to negative shocks. The number and probability of potential shocks appear to have increased since 2007, including extreme weather events, sovereign debt crises, large-scale migration, populism, water crises and cyber & data attacks. The lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide any fiscal relief in the event of a negative shock. Moreover, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend more in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. The Great Recession and Financial Crisis cast a long shadow that will affect economies, policy and financial markets for years to come. Rather than reviewing the roots of the crisis, the first of our two-part series examined the areas where we believe structural change has occurred related to the economy or financial markets. We covered the changing structure of the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. We highlighted that the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. We made the case that the prolonged inflation undershoot is sowing the seeds of an overshoot in the coming years, in part related to central bank policymakers that are doomed to fight the last war. Finally, we argued that the forces behind the structural and cyclical bull market in bonds reached an inflection point in 2016/2017. In Part II, we examine the theory that the financial crisis has permanently lifted market correlations among risk assets. Next, we look at whether regulatory changes implemented as a result of the financial crisis have made the global financial system safer. Finally, we highlight the implications of the continued rise in global leverage over the past decade in the context of BCA’s Debt Supercycle theme. The bottom line is that the global financial system still faces substantial risks, despite a more highly regulated banking system. (1) Are Risk Asset Correlations Permanently Higher? Correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. For example, risk assets became more highly correlated, suggesting little differentiation within or across asset classes. Chart II-1 presents a proxy for U.S. equity market correlations, using a sample of current S&P 100 companies. The average correlation was depressed in the 1990s and 2000s relative to the 1980s. It spiked in 2007 and fluctuated at extremely high levels for several years, before moving erratically lower. It has jumped recently and is roughly in the middle of the post-1980s range. Chart II-1Two Factors Driving Correlation bca.bca_mp_2019_01_01_s2_c1 bca.bca_mp_2019_01_01_s2_c1 Correlations will undoubtedly ebb and flow in the coming years and will spike again in the next recession. But a key question is whether correlations will oscillate around a higher average level than in the 1990s and 2000s. The consensus seems to believe that the underlying level of correlation among risk assets has indeed shifted higher on a structural basis for two main reasons: Market Structure Changes: Many investors point to trading factors such as the increased use of index products (exchange-traded funds for example), and high-frequency/algorithmic trading as likely culprits. Macro “theme” investing has reportedly become more popular and is often implemented through algorithms. The result is an increase in stock market volatility and a tendency for risk-asset prices to move up and down based on momentum because they are all being traded as a group. These factors would likely be evident today even if the financial crisis never happened, but the popularity of algorithm trading may have been encouraged by the fact that the macro backdrop was so uncertain for years after Lehman collapsed. Risk On/Off Trading Environment: Trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. Even after the recession ended, the headwinds to growth were formidable and many felt that the sustainability of the recovery hinged largely on the success or failure of unorthodox monetary policies. The general feeling was that either the policies would “work”, the output gap would gradually close and risk assets would perform well, or it would fail and risk assets would be dragged down by a return to recession. Thus, markets traded on an extreme “risk-on/risk-off” basis, as sentiment swung wildly with each new piece of economic and earnings data. While the market structure thesis has merit on the surface, the impact should only be short term in nature. It is difficult to see how a change in the intra-day microstructure of the market could have such a fundamental, wide-ranging and permanent impact on market prices. Previous research suggests that any impact on market correlation beyond the very short term is likely to be small. For the sake of brevity, we won’t present the evidence here, but instead refer readers to two BCA Special Reports.2 The risk on/off trading environment thesis is a more plausible explanation. However, we find it more useful to think about it in terms of the equity risk premium (ERP). A higher ERP causes investors to revalue cash flows from all firms, which, in turn, causes structural shifts in the correlation among stocks. A lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious are an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Shifts in the ERP are sometimes structural in nature, but there is also a strong cyclical element in that persistent equity declines historically have had the effect of temporarily raising the ERP and correlations. A simple model based on the ERP and volatility explains a lot of the historical variation in equity correlation, including the elevated levels observed in the years after 2007 (Chart II-2).3 The shift lower in correlations after 2012 reflects both a lower equity risk premium and a dramatic decline in downside volatility. Chart II-2Simple Model Explains Correlation Simple Model Explains Correlation Simple Model Explains Correlation It is tempting to believe that the lingering shell-shock related to the financial crisis means that the underlying equity risk premium has shifted permanently higher. The ERP is still elevated by historical standards, but this is more reflective of extraordinarily low bond yields than an elevated forward earnings yield. Investors evidently believe that the U.S. and other developed economies are stuck in a “secular stagnation”, which will require low interest rates for many years just to keep economic growth near its trend pace. In other words, the equilibrium interest rate, or R-star, is still very low. The ERP and correlations among risk assets will undoubtedly spike again in the next recession. Nonetheless, in the absence of recession, we expect fears regarding secular stagnation to fade further. If the advanced economies hold up as short-term interest rates and bond yields rise, then concerns that R-star is extremely low will dissipate and expectations regarding equilibrium bond yields will shift higher. The ERP will move lower as bond yields, rather than the earnings yield, do most of the adjustment. The underlying correlations among risk asset prices should correspondingly recede. This includes correlations among a wide variety of risk assets, such as corporate bonds and commodities. While this describes our base case outlook, there is a non-trivial risk that the next recession arrives soon and is deep. This would underscore the view that R-star is indeed very low and the economy needs constant monetary stimulus just to keep it out of recession (i.e. the secular stagnation thesis). The ERP and correlations would stay elevated on average in that scenario. What About The Stock/Bond Correlation? Chart II-3 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and the early-2000s. Bond yields tended to rise whenever the S&P 500 was falling. Over the past two decades, however, bond yields have generally declined when the stock market has swooned. Chart II-3Structural Shifts In The Stock/Bond Correlation Structural Shifts In The Stock/Bond Correlation Structural Shifts In The Stock/Bond Correlation Inflation expectations can help explain the shift in stock/bond correlation. Expectations became unmoored after 1970, which meant that inflationary shocks became the primary driver of bond yields. Strong growth became associated with rising inflation and inflation expectations, and the view that central banks had fallen behind the curve. Bond yields surged as markets discounted aggressive tightening designed to choke off inflation. And, given that inflation lags the cycle and had a lot of persistence, central banks were not in a position to ease policy at the first hint of a growth slowdown. This was obviously a poor backdrop for stocks. When inflation expectations became well anchored again around the late 1990s, investors no longer feared that central banks would have to aggressively stomp on growth whenever actual inflation edged higher. Central banks also had more latitude to react quickly by cutting rates at the first sign of slower economic growth. Fluctuations in growth became the primary driver of bond yields, allowing stock prices to rise and fall along with yields. The correlation has therefore been positive most of the time since 2003. Bottom Line: A negative correlation between stocks and bond yields reared its ugly head in the last quarter of 2018. The equity correction reflected several factors, but the previous surge in bond yields and hawkish Fed comments appeared to spook markets. Investors became nervous that the fed funds rate had already entered restrictive territory, at a time when the global economy was cooling off. We expect more of these episodes as the Fed normalizes short-term interest rates over the next couple of years. Nonetheless, we see no evidence that inflation expectations have become unmoored. This implies that the stock-bond correlation will generally be positive most of the time over the medium term. In addition, the average level of correlation among risk assets has probably not been permanently raised, although spikes during recessions or growth scares will inevitably occur. (2) Is The Global Financial System Really Safer Today? The roots of the great financial crisis and recession involved a global banking and shadow banking system that encouraged leverage and risk-taking in ways that were hard for investors and regulators to assess. Complex and opaque financial instruments helped to hide risk, at a time when regulators were “asleep at the switch”. In many countries, credit grew at a much faster pace than GDP and capital buffers were dangerously low. Banking sector compensation skewed the system toward short-term gains over long-term sustainable returns. Lax lending standards and a heavy reliance on short-term wholesale markets to fund trading and lending activity contributed to cascading defaults and a complete seizure in parts of the money and fixed income markets. A vital question is whether the financial system is any less vulnerable today to contagion and seizure. The short answer is that the financial system is better prepared for a shock, but the problem is that the number of potential sources of instability have increased since 2007. Since the financial crisis, regulators have been working hard to ensure that the financial crisis never happens again. Reforms have come under four key headings: Capital: Regulators raised the minimum capital requirement for banks, added a buffer requirement, and implemented a surcharge on systemically important banks. Liquidity: Regulators implemented a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR) in order to ensure that banks have sufficient short-term funds to avoid liquidity shortages and bank runs.4 Risk Management: Banks are being forced to develop systems to better monitor risk, and are subject to periodic stress tests. Resolution Planning: Banks have also been asked to detail options for resolution that, hopefully, should reduce systemic risk should a major financial institution become insolvent. Global systemically-important banks, in particular, will require sufficient loss-absorbing capacity. A major study by the Bank for International Settlements,5 along with other recent studies, found that systemic risk in the global financial system has diminished markedly as a result of the new regulations. On the whole, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. Lending standards have tightened almost across the board relative to pre-crisis levels, particularly for residential mortgages. Additional capital and liquid assets provide a much wider buffer today against adverse shocks, allowing most banks to pass recent stress tests (Chart II-4). Financial institutions have generally re-positioned toward retail and commercial banking and wealth management, and away from more complex and capital-intensive activities (Chart II-5). The median share of trading assets in total assets for individual G-SIBs has declined from around 20% to 12% over 2009-16. Chart II-4 Chart II-5 Moreover, the propensity for contagion among banks has diminished. The BIS notes that assessing all the complex interactions in the global financial system is extremely difficult. Nonetheless, a positive sign is that banks are focusing more on their home markets since the crisis, and that direct connections between banks through lending and derivatives exposures have declined. The BIS highlights that aggregate foreign bank claims have declined by 16% since the crisis, driven particularly by banks from the advanced economies most affected by the crisis, especially from some European countries (Chart II-6). It is also positive that European banks have made some headway in diminishing over-capacity, although problems still exist in Italy. Finally, and importantly, there has been a distinct shift toward more stable sources of funding, such as deposits, away from fickle wholesale markets (Charts II-7 and II-8). Chart II-6Less Cross Border Lending (Until Recently) Less Cross Border Lending (Until Recently) Less Cross Border Lending (Until Recently)   Chart II-7 Chart II-8 Outside of banking, many other regulatory changes have been implemented to make the system safer. One important example is that rules were adjusted to reduce the risk of runs on money market funds. What About Shadow Banking? Of course, more could be done to further indemnify the financial system. Concentration in the global banking system has not diminished, and it appears that the problem of “too big to fail” has not been solved. And then there is the shadow banking sector, which played a major role in the financial crisis by providing banks a way of moving risk to off-balance sheet entities and securities, and thereby hiding the inherent risks. Shadow banking is defined as credit provision that occurs outside of the banking system, but involves the key features of bank lending including leverage, and liquidity and maturity transformation. Complex structured credit securities, such as Collateralized Debt Obligations, allowed this type of transformation to mushroom in ways that were difficult for regulators and investors to understand. A recent study by the Group of Thirty6 concluded that securitization has dropped to a small fraction of its pre-crisis level, and that growing non-bank credit intermediation since the Great Recession has primarily been in forms that do not appear to raise financial stability concerns. Much of the credit creation has been in non-financial corporate bonds, which is a more stable and less risky form of credit extension than bank lending. Other types of lending have increased, such as corporate credit to pension funds and insurance companies, but this does not involve maturity transformation, according to the Group of Thirty. There has been a dramatic decline in the volume of complex structured credit securities such as collateralized debt obligations, asset-backed commercial paper, and structured investment vehicles since 2007 (Chart II-9). While the situation must be monitored, the Group of Thirty study concludes that the financial system in the advanced economies appears to be less vulnerable to bouts of self-reinforcing forced selling, such as occurred during the 2008 crisis. Chart II-9Less Private-Sector Securitization Less Private-Sector Securitization Less Private-Sector Securitization One exception is the U.S. leveraged loan market, which has swelled to $1.13 trillion and about half has been pooled into Collateralized Loan Obligations. As with U.S. high-yield bonds, the situation is fine as long as profitability remains favorable. But in the next recession, lax lending standards today will contribute to painful losses in leveraged loans. The Bad News That’s the good news. The bad news is that, while the financial system might have become less complex and opaque, the level of debt has increased at an alarming rate in both the private and public sectors in many countries. Elevated levels of debt could cause instability in the global financial system, especially as global bond yields return to more normal levels by historical standards. We discuss other pressure points such as Emerging Markets and China in the next section, although the latter deserves a few comments before we leave the subject of shadow banking. The Group of Thirty notes that 30% of Chinese credit is provided by a broad array of poorly regulated shadow banking entities and activities, including trust funds, wealth management products, and “entrusted loans.” Links between these entities and banks are unclear, and sometimes involve informal commitments to provide credit or liquidity support. The study takes some comfort that most of Chinese debt takes place between Chinese domestic state-owned banks and state-owned companies or local government financing vehicles. Foreign investors have limited involvement, thus reducing potential direct contagion outside of China in the event of a financial event. Still, the potential for contagion internationally via global sentiment and/or the economic fallout is high. The other bad news is that, while regulators in the advanced economies have managed to improve the ability of financial institutions to weather shocks, potential risks to the financial system have increased in number and in probability of occurrence. The Global Risk Institute (GRI) recently published a detailed comparison of potential shocks today relative to 2007.7 The report sees twice the number of risks versus 2007 that are identified as “current” (i.e. could occur at any time) and of “high impact”. The most pressing risks today include extreme weather events, asset bubbles, sovereign debt crises, large-scale involuntary migration, water crises and cyber & data attacks. Any of these could trigger a broad financial crisis if the shock is sufficiently intense, despite improved regulation. The GRI study also eventuates how the risks will evolve over the next 11 years. Readers should see the study for details, but it is interesting that the experts foresee cyber dependency rising to the top of the risk pile by 2030. The increase is driven by the importance of data ownership, the increasing role of algorithms and control systems, and the $1.2 trillion projected cost of cyber, data and infrastructure attacks. Our computer systems are not prepared for the advances of technology, such as quantum computing. Climate change moves to the number two risk spot in its base-case outlook. Space limitations precluded a discussion of the rise of populism in this report, but the GRI sees the political tensions related to income inequality as the number three threat to the global financial system by 2030. Bottom Line: Regulators have managed to substantially reduce the amount of hidden risk and the potential for contagion between financial institutions and across countries since 2007. Banks have a larger buffer against stocks. Unfortunately, the number and probability of potential shocks to the financial system appear to have increased since 2007. (3) Implications Of The Global Debt Overhang The End of the Debt Supercycle is a key BCA theme influencing our macro view of the economic and market outlook for the coming years. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness of monetary policy. During times of economic and/or financial stress, it was relatively easy for the Federal Reserve and other central banks to improve the situation by engineering a new credit up-cycle. However, since the 2007-09 meltdown, even zero (or negative) policy rates have been unable to trigger a strong revival in private credit growth in the major developed economies, except in a few cases. The end of the Debt Supercycle has severely impaired the key transmission channel between changes in monetary policy and economic activity. The combination of high debt burdens and economic uncertainty has curbed borrowers’ appetite for credit while increased regulatory pressures and those same uncertainties have made lenders less willing to extend loans. This has severely eroded the effectiveness of lower interest in boosting credit demand and supply, forcing central banks to rely increasingly on manipulating asset prices and exchange rates. On a positive note, the plunge in interest rates has lowered debt servicing costs to historically low levels. Yet, it is the level, rather than the cost, of debt that seems to have been an impediment to the credit cycle, contributing to a lethargic economic expansion. The Bank for International Settlements (BIS) publishes an excellent dataset of credit trends across a broad swath of developing and emerging economies. Some broad conclusions come from an examination of the data (Charts II-10 and II-11):8 Chart II-10Advanced Economies: Some Deleveraging Advanced Economies: Some Deleveraging Advanced Economies: Some Deleveraging Chart II-11EM: Deleveraging Has Not Even Started EM: Deleveraging Has Not Even Started EM: Deleveraging Has Not Even Started Private debt growth has only recently accelerated for the advanced economies as a whole. There are only a handful of developed economies where private debt-to-GDP ratios have moved up meaningfully in the past few years. These are countries that avoided a real estate/banking bust and where property prices have continued to rise (e.g. Canada and Australia). The high level of real estate prices and household debt currently is a major source of concern to the authorities in those few countries. Even where some significant consumer deleveraging has occurred (e.g. the U.S., Spain and Ireland), debt-to-income ratios remain very high by historical standards. In many cases, a stabilization or decline in private debt burdens has been offset by a continued rise in public debt, keeping overall leverage close to peak levels. This is a key legacy of the financial crisis; many governments were forced to offset the loss of demand from private sector deleveraging by running larger and persistent budget deficits. Weak private demand accounts for close to 50% of the rise in public debt on average according to the IMF. Global debt of all types (public and private) has soared from 207% of GDP in 2007 to 246% today. The Debt Supercycle did not end everywhere at the same time. It peaked in Japan more than 20 years ago and has not yet reached a decisive bottom. The 2007-09 meltdown marked the turning point for the U.S. and Europe, but it has not even started in the emerging world. The financial crisis accelerated the accumulation of debt in the latter as investors shifted capital away from the struggling advanced economies to (seemingly less risky) emerging markets. Both EM private- and public-sector debt ratios have continued to move up at an alarming pace. The lesson from Japan is that deleveraging cycles following the bursting of a major credit bubble can last a very long time indeed. One key area where there has been significant deleveraging is the U.S. household sector (Chart II-12). The ratio of household debt to income has fallen below its long-term trend, suggesting that the deleveraging process is well advanced. However, one could argue that the ratio will undershoot the trend for an extended period in a mirror image of the previous overshoot. Or, it may be that the trend has changed; it could now be flat or even down. Chart II-12U.S. Household Deleveraging... U.S. Household Deleveraging... U.S. Household Deleveraging... What is clear is that U.S. attitudes toward saving and spending have changed dramatically since the Great Financial Crisis (GFC) (Chart II-13). Like the Great Depression of the 1930s that turned more than one generation off of debt, the 2008/09 crisis appears to have been a watershed event that marked a structural shift in U.S. consumer attitudes toward credit-financed spending. The Debt Supercycle is over for this sector. Chart II-13...As Attitudes To Debt Change ...As Attitudes To Debt Change ...As Attitudes To Debt Change Developing Countries: Debt And Economic Fundamentals BCA’s long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Trade wars and a tightening Fed are negative for EM assets, but the main headwinds facing this asset class are structural. Excessive debt is a ticking time bomb for many of these countries. EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart II-14). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart II-14, bottom panel). Chart II-14EM: High Debt And Slow Growth... EM: High Debt And Slow Growth... EM: High Debt And Slow Growth... The 2019 Key Views9 report from our Emerging Markets Strategy team highlights that excessive capital inflows over the past decade have contributed to over-investment and mal-investment. Much of the borrowing was used to fund unprofitable projects, as highlighted by the plunge in productivity growth, profit margins and return on assets in the EM space relative to pre-Lehman levels (Chart II-15) Decelerating global growth in 2018 has exposed these poor fundamentals. Chart II-15...Along With Deteriorating Profitability ...Along With Deteriorating Profitability ...Along With Deteriorating Profitability As we highlighted in the BCA Outlook 2019, emerging financial markets may enjoy a rally in the second half of 2019 on the back of Chinese policy stimulus. However, this will only represent a ‘sugar high’. The debt overhang in emerging market economies is unlikely to end benignly because a painful period of corporate restructuring, bank recapitalization and structural reforms are required in order to boost productivity and thereby improve these countries’ ability to service their debt mountains. China’s Debt Problem Space limitations preclude a full discussion of the complex debt situation in China and the risks it poses for the global financial system. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart II-16). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart II-17). Chinese banks are currently being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. Chart II-16China's Overinvestment... China's Overinvestment... China's Overinvestment... Chart II-17Has Undermined The Return On Assets Has Undermined The Return On Assets Has Undermined The Return On Assets The previous section highlighted that much of the debt has been created in the opaque shadow banking system, where vast amounts of hidden risk have likely accumulated. Whether or not the central government is willing and/or able to cover a wave of defaults and recapitalize the banking system in the event of a negative shock is hotly debated, both within and outside of BCA. But even if a financial crisis can be avoided, bringing an end to the unsustainable credit boom will undoubtedly have significant consequences for the Chinese economy and the emerging economies that trade with it. Interest Costs To Rise Globally, many are concerned about rising interest costs as interest rates normalize over the coming years. In Appendix Charts II-19 to II-21, we provide interest-cost simulations for selected government, corporate and household sectors under three interest-rate scenarios. The good news is that the starting point for interest rates is still low, and that it takes years for the stock of outstanding debt to adjust to higher market rates. Even if rates rise by another 100 basis points, interest burdens will increase but will generally remain low by historical standards. It would take a surge of 300 basis points across the yield curve to really ‘move the needle’ in terms of interest expense. This does not imply that the global debt situation is sustainable or that a financial crisis can be easily avoided. The next economic downturn will probably not be the direct result of rising interest costs. Nonetheless, elevated government, household and/or corporate leverage has several important long-term negative implications: Limits To Counter-Cyclical Fiscal Policy: Government indebtedness will limit the use of counter-cyclical fiscal policy during the next economic downturn. Chart II-18 highlights that structural budget deficits and government debt levels are higher today compared to previous years that preceded recessions. The risk is especially high for emerging economies and some advanced economies (such as Italy) where investors will be unwilling to lend at a reasonable rate due to default fears. Even in countries where the market still appears willing to lend to the government at a low interest rate, political constraints may limit the room to maneuver as voters and fiscally-conservative politicians revolt against a surge in budget deficits. This will almost certainly be the case in the U.S., where the 2018 tax cuts mean that the federal budget deficit is likely to be around 6% of GDP in the coming years even in the absence of recession. A recession would push it close to a whopping 10%. Even in countries where fiscal stimulus is possible, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend and take on more debt. Chart II-18 Growth Headwinds: The debt situation condemns the global economy to a slower pace of trend growth in part because of weaker capital spending. From one perspective this is a good thing, because spending financed by the excessive use of credit is unsustainable. Still, deleveraging has much further to go at the global level, which means that spending will have to be constrained relative to income growth. The IMF estimates that deleveraging in the private sector for the advanced economies is only a third of historical precedents at this point in the cycle. The IMF also found that debt overhangs have historically been associated with lower GDP growth even in the absence of a financial crisis. Sooner or later, overleveraged sectors have to retrench. Vulnerability To Negative Shocks: If adjustment is postponed, debt reaches levels that make the economy highly vulnerable to negative shocks as defaults rise and lenders demand a higher return or withdraw funding altogether. IMF work shows that economic downturns are more costly in terms of lost GDP when it is driven or accompanied by a financial crisis. This is particularly the case for emerging markets. Bottom Line: Although credit growth has been subdued in most major advanced economies, there has been little deleveraging overall and debt-to-GDP is still rising at the global level. Elevated debt levels are far from benign, even if it appears to be easily financed at the moment. It acts as dead weight on economic activity and makes the world economy vulnerable to negative shocks. It steals growth from the future and, in the event of such a shock, the lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide fiscal relief. The end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. Mark McClellan Senior Vice President The Bank Credit Analyst APPENDIX Chart II-19Corporate Interest Cost Scenarios Corporate Interest Interest Cost Scenarios Corporate Interest Interest Cost Scenarios   Chart II-20Government Interest Cost Scenarios Government Interest Cost Scenarios Government Interest Cost Scenarios   Chart II-21U.S. Household Sector Interest Cost Scenarios U.S. Household Sector Interest Cost Scenarios U.S. Household Sector Interest Cost Scenarios   III. Indicators And Reference Charts Our tactical upgrade of equities to overweight this month goes against most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicators for the U.S., Japan and Europe are all heading lower. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors are clearly moving funds away from the equity market at the moment. Our Revealed Preference Indicator (RPI) for stocks continues to issue a ‘sell’ signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, supporting the view that caution is still warranted. The U.S. net earnings revisions ratio has dropped into negative territory. The earnings surprises index has also declined, although it remains above 60%. Finally, our Composite Technical Equity Indicator has broken below the zero line and its 9-month exponential moving average, sending a negative technical signal. On the positive side, our Monetary Indicator has hooked up, although it is still in negative territory for equities. From a contrary perspective, the fact that equity sentiment has turned bearish is positive for stocks. In fact, this is the main reason why we upgraded stocks this month. While it is late in the U.S. economic expansion and the Fed is tightening, sentiment regarding U.S. and global growth has become overly pessimistic. Thus, we are playing a late-cycle bounce in stocks. For bonds, the term premium moved further into negative territory in December, which is unsustainable from a long-term perspective. Long-term inflation expectations are also too low to be consistent with the Fed meeting its 2% target over the medium term. These facts suggest that bond yields have not peaked for the cycle, although at the moment they have not yet worked off oversold conditions according to our technical indicator. The U.S. dollar is overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator   Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals   Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators   Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst   1      For more details, please see BCA Geopolitical Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at gps.bcaresearch.com 2      Please see BCA U.S. Investment Strategy Special Report "The Bane Of Investors’ Existence: Why Is Correlation High And When Will It Fall?" dated January 4, 2012, available at usis.bcaresearch.com. Also see BCA Global ETF Strategy Special Report "The Passive Menace," dated September 13, 2017, available at etf.bcaresearch.com 3       We use only below average returns in the calculation of volatility (downside volatility) because we are more concerned with the risk of equity market declines for the purposes of this model. 4       The LCR requires a large bank to hold enough high-quality liquid assets to cover the net cash outflows the bank would expect to occur over a 30-day stress scenario. The NSFR complements the LCR by requiring an amount of stable funding that is tailored to the liquidity risk of a bank’s assets and liabilities, based on a one-year time horizon. 5       Structural Changes in Banking After the Crisis. CGFS Papers No.60. Bank for International Settlements, January 2018. 6       Shadow Banking and Capital Markets Risks and Opportunities. Group of Thirty. Washington, D.C., November 2016. 7       Back to the Future: 2007 to 2030. Are New Financial Risks Foreshadowing a Systemic Risk Event? Global Risk Institute. 8       For more details on public and private debt trends, please see BCA Special Report "The End Of The Debt Supercycle: An Update," dated May 11, 2016, available at bca.bcaresearch.com 9       Please see BCA Emerging Markets Strategy Weekly Report "2019 Key Views: Will The EM Lost Decade End With A Bang Or A Whimper?" dated December 6, 2018, available at ems.bcaresearch.com EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Dear Client, We are sending you our last issue of the year, which contains a lighter fare than usual, highlighting 10 charts we find important. The first three charts tackle questions of Chinese growth, global activity and the outlook for the Federal Reserve. The other seven relate directly to the currency market. We will resume our regular publishing schedule on January 4th, 2019. The Foreign Exchange Strategy team would like to thank you for your continued readership and wish you and yours a joyful holiday season as well as a healthy, happy and prosperous 2019.   Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) Chinese Growth Outlook Since the 19th National Congress of the Communist Party of China, Beijing has been focused on controlling debt growth. The Chinese leadership is worried that too much debt will lead to the dreaded middle-income trap, whereby a country’s development stalls once it achieves middle-income status. Because of Beijing’s laser focus on debt, Chinese growth, especially in the industrial sector, has slowed. Yet in the second half of 2018, Chinese policymakers have grown concerned by the deepening malaise in the domestic economy. Consequently, they have loosened policy, accelerating the issuance of local government bonds, letting the repo rate fall to 2.7% and cutting the reserve requirement ratio to 14.5%. Despite these measures, credit growth has continued to slow, hitting 16-year lows, and crucially, the shadow banking system is still contracting (Chart 1, left panel). While the supply of credit remains tepid, declining demand for credit is more concerning. China’s marginal propensity to save, as approximated by the gap between the growth of M2 and M1 money supply, is still rising. Historically, a rising marginal propensity to save leads to slowing industrial activity and slowing import growth (Chart 1, right panel). This implies that China will continue to weigh on global trade and global industrial activity. Thus, to turn growth around, Chinese policymakers will need to ease policy further. Chart 1AChinese Growth Will Slow Further (I) Chinese Growth Will Slow Further (I) Chinese Growth Will Slow Further (I) Chart 1BChinese Growth Will Slow Further (II) Chinese Growth Will Slow Further (II) Chinese Growth Will Slow Further (II) 2) Global Growth And Inflation Outlook Already, the outlook for Chinese growth points to additional downside to global growth – something EM carry trades financed in yen are already sniffing out (Chart 2, left panel). The deterioration in the performance of those carry trades further amplifies the negative impulse emanating from China. If high-yielding EM currencies depreciate versus funding currencies like the yen, money is leaving those economies. Hence, EM liquidity conditions are tightening and financial conditions are deteriorating, reinforcing the leading property of EM carry trades vis-à-vis global industrial activity. Chart 2ASlowing Global Growth And Inflation (I) Slowing Global Growth And Inflation (I) Slowing Global Growth And Inflation (I) Chart 2BSlowing Global Growth And Inflation (II) Slowing Global Growth And Inflation (II) Slowing Global Growth And Inflation (II) Moreover, as telegraphed by the relative performance of EM bonds to EM equities, global inflation is set to peak soon, and then decelerate (Chart 2, right panel). This is a natural consequence of the deflationary impact of slowing Chinese growth and tightening EM liquidity conditions – the two most crucial factors lying behind the softness in global growth. Thus, financial markets are likely to remain volatile, at least until global policymakers have changed their tune enough to reverse global growth and inflation dynamics. 3) The Fed Is On Track To Hike More Than The Market Believes In its latest set of forecasts, the Federal Reserve may have been forced to adjust how much it will hike interest rates over the coming years. Nonetheless, by the end of 2020, the FOMC still anticipates having to increase interest rates by more than the -8 basis points currently priced into the futures curve. We are inclined to side with the Fed. U.S. growth may be slowing, but it will remain above trend in 2019. Additionally, the U.S. economy is most likely already at full employment, thus inflationary pressures are building. For the Fed, the labor market remains the fulcrum of potential inflation. As the left panel of Chart 3 shows, both the Atlanta Fed Wage Tracker and BLS average hourly earnings are growing at an accelerating pace, giving the Fed ammo to hike rates further. Moreover, the highly interest-sensitive housing sector has been a great source of concern for U.S. growth. However, now that this year’s surge in mortgage rates is being digested, mortgage applications are once again rebounding (Chart 3, right panel). This suggests that real estate activity will stabilize. Hence, even if the Fed pauses, it will still surprise markets to the upside over the coming 24 months. Chart 3AGood Reasons To Keep Hiking In 2019 Good Reasons To Keep Hiking In 2019 Good Reasons To Keep Hiking In 2019 Chart 3BGood Reasons To Keep Hiking In 2019 Good Reasons To Keep Hiking In 2019 Good Reasons To Keep Hiking In 2019 4) The Dollar Can Rally Even If U.S. Growth Falls Off A Cliff In our assessment, U.S. growth will slow next year, but will nonetheless remain above trend. However, if we are wrong and U.S. growth weakens much more, the dollar is unlikely to crater. As Chart 4 illustrates, periods of broad growth weakness – as measured by our U.S. economic diffusion index – often generate a strong – not weak – dollar. U.S. growth weakness often happens as global growth deteriorates. Since the U.S. economy exhibits a low beta to global industrial activity – the segment of the economy that contributes most to the variance in GDP growth – it follows that if a shock is global, the U.S. is likely to perform better than the rest of the world, leading to a strong dollar. Today, the downside risk is that the U.S. catches the cold that has hit the global economy. Hence, if U.S. growth has significantly more downside, it would suggest that economies outside the U.S. would suffer even more. The dollar should perform well in this environment. Chart 4The Dollar Doesn't Really Care If U.S. Growth Slows The Dollar Doesn't Really Care If U.S. Growth Slows The Dollar Doesn't Really Care If U.S. Growth Slows 5) The Dollar Versus Global Growth And Global Inflation The most important question to forecast the path of the dollar is where we stand in the global growth and inflation cycle. As Chart 5 shows, the dollar tends to perform most poorly early in the business cycle, when global growth is picking up but inflation remains muted (bottom-right quadrant), and late in the cycle when global growth has begun to weaken but inflation remains perky (top-left quadrant). The best time to hold the greenback is during global downturns, when both global growth and inflation are decelerating (bottom-left quadrant). With global industrial activity on a downtrend and inflation set to roll over soon, we are entering the bottom-left quadrant. As a result, the greenback should continue to rally on a trade-weighted basis, gaining most against the commodity currency complex. The yen may be the one currency bucking this trend, as in recent years it has become even more counter-cyclical than the dollar. Chart 5 6) The Dollar Is A Momentum Currency One of the defining characteristics of the greenback is that from an investment-style perspective, it is a momentum currency. As the left panel of Chart 6 illustrates, among G-10 currencies, momentum continuation strategies work best for the USD. This is because of feedback loops present in the global economy. Chart 6 Chart 6BMomentum Still Flashing A Greenlight For The Greenback (II) Momentum Still Flashing A Greenlight For The Greenback (II) Momentum Still Flashing A Greenlight For The Greenback (II) Of the major economies, the U.S. is the least sensitive to global trade and global investment – a consequence of the low share of exports and manufacturing in GDP and employment. As a result, when global growth deteriorates, the U.S. economy experiences less of a slowdown and American rates of return decline less. Thus, money comes back into the U.S., lifting the dollar in the process. However, since there is USD 14-trillion in dollar-denominated foreign-currency debt, a rising dollar increases the cost of capital for these borrowers. The ensuing tightening in financial conditions hurts global growth, further enhancing the greenback’s appeal. The relationship goes in reverse once global growth improves. These powerful feedback loops explain why when the dollar strengthens, it remains stronger for longer than anyone anticipated, and vice versa when it weakens. Today, the momentum signal for the dollar remains positive (Chart 6, right panel). Along with slowing global growth, momentum was one of the key factors behind the dollar’s strength this year. If, as we expect, global inflation also weakens in the first half of 2019, the dollar will likely experience a beautiful first six months of the year. 7) Keep An Eye On Sino-U.S. Rate Differentials When one-year interest rate differentials between the U.S. and China widen, the DXY tends to strengthen (Chart 7, left panel). This is a reflection of global growth dynamics. U.S rates tend to rise relative to China when Chinese growth is decelerating. Since a slowing Chinese economy implies less intake of machinery and raw materials, a weaker China hurts Europe, Japan, EM and commodity producers a lot more than it affects the U.S. This lifts the dollar in the process. Moreover, so long as Chinese one-year interest rates keep falling versus the U.S., it also signals that any reflationary efforts by China have not yet had any impact on growth. Chart 7AU.S.-China Rate Differentials Point To A Stronger Dollar (I) U.S.-China Rate Differentials Point To A Stronger Dollar (I) U.S.-China Rate Differentials Point To A Stronger Dollar (I) Chart 7BU.S.-China Rate Differentials Point To A Stronger Dollar (II) U.S.-China Rate Differentials Point To A Stronger Dollar (II) U.S.-China Rate Differentials Point To A Stronger Dollar (II) This same rate differential between the U.S. and China also drives fluctuations in USD/CNY (Chart 7, right panel). Since falling relative Chinese rates are a symptom of a weaker Chinese economy, this relationship makes sense. Moreover, in recent years, more than against the dollar, Chinese policymakers have targeted the value of the CNY on a trade-weighted basis. Mechanically, if slowing Chinese growth flatters the trade-weighted dollar, it also forces USD/CNY up. This can further reinforce the strength in the broad trade-weighted dollar as a falling CNY is deflationary for the global economy. Because Chinese growth remains weak, we expect U.S. rates to continue to move higher vis-à-vis Chinese ones, lifting both the DXY and USD/CNY in the process. 8) EUR/USD: More Downside And A Complex Bottoming Process Ahead EUR/USD will suffer if global growth weakens and the dollar strengthens. On one hand, the European economy is much more sensitive to the Chinese and global industrial cycle than U.S. activity is. Our outlook for global growth therefore implies that the European Central Bank will find it difficult to raise rates in the fall of 2019, while the Fed is likely to surprise markets on the hawkish side. On the other hand, the simplest vehicle to bet on a strengthening dollar is to sell EUR/USD. Our fair-value model for EUR/USD currently pegs its equilibrium at 1.11 (Chart 8, left panel). However, EUR/USD never ends its downdrafts at its fair value – a consequence of its negative correlation with the dollar, a momentum currency that easily over- and under-shoots fair value. Thus, we expect the euro to find stability closer to 1.08. Chart 8AEUR/USD Will Bottom Later Next Year (I) EUR/USD Will Bottom Later Next Year (I) EUR/USD Will Bottom Later Next Year (I) Chart 8BEUR/USD Will Bottom Later Next Year (II) EUR/USD Will Bottom Later Next Year (II) EUR/USD Will Bottom Later Next Year (II) Moreover, inflationary dynamics do not suggest that EUR/USD is yet ripe for the taking. Since 2008, the gap between euro area and U.S. core CPI has been a reliable leading indicator for EUR/USD (Chart 8, right panel). In fact, this chart suggests that EUR/USD is more likely to bottom towards the second half of 2019; so as long as European inflation remains tepid, it will be hard for this currency to suddenly rebound and recoup the losses it has experienced this year. A complex bottom is more likely than a V-shaped one. 9) EUR/JPY: All About Bond Yields Even more so than USD/JPY, EUR/JPY remains beholden to trends in global bond yields (Chart 9). BCA’s view is that on a cyclical horizon of nine to 12 months, bond yields have upside. However, with global growth and inflation likely to decelerate further in the first half of 2019, safe haven assets could remain well bid over that timeframe. This implies the time to buy EUR/JPY is not now, and that a better buying opportunity will emerge once global growth stabilizes. Thus, we remain short EUR/JPY for the time being, a view we have held since the beginning of 2018. Chart 9Risks To Global Growth Equals EUR/JPY Downside Risks To Global Growth Equals EUR/JPY Downside Risks To Global Growth Equals EUR/JPY Downside 10) EUR/GBP Is At Risk At the current juncture, EUR/GBP is a binary bet: Either a hard Brexit comes to fruition, in which case U.K. real rates plummet and British inflation rises above 5%, creating a deeply pound-bearish environment. Alternatively, a soft Brexit (or even no Brexit) materializes, in which cases British real rates have upside, the Bank of England has a freer hand to combat inflationary pressures, and the pound can rally. With EUR/GBP currently trading toward the top of its historical distribution, we believe it is an attractive shorting opportunity (Chart 10). Marko Papic, BCA’s chief geopolitical strategist, assigns a less than 10% probability of a hard Brexit. As such, the pound is more likely to exist in a soft/no-Brexit world in 12 months than otherwise. This means the pound should be-revalued. Chart 10Sell EUR/GBP Sell EUR/GBP Sell EUR/GBP We prefer playing the pound’s strength against the euro rather than the dollar, as we expect the dollar to rally further in the first half of 2019, so cable would be swimming against the tide. Moreover, when the dollar strengthens, historically EUR/GBP weakens, as the GBP has a lower beta to the dollar than the euro does. Hence, our dollar view is also consistent with a lower EUR/GBP. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Asset allocation: Start 2019 with an overweight to industrial commodities versus equities. Await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Equities: Start 2019 with a cyclical equity sector tilt, but become more defensive as the global economy inevitably flips into a down-oscillation later in 2019. Start tactically overweight Italy’s MIB versus the Eurostoxx. Bonds: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. Currencies: Start 2019 short EUR/JPY combined with long EUR/USD. There will be a great opportunity to buy the GBP, but not yet. Alternatives: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. Feature 2019 will present investors a mirror-image pattern to 2018. Through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse. Growth To Rebound, Then Fade Global growth has entered an up-oscillation, for which the evidence is irrefutable: Industrial (non-oil) commodities are strongly outperforming equities, and rising even in absolute terms (Chart of the Week and Chart 2). Emerging markets are strongly outperforming developed markets (Chart 3). Financials are outperforming the broad equity market (Chart 4). Sweden’s manufacturing PMI – a bellwether of global activity – is rebounding strongly (Chart 5). Perhaps most importantly, China’s 6-month credit impulse has gone vertical (Chart 6). Chart of the WeekNon-Oil Commodities Are Strongly Outperforming Equities Non-Oil Commodities Are Strongly Outperforming Equities Non-Oil Commodities Are Strongly Outperforming Equities   Chart I-2Non-Oil Commodities Are Recovering In Absolute Terms Too Non-Oil Commodities Are Recovering In Absolute Terms Too Non-Oil Commodities Are Recovering In Absolute Terms Too   Chart I-3Emerging Markets Are Strongly Outperforming Developed Markets Emerging Markets Are Strongly Outperforming Developed Markets Emerging Markets Are Strongly Outperforming Developed Markets Chart I-4Financials Are Outperforming Financials Are Outperforming Financials Are Outperforming Chart I-5Sweden’s Manufacturing PMI Is Up Sharply Sweden's Manufacturing PMI Is Up Sharply Sweden's Manufacturing PMI Is Up Sharply Chart I-6China’s 6-Month Credit Impulse Has Gone Vertical China's 6-Month Credit Impulse Has Gone Vertical China's 6-Month Credit Impulse Has Gone Vertical Taken together, this is compelling evidence of a growth rebound, even if it is modest. Crucially, such up-oscillations tend to last at least six to eight months. Hence, equity sector performances, which always take their cue from global growth, will follow a mirror-image pattern in 2019 to that in 2018. Bottom Line: Start the year with an overweight to industrial commodities versus equities and a cyclical equity sector tilt, but prepare to fade to a more defensive tilt as the global economy inevitably flips into a down-oscillation later in 2019. Inflation Is The Dog That Will Not Bark There are not many things that are certain in the economy, but a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price – 40 percent so far and getting worse by the day – is about to feed through into headline consumer price indexes (Chart 7 and Chart 8). Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs. Chart I-7Headline Inflation Will Collapse In Europe Headline Inflation Will Collapse In Europe Headline Inflation Will Collapse In Europe Chart I-8Headline Inflation Will Collapse In The U.S. Headline Inflation Will Collapse In The U.S. Headline Inflation Will Collapse In The U.S. Coming at a time that central banks have professed a much greater reliance on “incoming data”, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Fed. This makes the dollar vulnerable, leaving us a choice between the euro and yen as our preferred major currency. And on this head-to-head the yen still beats the euro given its lower political risk: Bottom Line: Start 2019 short EUR/JPY combined with long EUR/USD. Use ‘The Rule Of 4’ And Fractals To Predict Tipping-Points For Equities Investment strategists are obsessed with timing the next recession. The thinking is that by predicting the next recession they can predict the next equity bear market. The logic sounds fine, except that the causality rarely runs from economic downturns to financial market instabilities. The causality almost always runs the other way. Paul Volcker, arguably the greatest central banker of the modern era, correctly points out that the danger to the economy almost always comes from systemic financial disturbances. The last three downturns, in 2000, 2007 and 2011, all resulted from financial disturbances: the bursting of the dot com bubble, the gross mispricing of U.S. sub-prime mortgages, and the distortion of euro area sovereign debt markets respectively. Instead of timing the next recession to predict financial market instability, the correct approach is to flip the logic around and ask: is there a glaring source of financial instability that could cause the next recession? To which the answer is yes. The current glaring instability is the hyper-vulnerability of elevated risk-asset valuations to the global bond yield. Near the lower bound of bond yields, bond prices develop the same unattractive negative asymmetry as equities, removing the need for an equity risk premium, and justifying sharply higher equity valuations. But when the 10-year global bond yield rises back to around 2 percent – or equivalently when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent ‘the rule of 4’ – the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower equity valuations (Chart 9 and Chart 10). Chart I-9Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Equities Plunged In February After A Spike In Bond Yields Chart I-10Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields Equities Plunged In October After A Spike In Bond Yields In 2019, just as in 2018, investors should use this dynamic to allocate tactically to equities versus cash as follows: 1. When the rule of 4 approaches 4 and the market’s 65-day fractal dimension signals an overbought rally, go underweight equities. 2. When the rule of 4 approaches 3 and the market’s 65-day fractal dimension signals an oversold sell-off, go overweight equities. 3. At all other times stay neutral. Bottom Line: With the rule of 4 now approaching 3, await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Britain Escalates EU Tensions, Italy De-Escalates The two points of political tension in Europe, the U.K. and Italy, have a common theme: brinkmanship with the EU. The Brexit tension remains high and may even intensify in early 2019 before a resolution. Hence, while 2019 will offer a great opportunity to buy the pound, it might require a little patience. In contrast, Italy is de-escalating its brinkmanship with Brussels over its budget deficit. Meanwhile the crux of Italy’s long-standing woes – its banking system – is also showing signs of healing. The proportion of bank loans that are non-performing is plummeting, while the solvency of the banking system continues to improve (Chart 11 and Chart 12). Chart I-11Italian Banks’ NPLs Are Plummeting… Italian Banks' NPLs Are Plummeting... Italian Banks' NPLs Are Plummeting... Chart I-12…And Italian Banks’ Solvency Is Improving ...And Italian Banks' Solvency Is Improving ...And Italian Banks' Solvency Is Improving Bottom Line: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. And tactically overweight Italy’s MIB versus the Eurostoxx. Cryptocurrencies Will Rebound 60 Percent Cryptocurrencies are here to stay, because the underlying technology, the blockchain, is here to stay. Just as the internet’s major innovation was to decentralise and democratise information, the blockchain’s major innovation is to decentralise and democratise trust. Until now, counterparties without an established trust relationship could only transact through an intermediary who could provide the necessary trust overlay. But once each participant in a transaction trusts the blockchain itself, they no longer need to use a conventional intermediary, like a bank or a law firm. One major argument against the blockchain is that it is energy intensive and therefore prohibitively costly. But conventional intermediation also exacts a significant cost. Let’s say that the stock of excess savings that the banks intermediate to borrowers conservatively equals global GDP. If the risk-adjusted interest rate spread that banks charge for their intermediation role conservatively equals 1 percent, it means that this conventional intermediation is costing 1 percent of global GDP. Against this, global energy consumption equals roughly 5 percent of global GDP. So even if the blockchain consumed a fifth of the world’s energy, its cost might still be comparable to conventional intermediation. The plunge in cryptocurrencies during 2018 was exacerbated by the recent ‘hard fork’ in bitcoin protocol. But such hard forks are a necessary part of the evolutionary process – being analogous to a Darwinian mutation which eliminates the weakest protocols while allowing the strongest and fittest to thrive. In the latest fork, the battle was between those who want cryptocurrencies to remain a speculative asset with low long-term survival prospects, and those who want them to become a stable means of payment with high long-term survival prospects. A year ago almost to the day, we recommended selling bitcoin at a price of $18,000. Our rationale was that excessive herding required a price gap down to normalise liquidity. The subsequent decline in the price to $3500 today has rewarded that recommendation handsomely. But today, Litecoin and Ethereum are approaching an opposite tipping-point where the price may have to gap up to normalise liquidity (Chart 13 and Chart 14). Chart I-13Litecoin Is Oversold On A 65-Day Horizon Litecoin Is Oversold On A 65-Day Horizon Litecoin Is Oversold On A 65-Day Horizon   Chart I-14Litecoin Is Oversold On A 130-Day Horizon Litecoin Is Oversold On A 130-Day Horizon Litecoin Is Oversold On A 130-Day Horizon Bottom Line: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. For a 50:50 basket, target a return of 60 percent. And on that positive note, I am signing off for the year. I do hope that you have enjoyed reading this year’s reports, but more importantly that you have found value in them. This publication’s philosophy is to think out of the box, independently and unconstrained, never to shirk from challenging the received wisdom, and ultimately to provide successful investment ideas. We promise to continue this way in 2019! It just remains for me to wish you a very happy holiday season and a prosperous new year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com   Fractal Trading Model* As discussed in the main body of this report, this week’s recommended trade is to buy a 50:50 combination of Litecoin and Ethereum. Set a profit target of 60 percent with a symmetrical stop-loss. As also discussed in the main body of this report, remain tactically overweight Italy’s MIB versus the Eurostoxx. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Long MIB Vs. Euro Stoxx Long MIB Vs. Euro Stoxx * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4 Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8 Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Dear Client, This will be the last Global Investment Strategy report of 2018. Publication will resume on January 4th. On behalf of the entire Global Investment Strategy team, I would like to wish you a Merry Christmas, Happy Holidays, and a Healthy New Year! Best regards, Peter Berezin, Chief Global Strategist Feature 1.  Will the Fed raise rates more or less than what is priced into the futures curve? Answer: More. The fed funds futures curve is pricing in less than one rate hike in 2019 and rate cuts beyond then. In contrast, we think the Fed will raise rates three or four times next year and continue hiking into 2020. For all the worries about a slowdown, U.S. real GDP growth is still tracking at 3% in Q4 according to the Atlanta Fed, while consumption is set to rise by 4.1%. Ongoing fiscal stimulus, decent credit growth, rising wages, and a decline in the savings rate should continue to support the economy in 2019. Housing construction should also stabilize thanks to a low vacancy rate and a pickup in household formation. The fact that mortgage applications for purchase have rebounded swiftly in recent weeks is evidence that the housing market is not as weak as many people believe (Chart 1). Chart 1U.S. Housing: No Oversupply Problem, While Demand Is Firming U.S. Housing: No Oversupply Problem, While Demand Is Firming U.S. Housing: No Oversupply Problem, While Demand Is Firming 2.  Will U.S. 10-year Treasury yields rise more or less than expected? Answer: More. Treasurys almost always underperform cash when the Fed delivers more rate hikes than the market is discounting (Chart 2). We expect a modest bear flattening of the yield curve in 2019, with rising bond yields nearly offsetting the increase in short-term rates. Most of the flattening is likely to come in the next six months, as slower global growth and the disinflationary effects of lower oil prices keep bond yields contained. As we enter the second half of next year, global growth should reaccelerate as the effects of Chinese stimulus measures fully kick in and the drag on global growth from the recent tightening in financial conditions dissipates. By that time, the U.S. unemployment rate will be in the low 3% range, a level that could trigger material inflationary pressures. Chart 2Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected 3. Will the yield spreads between U.S. Treasurys and other developed economy bond markets widen? Answer: Yes, particularly at the short end of the curve. The Fed is still the one central bank that is most likely to hike rates multiple times in 2019, which will support wider differentials between Treasurys and non-U.S. bond yields. The greatest potential for spread widening will be for Treasurys versus JGBs. With Japanese inflation still stubbornly low and fiscal policy set to tighten from a hike in the sales tax, the BoJ will be in no position to abandon its yield curve control regime. The 10-year Treasury-gilt spread could also widen if the Bank of England is forced to stay on the sidelines until Brexit uncertainty is resolved. Likewise, the U.S.-New Zealand spread will widen as the RBNZ stays on hold due to underwhelming growth and inflation momentum. The U.S.-Canada spread will be range-bound, with the Bank of Canada coming close to matching, but not surpassing, Fed tightening in 2019. While the ECB will refrain from raising rates next year, the U.S. Treasury-German bund spread should narrow marginally if the end of ECB QE lifts bund yields via a recovery in the German term premium. There is more (albeit still modest) scope for a narrowing in the 10-year U.S.-Australia and U.S.-Sweden spreads, as both the RBA and Riksbank begin a tightening cycle. 4. What will happen to U.S. corporate credit spreads? Answer: They are likely to finish 2019 close to current levels. As a rule of thumb, corporate bond returns are highest when the yield curve is very steep, and lowest when it is inverted (Table 1). The former generally corresponds to the early stages of business-cycle expansions, while the latter encompasses the period directly preceding recessions. We are still in the intermediate phase, when excess corporate bond returns (relative to cash) are positive but low. This conclusion is consistent with the observation that corporate balance-sheet leverage has increased over the past four years, but not by enough to instigate a major wave of defaults. Table 1Corporate Bond Performance Given The Slope Of The Yield Curve (1975-Present) 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions 5. Will the U.S. dollar continue to strengthen? Answer: The dollar will strengthen until the middle of 2019 and then begin to weaken. Three main factors determine the short-to-medium term direction of the dollar: 1) momentum; 2) interest rate spreads between the U.S. and its trading partners; and 3) global growth. In general, the dollar does well when it is trending higher, spreads relative to the rest of the world are wide and getting wider, and global growth is slowing (Chart 3). For the time being, momentum continues to work in the greenback’s favor. Spreads have narrowed a bit recently, but the dollar still looks cheap relative to what one would expect based on the current level of spreads (Chart 4). As in 2017, the direction of global growth will likely be the key driver of the dollar next year. If growth bottoms in mid-2019, as we expect, the dollar will probably put in a top. Chart 3Dollar Returns Driven By Momentum, Rate Differentials, And Global Growth 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 4Wider Spreads Bode Well For The Dollar Wider Spreads Bode Well For The Dollar Wider Spreads Bode Well For The Dollar   6. Will global equities rise or fall? Answer: Rise. Our tactical MacroQuant stock market timing model finally moved back into neutral territory on Monday after having successfully flagged the correction that began in October (Chart 5). Having downgraded global equities this past summer, we will return to overweight if the ACWI ETF drops to $64, which is only 2.4% below yesterday’s close. The cyclical backdrop for stocks is reasonably constructive. We expect the MSCI All-Country World Index to rise by about 10%-to-15% in dollar terms from current levels by the end of 2019. The higher end of this range would leave it slightly below its January 2018 peak (Chart 6). The index is currently trading at 13.3-times forward earnings, similar to where it was in early-2016. The U.S. accounts for over 50% of global stock market capitalization (Chart 7). As such, the U.S. equity market tends to influence non-U.S. stocks more than the other way around. Sustained U.S. equity bear markets are rare outside of recessions (Chart 8). With another U.S. recession unlikely to occur at least until late-2020, that gives global stocks enough room to rally. Indeed, history suggests that the late stages of business-cycle expansions are often the juiciest for equity investors (Table 2).  Chart 5The MacroQuant Equity Score* Improves To Neutral 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 6Global Stocks Have Cheapened Global Stocks Have Cheapened Global Stocks Have Cheapened Chart 7The U.S. Is The Dominant Equity Market 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 8Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap Recessions And Bear Markets Usually Overlap     Table 2Too Soon To Get Out 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions 7. Will cyclical stocks outperform defensives? Answer: Yes, although this is likely to be more of a phenomenon for the second half of 2019. Cyclicals typically outperform defensives when bond yields are climbing (Chart 9). Rising bond yields are usually a sign of stronger growth — manna from heaven for capital goods and commodity producers. As long as global growth is under pressure, cyclicals will struggle. But once growth bottoms in the middle of next year, cyclical stocks will have their day in the sun. Chart 9Cyclicals Tend To Outperform When Yields Rise Cyclicals Tend To Outperform When Yields Rise Cyclicals Tend To Outperform When Yields Rise 8. Will U.S. equities continue to outperform other global stock markets? Answer: Yes, but probably only until mid-2019. The U.S. stock market has less exposure to cyclical sectors such as industrials, materials, energy, and financials than the rest of the world (Table 3). Therefore, it stands to reason that an inflection point for cyclicals versus defensives will correspond to an inflection point for U.S. versus non-U.S. stocks. If this were to happen, it would resemble the period between October 1998 and April 2000, a time when bond yields rose, the dollar rally stalled, cyclicals outperformed defensives, and non-U.S. equities outperformed (Chart 10). Table 3Tech And Health Care Stocks Are Heavily Weighted In The U.S., While Financials And Materials Are Overrepresented In Markets Outside The U.S. 2019 Key Views: Ten Market Questions 2019 Key Views: Ten Market Questions   Chart 10Will The Late-1990s Pattern Be Repeated? Will The Late-1990s Pattern Be Repeated? Will The Late-1990s Pattern Be Repeated?   9. Will oil prices rise more than expected? Answer: Yes. The December-2019 Brent futures contract is currently trading at $61/bbl (Chart 11). Our energy strategists expect Saudi Arabia and Russia to cut production by enough to push prices to an average of $82/bbl in 2019. Looking further out, the outlook for oil prices is less favorable. As every first-year economics student learns, prices in a competitive market eventually converge to average costs. Shale companies are now the swing producers in the global petroleum market. Their breakeven costs are in the low-$50 range, a number that has been trending lower due to productivity gains. If that is the long-term anchor for oil prices, it means that any major rally in oil is unlikely to extend deep into the next decade. Chart 11Oil Prices Will Recover Oil Prices Will Recover Oil Prices Will Recover 10. Will gold prices finally rally? Answer: Yes, but only in the second half of 2019. Gold prices typically fall when the dollar is strengthening (Chart 12). Given our view that the dollar will rally into mid-2019, now is not the time to be loading up on bullion. However, once the dollar peaks and U.S. inflation moves decidedly higher late next year, gold should become a star performer. Chart 12Gold Will Shine Bright After The Dollar Peaks Gold Will Shine Bright After The Dollar Peaks Gold Will Shine Bright After The Dollar Peaks     Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com     Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades

Highlights On the bright side, Malaysia’s structural backdrop is improving notably, especially in the semiconductors segment. Yet the cyclical growth outlook remains downbeat. While we are maintaining a market-weight allocation to Malaysian equities within an EM equity portfolio, we are putting this bourse on our upgrade watch list. As a play on the ameliorating structural outlook, we recommend an overweight position in Malaysian small-cap stocks relative to the EM universe – both the small-cap and overall equity benchmarks. Feature Malaysian stocks have performed quite poorly in recent years: the equity index, in U.S. dollars, is close to its 2016 lows in absolute terms, and relative to the emerging markets (EM) benchmark, it is not far from the lows of last decade (Chart I-1). Chart I-1Malaysian Stocks & Commodities Prices: Tight Relationship Malaysian Stocks & Commodities Prices: Tight Relationship Malaysian Stocks & Commodities Prices: Tight Relationship Odds are that a structural bottom in this bourse’s relative performance versus the EM index may have been reached. Hence, we are putting Malaysian equities on our upgrade watch list while maintaining a market-weight allocation due to tactical considerations. On the negative side, the past credit excesses have not been recognized and provisioned for by Malaysian commercial banks. The latter account for a notable 34% of the MSCI Malaysia index, and they will be a drag on this bourse's performance. Absolute performance also still hinges on global growth, commodities prices and the overall direction of Asian/EM markets. We are still negative on these parameters. Critically, there are various signs indicating an ameliorating structural backdrop in Malaysia. The country is undergoing notable improvements in the semiconductor sector, thereby reducing its dependence on commodities and increasing its exposure to a high-value industry. To capitalize on this theme of an improving structural backdrop, we are recommending an overweight position in Malaysian small-cap stocks relative to the EM universe – both the small-cap and overall equity benchmarks. Shifting Away From Commodities And Toward Electronics Parting Ways With Commodities Malaysia and its financial markets have been very exposed to commodities prices over the past 15 years or so (Chart I-1, top panel). Nevertheless, the country seems to be shifting away from its considerable reliance on the resource sector and moving into other value-added segments: in particular, semiconductors and technology. Such a structural shift – if successful – would be an extremely positive development as it would lead to rising productivity gains and higher per capita income growth. In short, the country would be able to achieve higher rates of sustainable non-inflationary growth, feeding into a sustainable bull market in Malaysian equities. Several points are noteworthy in this regard: The real output of crude and petroleum products as well as palm oil are declining sharply relative to the economy’s real total output (Chart I-2). Chart I-2Malaysia's Commodities Output Is Falling In Importance Malaysia's Commodities Output Is Falling In Importance Malaysia's Commodities Output Is Falling In Importance Exports volumes of palm oil, crude oil and natural gas have all been falling relative to Malaysia’s total overseas shipment volumes (Chart I-3). Chart I-3Commodities Export Volumes Are Declining In Relative Terms Commodities Export Volumes Are Declining In Relative Terms Commodities Export Volumes Are Declining In Relative Terms Crude oil, gas, and palm oil now account for 4%, 5%, and 7% of total exports in value terms, respectively. Crucially, not only is the importance of commodities in the overall Malaysian economy diminishing in volume terms, it is also falling in nominal terms due to low resource prices. For instance, net export revenues from fuel (i.e. crude oil, petroleum and natural gas) have fallen from US$18 billion in 2013 to US$5 billion today (Chart I-4, top panel). Chart I-4Commodities' Net Export Revenues Are Also Diminishing Commodities' Net Export Revenues Are Also Diminishing Commodities' Net Export Revenues Are Also Diminishing Meanwhile, net exports of palm oil (and other plant-based fats) have dropped from US$20 billion to US$10 billion (Chart I-4, bottom panel). Improvement In High-Value-Added Manufacturing There are also some positive structural signs taking place in the Malaysian economy that are signaling an improvement in productivity and competitiveness: Malaysian export volumes of machinery and transport equipment are expanding in absolute terms as well as relative to overall export volumes (Chart I-5, top and middle panels). Chart I-5Malaysia's Machinery Exports Are Rocking Malaysia's Machinery Exports Are Rocking Malaysia's Machinery Exports Are Rocking Remarkably, Malaysian aggregate export volumes are quickly regaining lost global market share (Chart I-5, bottom panel). Further, the ratio of exports to imports has hit a structural bottom and is slowly picking up in volume terms (Chart I-6). Chart I-6Malaysian Overall Exports Are Regaining Lost Market Share Malaysian Overall Exports Are Regaining Lost Market Share Malaysian Overall Exports Are Regaining Lost Market Share This suggests some improvements in the competitiveness of domestic industries is slowly underway. Meanwhile, Malaysian high-skill and technology intensive exports as a share of global high-tech exports seem to have made a major bottom in U.S. dollar terms and will begin to rise (Chart I-7). Chart I-7Bottom In Malaysia's High-Tech Global Share? Bottom In Malaysia's High-Tech Global Share? Bottom In Malaysia's High-Tech Global Share? Advanced education enrollment is high and improving – and is only outpaced by Korea and China in emerging Asia (Chart I-8). Importantly, Malaysia has among the best demographics of mainstream developing countries. The working age population as a share of the total population will continue to be high all the way to 2040. Chart I-8Malaysians Like Going To School Malaysians Like Going To School Malaysians Like Going To School Malaysian expenditures on R&D have also been on the rise, outpacing a lot of other countries in the region (Chart I-9, top panel). R&D expenditures in Malaysia could also be catching up to Singapore’s (Chart I-9, bottom panel). Chart I-9Malaysia's Expenditure On R&D Is Rising Malaysia's Expenditure On R&D Is Rising Malaysia's Expenditure On R&D Is Rising In line with these positives, net FDIs into Malaysia have been rising briskly (Chart I-10). Importantly, these investments have been driven by European companies, meaning the latter are transferring valuable technological know-how to Malaysia. Chart I-10Net FDIs Are Rising Net FDIs Are Rising Net FDIs Are Rising The Malaysian ringgit is cheap (Chart I-11) and has reached almost two-decade lows against many Asian currencies. This makes Malaysia increasingly more competitive. Chart I-11The Ringgit Is Cheap The Ringgit Is Cheap The Ringgit Is Cheap Finally, our colleagues from the Geopolitical Strategy team believe that the recently elected Pakatan Harapan government will improve governance and transparency, which had significantly deteriorated under Najib Razak’s rule. A Marriage To Electronics Malaysia is attempting to reestablish itself as a major semiconductor hub in the region. Remarkably, after declining for 15 years, semiconductor exports are finally rising as a share of GDP (Chart I-12) and Malaysian semiconductor exports are outperforming those of its neighbors. Chart I-12Malaysian Semiconductor Exports Are Booming Malaysian Semiconductor Exports Are Booming Malaysian Semiconductor Exports Are Booming The Malaysian government since 2010, has identified the semiconductor sector as a key area for development and prosperity. In turn, it has been introducing programs and setting up institutions to support the industry. The 2019 budget reinforces the government’s priority to develop the sector. Several anecdotal observations confirm that Malaysia is moving up the value chain in the semiconductor industry, and is going beyond simple testing and assembly: Growing the semiconductor cluster: The Malaysian Institute of Microelectronic Systems (MIMOS) has established a shared services platform for advanced analytical services in the semiconductor industry to provide support to Malaysian semiconductor companies. The Economic Industrial Design Centre (EIDC) is also providing support to SMEs in order to enhance their efficiency. Similarly, the Semiconductor Fabrication Association of Malaysia (SFAM) has been partnering with local universities to enhance their engineering programs and offer training, internships and research opportunities for students. Developing home-grown semiconductors: In 2015, Malaysian public institutions in partnership with private companies developed the Green Motion Controller (GMS), an integrated circuit that reduces energy consumption. This semiconductor is an energy efficient controller that carries applications in hybrid cars and air conditioners, among other things. Nanotechnology: NanoMalaysia – a nanotechnology commercialization agency – is providing services to SMEs and start-ups to help increase their competitiveness by enabling them to upgrade to more efficient production methods. Light-emitting Diode (LED) manufacturing: Malaysia is becoming a hub for the manufacturing of energy efficient LED chips. This is the result of OSRAM’s – a German light manufacturer – large investment in a high-tech production facility. There are early signs already that the above developments are beginning to bear results. Chart I-13 shows that the difference between exports and imports of semiconductors (in U.S. dollars) have been surging. This shows Malaysia is able to add greater value to the semiconductors it imports and then re-exports. Chart I-13Malaysia Adds Value To The Semis It Imports Malaysia Adds Value To The Semis It Imports Malaysia Adds Value To The Semis It Imports Bottom Line: Commodities are declining in importance to the Malaysian economy. Meanwhile, Malaysia’s structural backdrop is improving as the semiconductor and hardware technology segments are rising in prominence. Cyclical Weakness Despite the positive structural backdrop, Malaysia’s cyclical outlook remains challenging. Our view on commodities and global trade continues to be negative. Not only are commodities prices deflating but semiconductor prices are also falling, and their global shipments are weakening (Chart I-14). Chart I-14Cyclical Weakness In Global Semiconductor Cycle Cyclical Weakness In Global Semiconductor Cycle Cyclical Weakness In Global Semiconductor Cycle The epicenter of the global trade slowdown, however, will be in Chinese construction activity. Consequently, industrial resources prices are more vulnerable than electronics in this global growth downturn. The above deflationary forces would negatively shock Asia’s growth outlook, and consequently Malaysian growth as well: The top panel of Chart I-15 shows that Malaysian narrow money growth has already rolled over decisively and is foreshadowing weaker bank loan growth. Chart I-15Malaysian Domestic Growth Set To Weaken Malaysian Domestic Growth Set To Weaken Malaysian Domestic Growth Set To Weaken Slower bank loan growth will weaken purchasing power and impact domestic consumption. The middle panel of Chart I-15 shows that car sales – having surged this summer because of the abolishment of the GST – are weakening anew. Malaysian companies and banks have among the largest foreign currency debt loads (Table I-1). We expect more currency depreciation in Malaysia, as we do in EM overall. This will make foreign currency debt more expensive to service, and consequently dampen companies’ and banks’ appetites for expansion. Table I-1Malaysia's External Debt Breakdown Malaysia: Structural Improvements Despite Cyclical Weaknesses Malaysia: Structural Improvements Despite Cyclical Weaknesses Finally, the real estate sector remains depressed. Property volume sales are contracting and have dropped to 2008 levels, and housing construction approvals are slumping (Chart I-16). Chart I-16Malaysia's Property Sector Is Depressed Malaysia's Property Sector Is Depressed Malaysia's Property Sector Is Depressed While this means that cleansing has been taking place in the property sector, the banking sector has not recognized NPLs and remains the weakest link in the Malaysian economy. Specifically, the top panel of Chart I-17 illustrates that the NPLs in the banking system still stand at a mere 1.5%. This is in spite of the fact that since 2009, non-financial private sector credit to GDP has risen significantly. Therefore, the true level of NPLs is probably considerably higher. Chart I-17Malaysian Banks Are Under-Provisioned Malaysian Banks Are Under-Provisioned Malaysian Banks Are Under-Provisioned Further, Malaysian banks have been lowering provisions to boost profits (Chart I-17, bottom panel). This is unsustainable. As growth weakens, Malaysian banks will see their NPLs rise and will need to raise provisions. Chart I-18 demonstrates that if provisions rise by 20%, bank operating earnings will contract and bank share prices would fall. Chart I-18Malaysian Banks' Share Prices Will Fall Malaysian Banks' Share Prices Will Fall Malaysian Banks' Share Prices Will Fall Bottom Line: Malaysia’s cyclical growth outlook is still feeble, with the banking system being the weakest link. Banks’ large weight in the equity index makes this bourse still vulnerable in the coming months. Optimal Macro Policy Mix Fiscal Consolidation… Fiscal policy is set to be tighter as per the Malaysian government budget announced on November 2 and its preference to pursue fiscal consolidation to reduce the deficit. The budget projects only a slight increase in expenditures in 2019, which means it will likely slowdown from 8% currently (Chart I-19). Chart I-19Government Expenditure Growth Will Soften Government Expenditure Growth Will Soften Government Expenditure Growth Will Soften The government will also recognize public-sector liabilities not presently shown on its balance sheet and strengthen both transparency and administrative efficiency. Critically, the budget also includes strategies to support the entrepreneurial part of the economy. Overall, this budget bodes very well for the structural outlook. Yet it will not support growth cyclically. …To Be Offset By Easy Monetary Policy Despite continued currency weakness, the Malaysian monetary authorities will not be in a hurry to raise interest rates to defend the ringgit. This is in contrast with other central banks in the region like Indonesia and the Philippines. This is presently an optimal policy mix for Malaysia and is positive for the stock market’s relative performance versus its counterparts in many other EMs. Malaysia’s structural inflation is low: core inflation hovers around zero. Therefore, the central bank will neither raise interest rates nor sell its foreign exchange reserves to defend the currency. Both currency depreciation and low interest rates are needed to mitigate the downturn in exports as well as offset fiscal consolidation. In the meantime, the ringgit is unlikely to depreciate in a sudden and vicious manner but rather will likely fall gradually. First, the current account will remain in surplus, even as global trade contracts. The basis is that if Malaysian exports fall, imports will simultaneously follow. The country imports a lot of intermediate goods to then process and re-export. Second, Malaysia is unlikely to witness pronounced capital flight as occurred in 2015. The new government has increased confidence in the economy among both locals and foreigners. In addition, net portfolio investments have been negative for a while. This means that a large amount of foreign capital has exited already, reducing the risk of further outflows. What’s more, foreign ownership of local currency bonds has fallen from 33% in June 2016 to 24% today. Moreover, at 28% of market cap, foreign ownership of equities is among the lowest in EM. These also limit potential foreign selling. Bottom Line: Policymakers are adopting a wise policy mix for the economy at the current juncture: tight fiscal and easy monetary policies. This is structurally positive, even if it does not preclude cyclical weakness. Investment Conclusions Weighing structural positives versus the cyclical growth weakness and the unhealthy banking system, we are maintaining a market-weight allocation to Malaysian stocks within the EM universe, but are placing this bourse on our upgrade watch list. We need to see a selloff in bank stocks before we upgrade it to overweight. Within Malaysian equities, we recommend shorting/underweighting banks and going long/overweighting small cap stocks. To capitalize on Malaysia’s improving structural growth outlook, we recommend buying Malaysian small caps, but hedging positions by shorting the EM aggregate or small-cap indexes. The ringgit is poised to depreciate further versus the U.S. dollar along with other EM/Asian currencies. We continue to short the ringgit versus the greenback. With respect to sovereign credit and local government bonds, dedicated portfolios should currently have a market-weight allocation. The negative cyclical growth outlook is offset by the right macro policy mix and improving growth potential.   Ayman Kawtharani, Associate Editor ayman@bcaresearch.com​​​​​​​ Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The delay to the U.K. parliamentary vote on the current Brexit deal has edged up our assessed probability of no-deal to 20 percent. Our probability-weighted value of the GBP is still around 5 percent higher than today. Nevertheless, the optimal moment to buy the GBP lies ahead, as the Brexit catharsis cannot properly begin until the U.K. parliament expresses its will. Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade in the coming months, but this fading is going to be less pronounced in Europe than in the United States. These relative inflation dynamics should give EUR/USD a leg up in 2019. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Chart of the WeekThe Pound Has Decoupled From British Public Opinion On Brexit The Pound Has Decoupled From British Public Opinion On Brexit The Pound Has Decoupled From British Public Opinion On Brexit Feature Please note this report was written before the outcome of Conservative MPs vote of no confidence in Theresa May held on the evening of December 12. To assess the impact of Brexit on the financial markets, we are going to turn to a fundamental concept in physics – the concept of a ‘phase transition’. In physics, a phase transition is a disruptive tipping point at which a body transforms from one state into another. The classic example is when water transforms into ice. If the temperature drops from 10 degrees (Celsius) to a degree or so lower, you will experience no discernible difference in water. Even if the temperature drops to 2 degrees, the difference is only slight. But if the temperature drops to minus 2 degrees, water transforms into ice – and you will experience a huge difference as roads freeze over, pipes burst, and so on… Beware A Sudden Phase Transition We can draw a powerful analogy for how the various forms of Brexit would impact the British economy and financial markets. If the current membership of the EU equates to water at 10 degrees, a ‘Norway plus’ arrangement – European Economic Area (EEA) plus a customs union – might be a temperature only a degree or so lower, a barely noticeable difference. The Brexit deal negotiated by Theresa May (or an amended version of it) might be a temperature of 2 degrees, so a somewhat discernible change. But crashing out of the EU to WTO trading rules would equate to minus 2 degrees, or lower. This Brexit would be hard (Chart I-2). Its properties would be very different. Chart I-2Goods Still Dominate U.K. Exports Goods Still Dominate U.K. Exports Goods Still Dominate U.K. Exports Also important is the speed of the phase transition. If winter arrives gradually, over the course of several weeks, we can generally prepare, and adapt our behaviour and habits. Thereby, we can even enjoy and thrive in a new climate. But if winter arrives overnight, it causes severe disruption and suffering.1 As Brexit reaches its denouement, the options for the future EU/U.K. relationship – full membership of the EU, a ‘Norway plus’ arrangement, the Brexit deal negotiated by Theresa May, or complete and overnight detachment – are each quite differentiated from the perspective of politics and law. For example, EEA plus a customs union is politically sub-optimal compared with the U.K.’s current full membership of the EU which includes the bonus of precious legal opt-outs. However, from the perspective of an investor in the markets, the first three types of arrangement are not really that different (Chart I-3). Only the last type – complete and overnight detachment from the EU – constitutes a severely disruptive phase transition. Chart I-3For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome For Investors, Brexit Simplifies To A Binary Outcome We can simplify the various Brexit possibilities into a binary investment outcome: The complete and overnight detachment ‘no-deal’ outcome – in which GBP/EUR would collapse to below parity. All other outcomes – in which GBP/EUR would initially rally through 1.20, by liberating the BoE to remove its precautionary monetary policy (Chart I-4 and Chart I-5). Chart I-4U.K. Economic Fundamentals... U.K. Economic Fundamentals... U.K. Economic Fundamentals... Chart I-5...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit ...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit ...Would Require Higher U.K. Interest Rates Absent The Risk Of A No-Deal Brexit This makes the key question: what is the probability of no-deal? No-deal is the default outcome if a deal or extension to the Article 50 process is not agreed (by both sides) before March 29 2019. Therefore no-deal can happen either if: The U.K. parliament cannot coalesce a majority around a course of action that is also acceptable to the EU27. Or if: The Prime Minister and government – the executive branch – ignores the will of parliament and runs down the clock to no-deal regardless. Looking at the parliamentary arithmetic, it is conceivable that a majority could exist for either ‘Norway plus’, or a new referendum, or no confidence in the current government leading to a general election. As for the Prime Minister ignoring the will of parliament, this is legally possible though politically improbable. Nevertheless, the Article 50 clock is running down. The delay to the parliamentary vote on the current deal, possibly until January 21, has edged up our assessed probability of no-deal to 20%, slightly reducing our probability-weighted value of GBP/EUR to 1.175.2 On a one year horizon, this still offers respectable upside for the GBP versus the EUR or the USD (Chart of the Week). But the Brexit catharsis cannot properly begin until parliament gets a chance to express its will, meaning that the optimal moment to buy the pound still lies ahead. Explaining Central Banks’ Obsession With 2 Percent Inflation Back in 1979, Daniel Kahneman and Amos Tversky formalized a new branch of behavioural finance called Prospect Theory, which would ultimately win Kahneman the Nobel Prize for Economics. One of the key findings of Prospect Theory is that we are incapable of distinguishing the meaning of very small numbers. In the case of price inflation, we cannot really distinguish inflation rates between 0 percent and 2 percent. Anything within this range is indistinguishably perceived as ‘price stability’. Given that we cannot distinguish inflation rates between 0 percent and 2 percent, it is impossible for monetary policy to fine-tune our inflation expectations to a point-target such as 2 percent. And given that it is impossible to fine-tune our inflation expectations, it is also impossible to fine-tune inflation itself to a point-target such as 2 percent. Prospect Theory says it is much wiser to define price stability in terms of an inflation range such as 0-2 percent, because this is how we actually perceive price stability (Chart I-6). But despite this compelling Nobel Prize winning academic evidence, central banks remain obsessed with an inflation point-target, most commonly 2 percent. Why? Chart I-6Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target Price Stability Means An Inflation Range Of 0-2 Percent, Not A Point-Target The reason is that central banks have created a rod for their own back. Once a central bank has staked its credibility in terms of impossibly precise ‘data-dependency’ – such as an inflation point-target – it becomes extremely difficult to move the goalposts without risking accusations of bias, partiality and exceptionalism. Future generations will judge the inflation point-target as one of the monumental errors of early twenty-first century economic policy. But for the time-being this flawed policy will nonetheless govern central bank behaviour, and as investment strategists we must see it in that light.  Following the recent 35 percent plunge in the crude oil price, both headline and core inflation rates are very likely to fade. But this fading is going to be less pronounced in Europe compared with the United States (Chart I-7 and Chart I-8). The main reason is that tax rates on fuel are much higher in Europe compared with the United States, and this attenuates the proportionate pass-through into European retail fuel prices from lower (or higher) oil prices. Chart I-7The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... The Connection Between Falling Oil Inflation And Falling Core CPI Inflation Is Weak In Europe... Chart I-8...But Strong In The U.S ...But Strong In The U.S ...But Strong In The U.S The ECB has, in any case, committed to keep its policy rates on hold for most of 2019. By contrast, the Fed has been on a one hike per quarter tightening path. Hence, relative to this behaviour, the surprise could be that the Fed indicates an open-ended pause in its tightening. Even if this is discounted to some extent, weak prints on reported inflation in the coming months could still move the rates and currency markets. After a spectacular gain for the EUR in 2017, our stance turned broadly neutral in early 2018 by adding a short position in EUR/JPY to counterbalance a 50:50 long position in EUR/USD and SEK/USD. Overall, this has proved to be a successful strategy (Chart I-9). Chart I-9The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 The Euro Consolidated In 2018. Another Leg-Up Is Likely In 2019 Looking ahead to the first half of 2019, the aforementioned relative inflation dynamics should give EUR/USD another leg up. But given the euro area’s connection with the U.K., await more clarity on Brexit before committing to EUR/USD. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model* This week, we have spotted an excellent tactical opportunity in EUR/NZD which is at a technical level that has signaled several previous tuning points. On this basis, the recommended trade is long EUR/NZD setting a profit target of 2.5% with a symmetrical stop-loss. In other trades, long EM versus DM achieved its profit target while long banks versus healthcare reached the end of its 65 day holding also in profit. Against this, long nickel versus palladium and short Australian telecoms versus insurance both reached their stop-losses. This leaves two open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 Long EUR/NZD Long EUR/NZD The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com Footnotes 1 This analogy can also apply to the arrival of spring. If the spring thaw arrives in one day, the consequent severe flooding can also cause terrible disruption and suffering. 2 1.225*0.8 + 0.98*0.2 Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations

Highlights Our take on the key macro drivers of financial markets hasn’t evolved much since we laid it out this summer, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... but the inflection points are getting nearer: The good times won’t last forever, though. The Fed is resolutely tightening policy, BBB-heavy investment-grade issuance has the corporate bond market flirting with a plague of fallen angels, and the global economy is slowing. Our strategy remains more cautious than our outlook for now, … : Although we think the equity bull market has another year to run, and the expansion will stretch into 2020, we are only equal-weight equities, while underweighting bonds and overweighting cash. … but we’re alert to opportunities to get more aggressive: Investment-grade and high-yield bonds are unlikely to offer an attractive risk-reward profile, but the S&P 500 shouldn’t decline much more if the economy holds up. Feature Mr. and Ms. X’s annual visit is an occasion for every BCA service to look toward the coming year, mindful of how it could improve on the one just past. The theme we settled on in last year’s discussion, Policy and Markets on a Collision Course, began asserting itself in earnest in October, and appears as it will be with us throughout 2019. The Fed is nearing its fourth rate hike this year, on the heels of three in 2017, and markets are warily contemplating the tipping point at which higher interest rates begin to interfere with activity. The yield curve has become a constant worry (Chart 1), with short rates moving in step with the fed funds rate while yields at the long end have been just one-half as sensitive (Chart 2). Chart 1Yield Curve Anxiety Has Exploded ... Yield Curve Anxiety Has Exploded ... Yield Curve Anxiety Has Exploded ...   Chart 2... As The Curve Has Steadily Flattened 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? Trade tensions are an even thornier policy challenge. After flitting on and off investors’ radar earlier in the year, trade barriers have been a major source of angst in recent months as central banks, investor polls and company managements increasingly cite them among their foremost concerns. Unfortunately, our geopolitical strategists do not expect relief any time soon. They see trade as just one aspect of an extended contest for supremacy between China and the U.S. Late-Cycle Turbulence, our 2019 house theme, pairs nicely with Policy-Market Collision. The gap between our terminal fed funds rate expectation and the money market’s is huge, and leaves ample room for a repricing of the entire yield curve. Trade has been a roller coaster, capable of inducing whiplash in 140 characters or less, and it may already have brought global manufacturing to the brink of a recession. Oil lost 30% in two months at the stroke of a pen; its immediate fate is in the hands of OPEC, but the caprice with which Iranian sanctions may or may not be re-imposed is likely to feed uncertainty. As we advised Mr. and Ms. X a few weeks ago, investors should stay nimble; there is no point to committing to a twelve-month strategy right now.1 The Fed Funds Rate Cycle Our equilibrium fed funds rate model estimates that the equilibrium fed funds rate, the rate that neither encourages nor discourages economic activity, is currently around 3%. It projects that the equilibrium rate will approach 3¼% by the middle of 2019, and 3⅜% by year end. The implication is that policy is comfortably accommodative now, and will not cross into restrictive territory for another 12 months – assuming that the Fed hikes four times next year, in line with our ambitious expectation. If the Fed steps back from its gradual pace, and only hikes three times in 2019 (as per the dots), or just once (as per the money market), the day when the economy and markets will have to confront tight monetary conditions will be pushed even further into the future. Stretching monetary accommodation until late next year would seem to forestall the arrival of the next recession until at least the first half of 2020. Tight policy is a necessary, if not sufficient, condition for a recession, as recessions have only occurred when the policy rate has exceeded our estimate of equilibrium over the six decades covered by our model. A longer stretch of accommodation would also continue to nourish the equity bull market and discourage allocations to Treasuries. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 1), while Treasuries have wilted, especially in the current phase of the fed funds rate cycle (Table 2). Table 1Equities Flourish When Policy’s Easy ... 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last?   Table 2... While Treasuries Stumble 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? The Business Cycle The state of policy is one of the three components in our simple recession indicator. Neither of the other two is sounding the alarm, either. Our preferred 3-month-to-10-year segment of the Treasury yield curve is still comfortably upward sloping, even if it has been steadily flattening and we expect it to invert late next year (Chart 3). Year-over-year growth in leading economic indicators decelerated slightly last month, but remains well above the zero line that has reliably preceded past recessions. Chart 3Flattening, But Not Yet Flat Flattening, But Not Yet Flat Flattening, But Not Yet Flat The Credit Cycle Anyone following the credit cycle would do well to start with the axiom that bad loans are made in good times. Its converse is just as true: good loans are made in bad times. Loan officers are every bit as susceptible to the recency bias as other human beings, and they tend to extrapolate from the freshest observations when assessing a borrower’s prospects. When things are good, lenders assume they will continue to be good, and let their guard down by lending to marginal borrowers and/or relaxing the terms on which they will lend. When things are bad, on the other hand, loans have to be underwritten so tightly that they squeak. The upshot is that lending standards and loan performance are tightly bound up with one another. In the near term, standards and performance are joined at the hip; over a five-year period, standards lead performance as a contrary indicator. Defaults almost certainly bottomed for the cycle in 2014, to judge by speculative-grade bonds (Chart 4, top panel), and loans (Chart 4, bottom panel). Standards reliably followed, and the proportion of lenders easing standards for corporate borrowers, as per the Fed’s senior loan officer survey, spiked (Chart 5). Chart 4Weakening, But Not Yet Weak Weakening, But Not Yet Weak Weakening, But Not Yet Weak   Chart 5Standards Follow Performance In Real Time ... Standards Follow Performance In Real Time ... Standards Follow Performance In Real Time ... The 2012 and 2014 peaks in willingness suggest that performance is due to erode (Chart 6). We do not foresee a step-function move higher in defaults, or a sudden collapse in loan availability, but we do expect some fraying at the edges. Given how tight spreads remain, any weakness at the margin could go a long way to wiping out much, if not all, of spread product’s excess return. The bottom line is that the credit cycle is well advanced, and investors should expect borrower performance and lender willingness to weaken from their current levels. Chart 6... And Lead Them Over The Intermediate Term ... And Lead Them Over The Intermediate Term ... And Lead Them Over The Intermediate Term Bonds We have written at length on our bearish view on rates and Treasuries.2 The key pillar supporting our rationale is the gap between our terminal fed funds rate estimate, 3.5-4%, and the market’s view that the Fed will not go beyond 2.75%, if indeed it gets to that level at all (Chart 7). The gap is big enough to drive a truck through, and leaves a lot of room for yields to shift higher all along the curve, even if the Fed were to slow its 25-bps-a-quarter tempo, as the Wall Street Journal suggested it might in a report last Thursday. We continue to believe that inflation is the inevitable outcome once surging aggregate demand collides with limited spare capacity, and that the Fed will be forced to push the fed funds rate to 3.5% and beyond. Chart 7Something's Gotta Give Something's Gotta Give Something's Gotta Give Our view that the credit cycle has already passed its peak drives our view on spread product. Though we remain constructive on the economy and the outlook for corporate earnings, we are not enamored of the risk-reward offered by corporate bonds. Although high-yield spreads blew out by nearly 125 bps from early October to late November, high yield still does not look cheap (Chart 8, bottom panel). The same holds for investment-grade spreads, which remain near the bottom of their long-term range despite widening by over 50 bps (Chart 8, top panel). Chart 8Spreads Are Still Tight Spreads Are Still Tight Spreads Are Still Tight Bottom Line: We recommend that investors underweight fixed income within balanced portfolios, while underweighting Treasuries and maintaining below-benchmark duration. We recommend benchmark holdings in spread product, but we expect to downgrade it to underweight before the end of the first half. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive for another twelve months or so, the bull market should have about another year to go. We downgraded equities to equal weight as a firm in mid-June nonetheless, on signs of global deceleration and the potentially malign effects of tariffs and other impediments to global trade. U.S. Investment Strategy fully supported that decision, but we are alert to opportunities to upgrade equities to overweight within U.S. portfolios if prices decline enough to make the prospect of a new cycle high attractive on a risk-reward basis. The risk-reward requirement implies that the fall in price would have to occur without a material weakening of the fundamental backdrop. For now, we think the fundamental supports remain stable, as per the equity downgrade checklist we constructed to keep tabs on them. The checklist monitors recession indicators, none of which betray any concern now; factors that may weigh on corporate earnings; inflation measures, because higher inflation could motivate the Fed to hike more quickly than planned, with adverse consequences for the bull market; and signs of overexuberance (Table 3). Table 3Equity Downgrade Checklist 2019 Key Views: Inflection At Last? 2019 Key Views: Inflection At Last? The earnings-pressure section focuses on the key factors that might signal margin contraction – wage growth, dollar strength and rising bond yields – but none of them look especially problematic now. While we think compensation gains will eventually push the Fed to go beyond its own terminal rate estimates, they have not yet picked up enough to cause concern. The dollar has paused in its advance, mostly marking time since the end of October. Only BBB corporate yields have gotten closer to checking the box (Chart 9). BCA’s preferred margin proxies remain in good shape, on balance (Chart 10), and our EPS profit model is calling for robust profit growth across all of next year (Chart 11). Chart 9Higher Rates Will Exert Some Margin Pressure Higher Rates Will Exert Some Margin Pressure Higher Rates Will Exert Some Margin Pressure   Chart 10In The Absence Of Margin Pressures, ... In The Absence Of Margin Pressures, ... In The Absence Of Margin Pressures, ...   Chart 11... 2019 Earnings Could Hold Up Nicely ... 2019 Earnings Could Hold Up Nicely ... 2019 Earnings Could Hold Up Nicely Oil’s plunge has pulled both headline CPI and longer-run inflation expectations lower. Although we think that the inflation respite is merely a head fake, and that oil will soon regain its footing (please see below), the run of harmless inflation data has the potential to soothe some market concerns about the Fed. If the Fed itself takes the data at face value, it may signal that the current 25-bps-a-quarter gradual pace could be slowed. As for exuberance, the de-rating the S&P 500 has endured since its forward multiple peaked at 18.5 in January suggests that it’s not a problem. We are not living through anything remotely resembling an equity mania. Bottom Line: BCA’s mid-June downgrade of global equities from overweight to equal-weight was timely. We remain equal-weight in balanced U.S. portfolios, but are more likely to upgrade U.S. equities than downgrade them, given the supportive cyclical backdrop. Oil We devoted our report two weeks ago to the oil outlook and its implications for the economy. Our Commodity & Energy Strategy service’s bullish 2019 view has not changed: it still sees a market in a tight supply/demand balance with high potential for supply disruptions and a smaller-than-usual inventory reserve to make up the slack. The unexpected release of over a million barrels a day of Iranian output has played havoc with oil prices, but does not provoke the growth concerns that declining demand would. Provided OPEC is able to agree on production cuts, and abide by them going forward, our strategists see Brent and WTI averaging $82 and $76/barrel across 2019. The Dollar We remain bullish on the dollar, though it will find the going rougher than it did in 2018. Traders have built up sizable net long positions, so it will take more for the greenback to extend its advance than it did to begin it. Ultimately, we think desynchronization between the U.S. and the rest of the major DM economies will keep the dollar moving higher. If the U.S. does not continue to outgrow the currency-major economies by a healthy margin, and/or the Fed does not respond to that growth by hiking rates to prevent overheating, the dollar’s advance may be nearly played out. Putting It All Together Three major assumptions underpin our views: The U.S. economy is at risk of overheating in its second year of markedly above-trend growth fueled by fiscal stimulus, and the Fed will respond to that risk by decisively raising rates. There will be a noticeable global slowdown, but it will not go far enough to turn into a recession. The U.S. will remain mostly immune to the global slump. We will be positioned well if all of these assumptions are validated by events, though timing is always uncertain. Financial-market volatility often increases late in the cycle, and we expect the backdrop to remain fluid. We are trying to maintain a fluid mindset in kind, monitoring the incoming data to make sure our cyclical assessments still apply, while remaining alert to opportunities created by significant price swings. Although we are neither traders nor tacticians, we want to retain some flexibility, and are trying to resist mentally locking in our positioning for the entire year. We are particularly focused on the monetary policy backdrop and the transition from accommodative to restrictive policy, which has historically been critically important for asset allocation. Our main goal is to anticipate the approach of inflection points in the key cycles – business, credit and monetary – as adeptly as we can. We are also resolved to look through the noise of one-off price swings and the blather that has already been clogging the airwaves. We seek to help our clients formulate a strategy for navigating the turbulence without being swept up in it. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com   Footnotes 1 Please see the December 2018 Bank Credit Analyst, “Outlook 2019: Late-Cycle Turbulence,” available at www.bcaresearch.com. 2 Please see the July 30, 2018 U.S. Investment Strategy, “The Rates Outlook,” the September 17, 2018; U.S. Investment Strategy, “What Would It Take To Change Our Bearish Rates View?” and the November 5, 2018; U.S. Investment Strategy, “Checking In On Our Rates View,” available at usis.bcaresearch.com.

Highlights The dollar will continue to rally despite the trade truce agreed upon last weekend between U.S. President Donald Trump and China President Xi Jinping. Not only is this truce far from a permanent deal, but global growth continues to slow. Moreover, if the truce were to generate a genuine improvement in global growth conditions, this would likely result in a much more hawkish Federal Reserve than the market is currently pricing in. This would lead to a further deterioration in global liquidity conditions, causing additional growth problems for the world. Buy EUR/CHF, as the Swiss National Bank will soon have to intervene in the market. Sell AUD/NOK, as oil should outperform metals and the Norges Bank is better placed to tighten policy than the Reserve Bank of Australia. Feature Presidents Donald Trump and Xi Jinping have agreed to freeze additional new tariffs on Chinese exports to the U.S. for three months. This means that as of January 1, 2019, U.S. tariffs on US$200 billion of Chinese exports to the U.S. will remain at 10%, and will not jump to 25%. Meanwhile, China has agreed to immediately resume its imports of soybeans and LNG from the U.S. Moreover, China has also agreed to begin talks to open up Chinese markets to U.S. exports as well as to address U.S. worries regarding intellectual property theft. The world has let out a collective sigh of relief. A potent narrative exists that fears of a trade war have been the root cause of the slowdown in global growth witnessed this year. Consequently, since the dollar performs well when global industrial activity slows, this also means that ending the trade war could be key to abort the dollar’s bull market. We are doubtful this narrative will pan out, and we do not think that the Buenos Aires truce will lead to the end of the dollar rally. This also means that the G-20 armistice is also unlikely to reverse the underperformance of commodity and Scandinavian currencies. First, this truce does not mark the end of the trade war. It is only an agreement to delay the implementation of U.S. tariffs. Come March, the Trump administration may well sing a very different tune. The U.S. domestic political climate has not changed one iota, and protectionism, particularly when directed at China, still wins votes (Chart I-1). Meanwhile, the concessions China is willing to give are long-term in nature; however, Trump wants visible wins well ahead of the 2020 elections. This mismatch creates a real danger that the White House imposes new tariffs again beyond the three-month armistice agreed at the G-20. The news yesterday afternoon that the CFO of Huawei was indicted in Vancouver already casts doubts on the deal. Chart I-1Americans Will Remain Tough On China Waiting For A Real Deal Waiting For A Real Deal Second, the dollar has been strong, and risk assets have been weak for more reasons than the trade war alone. As shown by the slowdown in Japanese or Taiwanese exports, as well as by the contraction in German foreign orders and in the CRB Raw Industrial Index’s inflation, global trade and global growth are slowing (Chart I-2). This development is likely to last until mid-2019, as our global leading economic indicator continues to fall. This deterioration in the global LEI does not look set to stop soon, as normally any improvement in the global LEI is first telegraphed by a stabilization in the Global LEI Diffusion Index – an indicator that is still falling (Chart I-3). Chart I-2Global Growth Continues To Slow Global Growth Continues To Slow Global Growth Continues To Slow Chart I-3No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI No Bottom In Sight For The Global LEI China is not yet coming to the rescue either. The slowdown in Chinese economic activity continues, and in fact, the paucity of a rebound in Chinese credit growth despite injections of liquidity by Beijing suggests that a bottom is not yet in sight (Chart I-4). Hopes that were raised by increased bond issuance from local governments have also been dashed as this proved to be a very temporary phenomenon (Chart I-5). What is more worrisome is that so far Chinese exports have held their ground; however, the decline in the new export orders of the Chinese PMI suggests that this support to growth is likely to taper sharply in the coming months (Chart I-6). Chart I-4Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus Credit Growth Decelerating Despite Stimulus   Chart I-5Chinese Infrastructure Push Looks Transitory Waiting For A Real Deal Waiting For A Real Deal   Chart I-6Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Chinese Exports: The Last Shoe To Drop Finally, despite the cloudy outlook for global growth that built up this year, U.S. yields had risen 80 basis points by November 8, adding stress to economies already negatively impacted by weakening manufacturing activity. This increase in global borrowing costs has worsened the already noticeable decline in U.S.-dollar based liquidity (Chart I-7). This decline in liquidity has been a great source of concern as EM economies, the source of marginal growth in the global economy, have large dollar-denominated debt loads, and thus need abundant dollar liquidity in order to support their economies (Chart I-8). Chart I-7Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Slowing Dollar Liquidity Explains Weak Global Growth... Chart I-8...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated ...Because There Is A Lot Of Dollar Debt Where Growth Is Generated This last point is especially unlikely to change in response to the Buenos Aires truce. Since November, 10-year U.S. yields have fallen around 25 basis points, and now fed funds rate futures are only pricing in 45 basis points of rate hikes over the coming two years, including the December hike. If business sentiment improves because of a trade truce, and consequently U.S. capex proves more resilient than anticipated by market participants, the Federal Reserve will increase rates by much more than what is currently priced into the futures curve (Chart I-9). Chart I-9U.S. Rates Have Plenty Of Upside, Even More So If The Trade Truce Becomes A Peace Treaty Waiting For A Real Deal Waiting For A Real Deal This will lift yields, resuscitating one of the first reasons why markets have been weak this fall. This risk is even greater than the market appreciates. After Fed Chair Jerome Powell gave what was perceived as a dovish speech last week, markets were further emboldened to bet on a Fed pause. However, Fed Vice-Chairman Richard Clarida and New York Fed President John Williams have both argued since that the U.S. economy will continue to run above trend and warrants further gradual increases in interest rates. A truce in Buenos Aires may only provide them with more ammunition to implement those hikes. Global liquidity conditions are unlikely to improve significantly anytime soon. Moreover, the truce could also change the calculus in Beijing. Much of the stimulus implemented since last summer in China has been to limit the negative impact of a trade war. However, if a trade war is not in the cards, Beijing has fewer reasons to abandon its deleveraging campaign. It thus raises the possibility that with a risk to China evaporating, the Xi Jinping administration would instead not do anything to limit the slowdown in credit. This implies that Chinese capex would stay weak and that China’s intake of raw materials and machinery would not pick up. This means that the euro area and countries like Australia will continue to lag behind the U.S.  Ultimately, the market speaks louder than anything else. The incapacity for risk assets to catch a bid in the wake of what was good news is disconcerting. It suggests that the combined assault of slowing global growth and a tightening Fed remains the main problem for global financial markets. Hence, in this kind of deflationary environment, the dollar reign supreme – even if U.S. growth were to slow (Chart I-10). Chart I-10A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth A Strong Dollar Is Not A Function Of Strong U.S. Growth Bottom Line: A trade truce in Buenos Aires could have aborted the bull market in the dollar. So far, it has not, and we do not think it will be able to end the dollar’s rally. First, this truce remains flimsy, and does not guarantee an end of the trade war between China and the U.S. Second, global growth continues to exhibit downside. Finally, the Fed is unlikely to change its course and pause its hiking campaign. In fact, if a trade truce is so good for trade, it will give more reasons for the Fed to hike and may even incentivize Chinese authorities to abandon their efforts to cushion the Chinese economy against slowing global trade. Stay long the dollar and keep a defensive exposure in the FX market, one that favors the yen and the greenback at the expense of Scandinavian and commodity currencies. Buy EUR/CHF Despite our view that global growth is set to slow, we are inclined to buy EUR/CHF this week. We expect the Swiss National Bank to stop sitting on its hands as a stronger CHF is becoming too painful. First, as we highlighted last week, aggregate Swiss economic activity is slowing sharply.1 What is more concerning is that consumer spending is also suffering, as shown by the contraction in real retail sales (Chart I-11). This implies that despite record-low interest rates, Swiss households are feeling the pinch of the tightening in Swiss monetary conditions created by the stronger CHF. Chart I-11Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Swiss Households Are Feeling The Pinch Second, the franc remains a problem for Swiss competitiveness. As Chart I-12 shows, Swiss labor costs are completely out of line with its competitors. This phenomenon worsened significantly after 2008 due to the Franc’s strength vis-à-vis the euro. Despite the weakness in the franc from mid-January 2015 to April 2018, Swiss unit labor costs remain uncompetitive. This means that going forward, either the SNB will have to tolerate a further contraction in wages, something unpalatable as Swiss households have a debt load equal to 212% of disposable income, or the franc will have to fall. Chart I-12The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive The CHF Makes Switzerland Uncompetitive Third, the franc’s recent strength is only accentuating the deflationary impact of softer global growth on the local economy. As Chart I-13 illustrates, the recent strengthening in the trade-weighted CHF portends to a potentially painful contraction in import prices, while core inflation is already well off the SNB’s 2% objective. Moreover, as the second panel of Chart I-13 shows, our CPI model suggests that Swiss inflation is about to fall into negative territory again. This would imply that not only will the Swiss economy suffer from the recent strengthening in the franc, but also that Swiss real interest rates are about to increase by 100 basis points, the last thing a slowing economy needs. Chart I-13Swiss Deflation Will Return Swiss Deflation Will Return Swiss Deflation Will Return This economic backdrop suggests to us that after 16 months where the SNB played nearly no active role in managing the CHF exchange rate, the Swiss central bank is about to come back to the market in order to limit the downside in EUR/CHF. This makes buying this cross attractive, as it offers a favorable asymmetric payoff. EUR/CHF generates a small positive carry, has limited downside and offers ample upside if the SNB intervenes – all while offering low volatility. Meanwhile, if global growth picks up, EUR/CHF should also rebound. In fact, the pro-cyclical behavior of EUR/CHF, as well as its asymmetric payoff, increases the attractiveness of this trade within our broadly defensive portfolio stance: It hedges us against being wrong on the global growth outlook and the importance of the trade truce. Furthermore, any resolution to Italy’s battle with Brussels will also boost this cross. Bottom Line: EUR/CHF normally depreciates when global growth slows. While this pattern materialized in 2018, we anticipate EUR/CHF to stabilize and potentially rally, even if global growth slows. The strong CHF is now causing serious pain to the Swiss economy, and the SNB will have to prevent any deepening of the malaise. The SNB is thus set to begin intervening in the market. Additionally, if we are wrong and global growth does not slow further, being long EUR/CHF provides a hedge to our defensive market stance. AUD/NOK To Be Knocked Down An attractive opportunity to sell AUD/NOK has emerged. First, on the back of the weakness in oil prices relative to metals prices, AUD/NOK has caught a furious bid in recent weeks (Chart I-14). However, we expect the underperformance of oil relative to metals to peter off. The main factor that has weighed on petroleum prices is that Saudi Arabia has kept extracting oil at full speed, expecting a shortage of oil in global markets once U.S. sanctions on Iran kicked in. Chart I-14AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices AUD/NOK Strength: A Reflection Of Weak Crude Prices However, with President Trump greatly softening his stance and allowing exemptions for some countries to import Iranian oil, the crude market instead has experienced a mini unforeseen oil glut. OPEC 2.0, just agreed to essentially remedy this problem by limiting their oil output. This should boost oil prices. Meanwhile, slowing global growth centered on slowing Chinese capex will have a much deeper impact on industrial metals prices than on oil. This represents a negative terms-of-trade shock for Australia vis-à-vis Norway. Second, domestic economic conditions also favor betting on a weaker AUD/NOK. Australian nominal GDP growth often weakens when compared to Norway’s ahead of periods of depreciation in AUD/NOK. Today, Australia’s nominal GDP growth is sagging relative to Norway’s, and the contraction in Australia’s LEI relative to Norway suggests that this trend will deepen (Chart I-15). A rebound in oil prices relative to metals prices will only reinforce this process. Chart I-15Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Domestic Economic Conditions Point To A Lower AUD/NOK Third, AUD/NOK seems expensive relative to the anticipated path of policy of the Reserve Bank of Australia relative the Norges Bank (Chart I-16). Moreover, the Norwegian central bank has begun lifting rates, and since real interest rates in Norway are still negative, it will continue to tighten policy next year. Meanwhile, the RBA remains reticent to increase interest rates as Australian inflation and wage growth are still tepid. The recent deceleration in Australian GDP growth as well as budding problems in the Aussie real estate market will only further cajole the RBA in its reluctance to lift the cash rate higher. Hence, the real interest rate differentials will continue to point toward a lower AUD/NOK. Chart I-16AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates AUD/NOK At A Premium To Expected Rates Fourth, AUD/NOK is once again very expensive, trading at a 12% premium to it purchasing power parity equilibrium (Chart I-17). It only traded for an extended period of time at a richer premium when Brent was free-falling to US$25/bbl. Since we anticipate oil to rebound, such a premium in AUD/NOK is unwarranted. Chart I-17AUD/NOK Is Pricey AUD/NOK Is Pricey AUD/NOK Is Pricey Finally, all our technical indicators show that AUD/NOK is massively overbought (Chart I-18). The study on momentum we conducted last year showed that out of 45 G-10 FX pairs tested, after AUD/SEK, AUD/NOK was the second worst one to implement momentum-continuation trades.2 As a result, we would anticipate that the recent period of overbought conditions will lead to a period of oversold conditions. Chart I-18The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought The Mean-Reverting AUD/NOK Is Overbought Bottom Line: Selling AUD/NOK today makes sense. BCA anticipates oil prices to rebound relative to metals prices, the Australian economy is slowing relative to Norway’s, monetary policy is moving in a NOK-friendly fashion, AUD/NOK is expensive, and the cross is well-placed to experience a large episode of momentum reversal.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com  Footnotes 1 Please see Foreign Exchange Strategy Special Report, titled “2019 Key Views: The Xs And The Currency Market”, dated November 30, 2018, available at fes.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, titled “Riding The Wave: Momentum Strategies In Foreign Exchange Markets”, dated December 8, 2017, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. has been mixed: The price component of the ISM manufacturing survey underperformed expectations, coming in at 60.7. This measure also declines sharply from the previous month. However, the headline ISM Manufacturing survey surprised to the upside, coming in at 59.3. Total vehicle sales also outperformed expectations, coming in at 17.50 million. The DXY U.S. dollar Index was flat for the past two weeks. We continue to be bullish on the U.S. dollar. The current environment of falling global growth and falling inflation has historically been very positive for this currency. Moreover, the fed will likely hike more than anticipated by the market, providing another tailwind for the dollar until at least the first quarter of 2019. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in Europe has been mixed: Retail sales growth underperformed expectations, coming in at 1.7%. Moreover, core inflation also surprised to the downside, coming in at 1%. However, market services and composite PMI surprised positively, coming in at 53.4 and 52.7 respectively. EUR/USD has been flat for the past two weeks. We are bearish on the euro, given that we expect Chinese tightening to continue to weigh on global growth. Furthermore, recent disappointment in euro area inflation confirms our view that it will be very difficult for the ECB to tighten policy. This means that rate differentials will continue to move against EUR/USD. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan has been mixed: The Nikkei manufacturing PMI outperformed expectations, coming in at 52.2. Moreover, housing starts yearly growth came in line with expectations, at 0.3%. However, Markit Services PMI came in at 52.3, decreasing from last month’s number. USD/JPY has decreased by -0.4% these past two weeks. We are positive on the yen for the first quarter of 2019. The current risk off environment should be positive for safe havens like the yen. We are particularly negative on EUR/JPY, as this cross is very well correlated with bond yields, which should keep decreasing as markets continue to sell off. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. has been mixed: Nationwide housing prices yearly growth came in at 1.9%, outperforming expectations. Moreover, Markit manufacturing PMI as well as construction PMI both surprised positively, coming in at 53.1 and 53.4 respectively. However, Markit Services PMI underperformed expectations, coming in at 50.4. GBP/USD has decreased by 0.7% these past two weeks. The pound continues to be a complex currency to forecast. While the pound is cheap and makes for a potentially attractive long-term buy, current political risk continue to make a shorter-term position very risky. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.8%. Moreover, building permits month-on-month growth also surprised negatively, coming in at -1.5%. Finally, construction done also surprised to the downside, coming in at -2.8%. AUD/USD has decreased by -0.5% these past two weeks. We believe that the AUD is the currency with the most potential downside in the G10. After all, the Australian economy is the economy in the G10 most leveraged to the Chinese industrial cycle, due to Australia’s high reliance on industrial metal exports. This means that the continued tightening by Chinese authorities should be most toxic for this currency. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn’t Always Help The World - June 29, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand has been mixed: Building permits month on month growth outperformed expectations, coming in at 1.5%. However, retail sales as well as retail sales ex-autos both declines from the previous quarter, coming in at 0% and 0.4%. NZD/USD has increased by 1% these past two weeks. After being bullish in the NZD for a couple of months, we have recently turned bearish, as we believe that this currency is very likely to suffer in the current environment of declining inflation and global growth. With that said, we remain bullish on the NZD relative to the AUD, given that the kiwi economy is less exposed to the Chinese industrial cycle than Australia. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada has been positive: Retail sales month on month growth outperformed expectations, coming in at 0.2%. Moreover, headline inflation also surprised to the upside, coming in at 2.4%. Finally, the BOC core inflation measure increased from last month’s number, coming in at 1.6%. USD/CAD has risen by 1.7% these past two weeks. A lot of this weakness was caused by the dovish communication of the Bank of Canada following their announcement to keep rates on hold at 1.75%. This change in stance is likely a response to the collapse in oil prices in the past months. With that in mind, we are inclined to believe that the CAD might be reaching oversold levels, as oil is likely to stabilize and the economy continue to show signs of strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland has been negative: Gross domestic product yearly growth underperformed expectations, coming in at 2.4%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 99.1. Finally, headline inflation also surprised negatively, coming in at 0.9%. EUR/CHF has decreased by 0.5% these past two weeks. Our bullish view on EUR/CHF is a high conviction view for the first part of 2019. This is because the recent strength in the franc is choking out any inflationary pressures in the Swiss economy. Thus, we are reaching the threshold at which the SNB is very likely to intervene in the currency market to prevent the franc’s strength from derailing the path toward the inflation target. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been negative: Retail sales growth underperformed expectations, coming in at -0.2%. Moreover, registered unemployment also surprised negatively, coming in at 2.3%. Finally, the credit indicator came in line with expectations at 5.7%. USD/NOK has been flat these past two weeks. We are shorting AUD/NOK this week, as a way to take advantage of stabilizing oil prices and a continued growth slowdown in China. Moreover, AUD/NOK is expensive in PPP terms, and is technically overbought. Finally, this currency shows one the most mean reverting tendencies in the G10, which means that the recent surge in this cross is likely to reverse. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden has been negative: Consumer confidence underperformed expectations, coming in at 97.5. Moreover, retail sales growth also underperformed expectations, coming in at -0.1%. Finally, gross domestic product yearly growth also surprised negatively, coming in at 1.6%. USD/SEK has fallen by roughly 1% these past two weeks. On a short-term basis, we are negative on the krona, given that this currency is very sensitive to global growth dynamics, which means that the continued tightening by both Chinese authorities and the Fed will create a headwind for any SEK rally. That being said, on a longer-term basis we are more positive on the krona, as the Riksbank continues to be too dovish given the current inflationary backdrop. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades