Euro Area

Highlights In case you missed it in real-time, please listen to a playback of this this quarter’s webcast ‘What Are The Most Attractive Investments In Europe?’ available at eis.bcaresearch.com. Growth is set to plunge in the first quarter, keeping bond yields depressed for the early part of 2020 at least. Stay structurally overweight equities versus bonds so long as bond yields stay around current or lower levels. A 10 basis points decline in the 10-year bond yield can offset a 2 percent decline in stock market profits. Underweight economically sensitive sectors – and regional and country equity indexes with a high weighting to them – until growth and bond yields enter a convincing uptrend. A strong signal for shifting to a more pro-cyclical stance in the coming months would be if/when the 10-year bond yield has reached a sufficiently strong 6-month deceleration. Fractal trade: the strong outperformance of utilities versus oil and gas is technically stretched. Feature Chart I-1Forget Growth, It's All About Valuation Forget Growth, It's All About Valuation Forget Growth, It's All About Valuation ‘Global health scare takes world stock markets to new highs’ would make a jarring, provocative, and counterintuitive headline. But it would be true… at least so far. Most economists expect the global health scare emanating from China to depress economic growth. My colleague, Peter Berezin, forecasts global growth to drop to near zero during the first quarter. Yet the aggregate stock market seems largely unfazed. Most bourses are riding high, and in some cases not far from all-time highs. How can this be if the market is downgrading growth? Ultra-Low Bond Yields Are Protecting The Stock Market Although stock market profits are being revised down, the multiple paid for those profits is rising by more than the profits are falling. Stock market valuations have become hyper-sensitive (inversely) to ultra-low bond yields. Meaning that the valuation boost from a small decline in bond yields is more than sufficient to counter the growth drag from the coronavirus scare. This is not just a recent phenomenon. For the past two years, a good motto for investors has been: forget growth, it’s all about valuation (Chart of the Week). Through 2018-19, profits drifted sideways. Yet the stock market fell 30 percent, then rose 30 percent – because the multiple paid for the profits plunged in 2018, then surged in 2019 (Chart I-2 and Chart I-3). The reason was the dramatic swing in bond yields. This is hardly surprising given that the prospective return on equities is sensitive to the prospective return offered by competing (long-duration) bonds. But crucially, at ultra-low bond yields, this sensitivity becomes hyper-sensitivity. Chart I-2The Big Moves In The Stock Market... The Big Moves In The Stock Market... The Big Moves In The Stock Market... Chart I-3...Have Been About Valuation, Not Growth ...Have Been About Valuation, Not Growth ...Have Been About Valuation, Not Growth When bond yields approach their lower bound, bonds become extremely risky investments because the scope for price rises diminishes while the scope for price collapses increases. The upshot is that all (long-duration) investments become equally risky, and the much higher prospective returns required on formerly more risky equities collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, the valuation of equities becomes hyper-sensitive to small changes in bond yields. A 10 basis points decline in the bond yield can offset a 2 percent decline in stock market profits Through 2018-2019, the 10-year T-bond yield took a round trip from around 2 percent to 3.2 percent and then down to around 1.6 percent today. This explains the mirror-image round trip in the stock market’s multiple: from 16 down to 13 and then up to around 17 today, a 30 percent increase. Which means that broadly speaking, a 10 basis points decline in the bond yield can offset a 2 percent decline in stock market profits (Chart I-4). Chart I-4The Bond Yield Is Driving The Stock Market's Valuation The Bond Yield Is Driving The Stock Market's Valuation The Bond Yield Is Driving The Stock Market's Valuation Therefore, as the coronavirus scare illustrates, the biggest structural threat to the aggregate stock market does not come from slowing growth so long as bond yields continue to adjust downwards. The biggest threat comes from an outsized increase in bond yields, stemming from a subsequent modest acceleration in either growth or inflation. But we do not expect this in the first half of the year (at least). Bond Yields To Stay Depressed For The First Half At Least Although the coronavirus scare is a convenient scapegoat for the growth downgrade, the scare has just amplified a growth deceleration that was going to happen anyway. As we explained at the start of the year in Strong Headwind Warrants Caution In H1, a growth deceleration in Europe and worldwide during early 2020 was already well baked in the cake. The 6-month acceleration in bond yields at the end of 2019 was among the sharpest in recent years. Growth decelerations stem neither from the level of bond yields nor from the change in bond yields (or financial conditions). Growth decelerations stem from the acceleration of bond yields. And the 6-month acceleration in bond yields at the end of 2019 – both in Europe and worldwide – was among the sharpest in recent years (Chart I-5). Chart I-5After A Sharp 6-Month Acceleration In Bond Yields, Yields Stay Depressed For The Following 6 Months After A Sharp 6-Month Acceleration In Bond Yields, Yields Stay Depressed For The Following 6 Months After A Sharp 6-Month Acceleration In Bond Yields, Yields Stay Depressed For The Following 6 Months Although the link between a bond yield acceleration and a GDP deceleration seems hard to grasp, it results from a basic accounting identify. GDP is a flow statistic. So if a credit flow contributes to GDP, it must be a credit flow deceleration that contributes to a GDP deceleration. And if the level of the bond yield establishes the size of a credit flow, it must be a bond yield acceleration that establishes the size of a credit flow deceleration (Chart I-6).  Chart I-6A Bond Yield Acceleration Causes A Credit Flow Deceleration A Bond Yield Acceleration Causes A Credit Flow Deceleration A Bond Yield Acceleration Causes A Credit Flow Deceleration Given the lags between bond yields impacting credit flows and credit flows impacting spending, a sharp 6-month acceleration in the bond yield – like the one experienced at the end of 2019 – tends to keep the bond yield depressed for the following six months. On this basis, we would not expect an outsized increase in the bond yield during the first half of this year. In fact, a continued decline in yields could eventually turn into a sharp 6-month deceleration in the bond yield, leading to an acceleration in credit flows and growth, and providing a forthcoming opportunity to become more pro-cyclical.  Big Winners And Losers Across Sectors, Regions, And Countries To repeat, the growth scare has not had a major impact on the aggregate stock market (so far) because the valuation boost from a small decline in bond yields is more than sufficient to counter the downgrade to profits. But the growth scare has had a major impact on sector, regional, and country winners and losers. Understandably, the sectors most exposed to the declining bond yield have performed very well. These fall under two categories: the first is bond proxies, meaning sectors that pay a stable bond-like income, such as utilities; the second is long-duration investments meaning sectors whose income is likely to grow rapidly, such as tech and healthcare. This is because the more distant is the future cash flow, the greater is the uplift to its ‘net present value’ for a given decline in the bond yield. The growth scare has had a major impact on sector, regional, and country winners and losers. Conversely, the sectors most exposed to short-term growth have performed poorly. These include banks and energy. Banks suffer also because declining bond yields erode their net interest (profit) margin (Chart I-7). In turn, the sector winners and losers have determined the regional and country equity market winners and losers. Nowadays, a stock market’s relative performance is predominantly a play on its distinguishing overweight and underweight ‘sector fingerprint’. This is because major stock markets are dominated by multinational corporations which are plays on their global sectors, rather than the region or country in which they have a stock market listing. It follows that when tech and healthcare outperform, the tech-heavy Netherlands and healthcare-heavy Denmark stock markets must outperform. When energy underperforms, the energy-heavy Norway and UK stock markets must underperform. It also follows that the tech-heavy and healthcare-heavy US stock market must outperform (Chart I-8).  Chart I-7Sector Winners And ##br##Losers... Sector Winners And Losers... Sector Winners And Losers... Chart I-8...Explain Regional And Country Winners And Losers ...Explain Regional And Country Winners And Losers ...Explain Regional And Country Winners And Losers Some of the more extreme sector and country outperformances and underperformances are now technically stretched (see following section). Nevertheless, a general strategy to underweight economically sensitive sectors – and regional and country equity indexes with a high weighting to them – will remain appropriate until growth and bond yields enter a convincing uptrend. To reiterate, one strong signal for shifting to a more pro-cyclical stance in the coming months would be if/when the bond yield has reached a sufficiently strong 6-month deceleration. Stay tuned. Fractal Trading System* The strong outperformance of utilities versus oil and gas is technically stretched, especially in the US, and a reversal is likely within the next three months. Short US utilities versus oil and gas, setting a profit target of 7.5 percent with a symmetrical stop-loss. In other trades, short Ireland versus Europe reached the end of its holding period having achieved half of its profit target. The rolling 1-year win ratio now stands at 59 percent. Chart I-9US: Utilities Vs. Oil And Gas US: Utilities Vs. Oil And Gas US: Utilities Vs. Oil And Gas 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. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading Model Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Cyclical Recommendations Structural Recommendations Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets Forget Growth, It's The Bond Yield That's Driving Markets 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 The elevated uncertainty about global growth stemming from the COVID-19 virus in China has not only made investors more anxious, but central bankers as well. This means that, only six weeks into the year, policymakers may already be having to rethink their expected strategies for 2020 - which were, for the most part, sitting on hold after the monetary easing in 2019. This has important implications for the direction of global bond yields, which were starting to see a cyclical increase before the viral outbreak. In this report, we present what we see as the most important data for investors to focus on in the major developed markets to get the central bank call correct. This is based on our interpretation of recent speeches, press conferences and published research. We also provide our own suggested data series to watch for each country – which do not always line up with what central bankers are saying they are most worried about. We conclude that it is still not clear that the global growth backdrop has turned sustainably more bond bullish, but there is no pressure on any of the major central banks to move away from extremely accommodative policy settings. Feature Over the past four weeks, all of the major central banks have had the opportunity to formally communicate their current views to financial markets. Whether it was through post-policy- meeting press conferences or published monetary policy reports, central bankers have tried to signal their intentions about future changes in the direction of interest rates, given the heightened uncertainties about the momentum of global growth. At the moment, our global leading economic indicator (LEI) is still signaling that 2020 should see some rebound in global growth – and bond yields – after the sharp 2019 manufacturing-led slowdown (Chart 1). Unfortunately, the latest read on the global LEI uses data as of December, so it does not include what is almost certainly to be a very severe slowdown in the Chinese (and global) economy in the first quarter of 2020 due to the COVID-19 virus outbreak. Underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year.  Central bankers are in the same spot as investors, trying to ascertain the extent of the hit to global growth from the virus, both in terms of size and, more importantly, duration. This comes at a time when many central banks were already formally rethinking how to meet their own individual inflation-targeting mandates given the persistence of low global inflation alongside tight labor markets (Chart 2). Chart 1Global Bond Yields: Think Globally, Act Locally Global Bond Yields: Think Globally, Act Locally Global Bond Yields: Think Globally, Act Locally Chart 2Common Worries For All CBs: China & Global Inflation Common Worries For All CBs: China & Global Inflation Common Worries For All CBs: China & Global Inflation That all sounds potentially very bond-bullish, but a lot of bad economic news is already discounted in the current low level of global bond yields. More importantly, the underlying stories within each developed market economy – on growth, inflation and potential financial imbalances – suggest that the additional interest rate cuts now discounted globally may not come to fruition if the China shock is contained to the first quarter of the year. In this Weekly Report, we provide a brief synopsis of what we believe are the biggest concerns for each of the major developed economy central banks. This is based on our read of recent policy decisions and central banker statements, as well as our own understanding of the current reaction function of policymakers. Our intention is to provide a short list of indicators to watch for each central bank, to help cut through the noise of data and news during this current period of unusual uncertainty, as well as our own assessment of what policymakers should be focusing on more. We conclude that it is still too soon to expect a new wave of bond-bullish global monetary policy easings in 2020. It will take evidence pointing to an extended shock to global growth from the COVID-19 virus to reverse the bond-bearish signal from other indicators like our global LEI. Federal Reserve Chart 3Federal Reserve: Focus On Financial Conditions & Inflation Expectations Federal Reserve: Focus On Financial Conditions & Inflation Expectations Federal Reserve: Focus On Financial Conditions & Inflation Expectations Currently, the Fed’s commentary suggests a policy bias that can be described as “neutral-to-dovish”, but it is giving no indication that additional rate cuts are likely in 2020 after the 75bps of cuts last year. Markets remain skeptical, however, with -42bps of cuts over the next twelve months now priced into the USD overnight index swap (OIS) curve according to our Fed Discounter (Chart 3). What the Fed seems most focused on: Fed officials seem focused on measures of market-based inflation expectations, like TIPS breakevens, as the best indication that current policy settings are appropriate (or not) relative to the growth outlook of investors. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019 (middle panel). Right now, with the 10-year TIPS breakeven at 1.67% and the 10-year/3-month US Treasury curve now at only -1bp, another decline in longer-term inflation expectations will likely invert the Treasury curve. What the Fed should be more focused on: US financial conditions are highly stimulative, with equity indices back near all-time highs and corporate credit spreads remaining well-contained at tight levels. Given the usual lead times of financial conditions indices to US cyclical growth indicators like the ISM manufacturing index (bottom panel), a continuation of the most recent bounce in the ISM is still the most likely result – even allowing for a near-term hit to global growth from China. While FOMC members have expressed concern about TIPS breakevens being persistently below the 2% inflation target, they would not necessarily respond to a further decline in breakevens with more rate cuts without first seeing the US Treasury curve becoming inverted for a prolonged period, just like in 2019. Bottom Line: The incoming US growth data is critical to determine the Fed’s next move. If there is no follow through from easy financial conditions into faster growth momentum, the odds increase that the Treasury curve will become more deeply inverted for a longer period of time – an outcome that would likely prompt more rate cuts, especially if equity and credit markets also begin to sell off as growth disappoints. European Central Bank Chart 4ECB: Focus On Manufacturing & Inflation Expectations ECB: Focus On Manufacturing & Inflation Expectations ECB: Focus On Manufacturing & Inflation Expectations The ECB has been clearly signaling that it still has a dovish bias, although central bank officials have acknowledged that the options available to them to ease further are limited with policy rates already in negative territory. The market agrees, as there are only -7bps of cuts over the next twelve months now priced into the EUR OIS curve according to our ECB Discounter (Chart 4). What the ECB seems most focused on: The ECB has been paying the most attention to the contractions in euro area manufacturing data (like PMIs) and exports seen in 2019. Rightly so, as nearly all of the two percentage point decline in year-over-year euro area real GDP growth since the late-2017 peak has come from weaker net exports. The central bank has also been concerned about the depressed level of inflation expectations, with the 5-year EUR CPI swap rate, 5-years forward, now at only 1.23% - far below the ECB’s inflation target of “at or just below” 2%. What the ECB should be more focused on: We agree that the focus for the ECB should be most concerned about the weakness in manufacturing/exports and low inflation expectations – the latter having not yet responded to extremely stimulative euro area financial conditions (most notably, the weak euro). The euro area economy is highly leveraged to Chinese demand, with exports to China representing 11% of total euro area exports. This makes leading indicators of Chinese economic activity, like the OECD China LEI and the China credit impulse, critically important indicators in determining the future path of European export demand. The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. Bottom Line: The COVID-19 outbreak in China could not have come at a worse time for the ECB, as there have been tentative signs of stabilization in cyclical euro area indicators like manufacturing PMIs in recent months. If the China demand shock to euro area exports is large enough, the ECB will likely be forced to deliver a modest interest rate cut – or an expansion of the size of its monthly asset purchases – to try and boost growth. Bank Of England Chart 5Bank Of England: Focus On Business Sentiment & Labor Costs Bank Of England: Focus On Business Sentiment & Labor Costs Bank Of England: Focus On Business Sentiment & Labor Costs The Bank of England (BoE) has a well-deserved reputation as having an unpredictable policy bias under outgoing Governor Mark Carney, but the central bank does appear to be currently leaning on the moderately dovish side of neutral. Short-term interest rate markets also feel the same way, with -19ps of easing over the next twelve months priced into the GBP OIS curve according to our BoE Discounter (Chart 5). What the BoE seems most focused on: The BoE has been paying a lot of attention to indicators of UK business sentiment, which had been negatively impacted by both Brexit uncertainty and global trade tensions in 2019. The BoE has focused on the link from depressed business sentiment to weak investment spending and anemic productivity growth as an important reason why UK potential GDP growth has been so low and why UK inflation expectations have been relatively high. What the BoE should be more focused on: We agree that business sentiment should be the BoE’s greatest area of focus. Sentiment has shown a solid improvement of late, after the signing of the “phase one” US-China trade deal in December and the formal exit of the UK from the EU on January 31. The CBI Business Optimism survey (measuring the net balance of optimists versus pessimists) soared from -44 in October to +23 in January – the biggest quarterly jump ever recorded in the series. It remains to be seen if this improvement in confidence can be sustained and begin to arrest the steady decline in UK capital spending and productivity growth, and the associated surge in unit labor costs and inflation expectations, that has taken place since the 2016 Brexit vote. Bottom Line: The BoE’s next move, under the new leadership of incoming Governor Andrew Bailey, is not clear. Inflation expectations remain elevated but the recovery in business sentiment is still fragile. One potential risk to watch: UK Prime Minister Boris Johnson may choose to take a bolder stand on trade negotiations with the EU after his resounding election victory in December, risking an outcome closer to the “no-deal Brexit” scenario that was most feared by UK businesses. Bank Of Japan Chart 6Bank of Japan: Focus On Exports & The Yen Bank of Japan: Focus On Exports & The Yen Bank of Japan: Focus On Exports & The Yen The Bank of Japan (BoJ) seems to have had a perpetually dovish bias since the 1990s. Yet the current group of policymakers under Governor Haruhiko Kuroda, realizing that they have run out of realistic policy options after years of extreme stimulus, has not been signaling that fresh easing measures are on the horizon, even with economic growth and inflation remaining very weak in Japan. Markets have taken the hint, with only -6bps of rate cuts over the next twelve months priced into the JPY OIS curve according to our BoJ Discounter (Chart 6). What the BoJ seems most focused on: The BoJ has been vocally concerned about the recent slump in Japanese consumer spending, which declined -2.9% (in real terms) in Q4 after the sales tax hike last October. That blow to consumption was expected, but could not have come at a worse time for a central bank that was already worried about plunging Japanese manufacturing activity and exports – the latter declining by -8% in nominal terms as of December 2019. There is little hope for a near-term rebound given the certain hit to global growth and export demand from virus-stricken China. What the BoJ should be more focused on: Given that Japan is still an economy with a large manufacturing sector that is levered to global growth, the BoJ should remain focused on the path for Japanese exports. A bigger risk, however, comes from the Japanese yen, which has remained very stable over the past year. It has proven very difficult to generate any rise in Japanese inflation without some yen weakness, and with headline CPI inflation now only at +0.2%, a burst of yen strength would likely tip Japan back into outright deflation. Bottom Line: The BoJ is now stuck in a very bad spot, with no real ability to provide a major monetary policy stimulus for the stagnant Japanese economy. At best, all the central bank could do is deliver a small interest rate cut and hope for a quick rebound in global manufacturing activity and/or some yen weakness to boost flagging inflation. Bank Of Canada Chart 7Bank of Canada: Focus On Housing & Capital Spending Bank of Canada: Focus On Housing & Capital Spending Bank of Canada: Focus On Housing & Capital Spending The Bank of Canada (BoC) surprised many observers by keeping policy on hold last year, even as central banks worldwide engaged in various forms of monetary easing to offset the effects of the global manufacturing downturn. The BoC’s recent messaging has been relatively neutral, in our view, although Governor Stephen Poloz has not completely dismissed the possibility of rate cuts in his speeches. The markets are strongly convinced that the BoC will need to belatedly join the global easing party, with -32bps of rate cuts now priced into the CAD OIS curve according to our BoC Discounter (Chart 7) What the BoC seems most focused on: The BoC remains highly concerned over the high level of Canadian household debt, especially given how Canadian consumer spending has been highly geared towards trends in house price inflation over the past few years. This is likely why the BoC has been reluctant to cut policy rates as “insurance” against the effects of a prolonged global growth slump, to avoid stoking a new Canadian housing bubble. Interestingly, the commentary from BoC officials has taken on a bit more dovish tone whenever USD/CAD has threatened to break down below 1.30, suggesting some fears of unwanted currency appreciation. What the BoC should be more focused: The BoC should continue to monitor developments in the Canadian housing market, given the implications for consumer spending and, potentially, financial stability if there is another boom in house prices. The central bank should also pay even greater attention than usual to the subdued level of oil prices, which has triggered a deep slump in the oil-rich Alberta province that has weighed on the overall level of Canadian business investment spending. Persistently soft oil prices would also force the BoC to continue resisting strength in the Canadian dollar. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Bottom Line: The BoC appears under no pressure to make any near-term interest rate adjustments, especially with realized inflation now sitting at the midpoint of the BoC’s 1-3% target band. It would likely take a breakdown in oil prices, or an outright decline in house prices, for the rate cut expectations currently discounted in the CAD OIS curve to come to fruition. Reserve Bank Of Australia Chart 8Reserve Bank Of Australia: Focus On Underemployment & Housing Reserve Bank Of Australia: Focus On Underemployment & Housing Reserve Bank Of Australia: Focus On Underemployment & Housing The Reserve Bank of Australia (RBA) has been very transparent over the past year, loudly signaling a dovish bias and following through with 75bps of rate cuts that took the Cash Rate to a record low of 0.75%. The latest messaging has been a bit more balanced, while still leaving the door to additional rate cuts if the economy worsens. Markets are expecting at least one more easing, with -24bps of rate cuts over the next twelve months priced into the AUD OIS curve, according to our RBA Discounter (Chart 8). What the RBA seems most focused on: The RBA’s main concerns have centered around the persistent undershoot of Australian inflation, with core inflation remaining below the central bank’s 2-3% target band since the beginning of 2016. The central bank has attributed this to persistent excess capacity in the Australian labor market, as evidenced by the elevated underemployment rate. The RBA is also paying close attention to the Australian housing market and its links to consumer spending, with house prices already responding positively to last year’s RBA rate cuts. The outlook for exports is also on the RBA radar, particularly after the recent surge that lifted the Australia trade balance into surplus but is now at risk from a plunge in Chinese demand. What the RBA should be more focused on: We agree that the labor market should be the main focus for the RBA, particularly the underemployment rate which is still high at 8.3%, signaling that core CPI inflation should remain subdued (bottom panel). We also see the RBA as potentially being more sanguine about the risks of a renewed upturn in the housing market than many observers expect, since that would provide a potential offset to a likely pullback in exports which are now a record 25% of GDP (middle panel). Bottom Line: The RBA still has a clear dovish bias, even though they are currently on hold to assess the impact of last year’s easing. RBA Governor Philip Lowe noted in a recent speech that more cuts may be necessary “if the unemployment rate deteriorates”, suggesting that the labor market is the main area of focus for the central bank. Reserve Bank Of New Zealand Chart 9Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation Reserve Bank Of New Zealand: Focus On The Terms Of Trade & Non-Tradeables Inflation The Reserve Bank of New Zealand (RBNZ) was one of the more dovish central banks in 2019, cutting the Cash Rate by 75bps to a record low of 1%. The overall tone of the central bank’s recent commentary remains cautious, but has taken on a more balanced tone. Markets are priced appropriately, with only -13bps of rate cuts over the next twelve months discounted in the NZD OIS curve according to our RBNZ Discounter (Chart 9). What the RBNZ seems most focused on: The latest messaging from the RBNZ has highlighted the downside risks to New Zealand from weak global growth, but those are now more manageable since the central bank estimates the economy is operating at full employment. In its latest Monetary Policy Statement (MPS), the RBNZ noted that the economy has been able to weather the weakness in global growth thanks to the positive terms of trade effect from elevated New Zealand export prices – a trend that the central bank expects will persist in 2020 even if external demand remains sluggish (middle panel). The central bank has also expressed some concern over the recent pickup in domestically-driven inflation measures, with core CPI inflation back above 2% (bottom panel). What the RBNZ should be more focused on: The RBNZ is right to focus on global growth, particularly given the coming demand shock from virus-stricken China. While the New Zealand dollar has always been a critical variable for the RBNZ in its policy decisions, the currency now takes on added importance given the central bank’s expectation that export prices and the terms of trade will remain elevated. If the latter turns out to be wrong, the RBNZ will be far more likely to take actions to ensure that the Kiwi dollar stays undervalued. Bottom Line: The RBNZ still has a dovish policy bias, but the hurdle to deliver additional rate cuts after last year’s easing seems a bit higher now. It would likely take a major downturn in global growth, combined with a decline in New Zealand export prices and some cooling of domestic inflation, to get the RBNZ to cut again in 2020. Investment Conclusions Based on our “whirlwind tour” of the major developed market central banks in this report, we can make the following conclusions regarding the expected path of interest rates, and bond yields, in these countries: There are no central banks with anything resembling a hawkish bias – not surprising in the current slow global growth environment with heightened uncertainty. The least dovish central banks are the BoC and the RBNZ, which are not signaling any urgency to cut rates. The most dovish central bank is the RBA, which is indicating a clear willingness to cut again if domestic growth deteriorates. The Fed and the BoE are somewhere in the middle of the “dovishness” spectrum, with both likely willing to ease policy but only under a specific set of circumstances. The ECB and BoJ are clearly boxed in having policy rates already below the zero bound, limiting their ability to ease further if needed. In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months.  Looking back at our Central Bank Discounters, the largest amount of rate cuts over the next year are now discounted in the US (-42bps), Canada (-32bps), Australia (-24bps) and the UK (-19bps). At the same time, the fewest cuts are priced in Japan (-6bps), the euro area (-7bps) and New Zealand (-13bps). In our view, the rate cut probabilities in the US and Canada seem a bit too aggressive, as we are not anticipating major growth slowdowns in either country over the next 6-12 months. The odds seem more “fair” in the other countries, in terms of the size of rate cut expectations versus the probability of those cuts actually being delivered because of domestic economic considerations. What does this all mean for global bond investing this year? For that we can turn to our Global Golden Rule framework, which links expected returns of government bonds versus cash to the difference between actual and expected rate cuts.1 US Treasuries and Canadian government bond yields are most at risk of underperforming their global peers in 2020 as the Fed and BoC disappoint the current dovish rate cut expectations discounted in interest rate markets.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Research Global Fixed Income Strategy Special Report, "The Global Golden Rule Of Bond Investing", dated September 25th 2018, available at gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index What Central Banks Are (Or Should Be) Watching What Central Banks Are (Or Should Be) Watching Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

In lieu of the next weekly report I will be presenting the quarterly webcast ‘What Are The Most Attractive Investments In Europe?’ on Monday 17 February at 10.00AM EST, 3.00PM GMT, 4.00PM CET, 11.00PM HKT. As usual, the webcast will take a TED talk format lasting 18 minutes, after which I will take live questions. Be sure to tune in. Dhaval Joshi Feature The recent coronavirus scare seems to have added a fresh deflationary impulse into the world economy, at a time that central banks are already struggling to achieve and maintain inflation at the 2 percent target. Begging the question: will central banks’ ubiquitous ultra-loose monetary policy ever generate inflation? The answer is yes, but not necessarily where the central banks desire it. Universal QE, zero interest rate policy (ZIRP), and negative interest rate policy (NIRP) have already created rampant inflation. The trouble is that it is in the wrong place. Rather than showing up in consumer price indexes it is showing up in sky-rocketing asset prices. Feature Chart Ultra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Feature ChartUltra-Low Bond Yields Have Created The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Since 2014, ultra-loose monetary policy has boosted the valuation of equities by 50 percent. But that’s the small fry. The really big story is that ultra-loose monetary policy has boosted the value of the world’s real estate from $180 trillion to $300 trillion (Chart I-2).1 Chart I-2Ultra-Low Bond Yields Have Boosted The Value Of The World’s Real Estate By $120 Trillion Ultra-Low Bond Yields Have Boosted The Value Of The World's Real Estate By $120 Trillion Ultra-Low Bond Yields Have Boosted The Value Of The World's Real Estate By $120 Trillion Just pause for a moment to digest those numbers. In the space of a few years the value of the world’s real estate has surged by $120 trillion, equivalent to one and half times the world’s $80 trillion GDP. Moreover, it is a broad-based boom encompassing not just Europe, but North America and Asia too. Now add in the surge in equity prices, as well as other risk-assets such as private equity, corporate bonds and EM debt and the rise in wealth conservatively equals at least two times world GDP. To the best of our knowledge, there is no other time in economic history that asset prices have risen so broadly and by so much as a multiple of world GDP in such a short space of time. Making this the greatest asset-price inflation of all time. Yet central banks seem unmoved. To add insult to injury, Europe’s central banks do not even include surging owner-occupied housing costs in their consumer price indexes. This seems absurd given that the costs of maintaining owner-occupied housing is one of the largest costs that European households face. Europe’s central banks do not include surging owner-occupied housing costs in their consumer price indexes. Including owner-occupied housing costs would lift European inflation closer to 2 percent, eliminating the need for QE and negative interest rates. But its omission has kept measured inflation artificially low (Chart I-3), forcing European central banks to double down on their ultra-loose policies. Which in turn lifts risk-asset prices even further, and so the cycle of asset-price inflation continues. Chart I-3Using The US Definition Of Inflation, The ECB Wouldn't Need Ultra-Loose Policy Using The US Definition Of Inflation, The ECB Wouldn't Need Ultra-Loose Policy Using The US Definition Of Inflation, The ECB Wouldn't Need Ultra-Loose Policy European QE has spawned other major imbalances. Germany, as the largest shareholder of the ECB, now owns hundreds of billions of ‘Italian euro’ BTPs that the ECB has bought. But given the fragility of Italian banks, the Italians who sold their BTPs to the ECB deposited the cash they received in German banks. Hence, Italy now owns hundreds of billions of ‘German euro’ bank deposits. This mismatch between Germans owning Italian euro assets and Italians owning German euro assets combined with other mismatches across the euro area constitutes the Target2 banking imbalance, which now stands at a record €1.5 trillion. It means that, were the euro to ever break up, the biggest casualty would be Germany (Chart I-4). Chart I-4ECB QE Has Taken The Target2 Banking Imbalance To An All-Time High The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Meanwhile, the US Federal Reserve, to its credit, does include surging owner-occupied housing costs in its measure of consumer prices. As a result, US inflation has been closer to the 2 percent target enabling the Fed to tighten policy when the ECB had to loosen policy. This huge divergence between euro area and US monetary policies, stemming from different treatments of owner-occupied housing costs, has depressed the euro/dollar exchange rate and thereby spawned yet another major imbalance: the euro area/US bilateral trade surplus which now stands at an all-time high. Providing President Trump with the perfect pretext to start a trade war with Europe, should he desire (Chart I-5).  Chart I-5ECB QE Has Taken The Euro Area/US Trade Surplus To An All-Time High ECB QE Has Taken The Euro Area/US Trade Surplus To An All-Time High ECB QE Has Taken The Euro Area/US Trade Surplus To An All-Time High What Caused The Greatest Asset-Price Inflation Of All Time? Why did the past decade witness the greatest asset-price inflation of all time? The answer is that universal QE, ZIRP, and NIRP took bond yields to the twilight zone of the lower bound (Chart I-6). At which point, the valuation of all risky assets undergoes an exponential surge. Chart I-6The Past Decade Was The Decade Of Universal QE The Past Decade Was The Decade Of Universal QE The Past Decade Was The Decade Of Universal QE Understand that when bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic. As holders of Swiss government bonds discovered last year, prices can no longer rise much in a rally, but they can collapse in a sell-off (Chart I-7). Chart I-7At Low Bond Yields, Bonds Become Much Riskier The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The upshot is that all (long-duration) assets become equally risky, and the much higher prospective returns offered on formerly more risky assets – such as real estate and equities – collapses to the feeble return offered on now equally-risky bonds. Given that valuation is just the inverse of the prospective return, this means that the valuation of risk assets undergoes an exponential surge. When bond yields approach their lower bound, bonds become extremely risky assets because their prices take on an unattractive ‘lose-lose’ characteristic.  An obvious question is: which valuation measure best predicts this depressed prospective return offered on equities? Most people gravitate to price to earnings (profits), but earnings are highly problematic – because even if you cyclically adjust them, they take no account of structurally high profit margins. The trouble is that earnings will face a headwind when profit margins normalise, depressing prospective returns. For this reason, price to earnings missed the valuation extreme of the 2007/2008 credit bubble and should be treated with extreme caution as a predictor of prospective returns (Chart I-8). Chart I-8Price To Earnings Missed The 2007/2008 Valuation Extreme Price To Earnings Missed The 2007/2008 Valuation Extreme Price To Earnings Missed The 2007/2008 Valuation Extreme A much more credible assessment comes from price to sales – or equivalently, market cap to GDP at a global level (Chart I-9). This is because sales are quantifiable, unambiguous, and undistorted by profit margins. Using these more credible prospective returns, we can now show that the theory of what should happen to risk-asset returns (and valuations) at ultra-low bond yields and the practice of what has actually happened agree almost perfectly (Feature Chart). Chart I-9Price To Sales (Or Global Market Cap To GDP) Is The Best Predictor Of Prospective Return Price To Sales (Or Global Market Cap To GDP) Is The Best Predictor Of Prospective Return Price To Sales (Or Global Market Cap To GDP) Is The Best Predictor Of Prospective Return Some Investment Conclusions It is instinctive for investors to focus first and foremost on the outlook for the real economy. After all, the evolution of the $80 trillion global economy drives company sales and profits. But the value of the world’s real estate, at $300 trillion, dwarfs the economy. Public and private equity adds another $100 trillion, while other risk-assets such as corporate bonds and EM debt add at least another $50 trillion. So even on conservative assumptions, risk-assets are worth $450 trillion – an order of magnitude larger than the world economy. Now combine this with the overwhelming evidence that risk-asset valuations are exponentially sensitive to ultra-low bond yields. A relatively modest rise in yields that knocked 20 percent off risk-asset valuations would mean a $90 trillion loss in global wealth. Even a 10 percent decline would equate to a $45 trillion drawdown. Could the $80 trillion economy sail through such declines in wealth? No way. Such setbacks would constitute a severe deflationary headwind, and likely trigger the next recession. Hence, though equities are preferable to bonds at current levels, a 50-100 bps rise in yields – were it to happen – would be a great opportunity to add to bonds. Meanwhile, the record high Target2 euro area banking imbalance means that the biggest casualty of the euro’s disintegration would not be Italy. It would be Germany. As all parties have no interest in such a mutually assured destruction, investors should go long high-yielding versus low-yielding euro area sovereign bonds. Finally, the record high euro area/US trade surplus is a political constraint to a much weaker euro versus the dollar. In any case, the ECB is close to the practical limit of monetary policy easing, while the Fed is not. Long-term bond investors should prefer US T-bonds versus German bunds or Swiss bonds. Long-term currency investors should prefer the euro versus the dollar. Fractal Trading System*  This week’s recommended trade is long EUR/CHF. As this currency cross has relatively low volatility, the profit target and symmetrical stop-loss is set at a modest 1 percent. In other trades, short NZD/JPY achieved its profit target, while long US oil and gas versus telecom reached the end of its 65-day holding period in partial loss having reached neither its profit target nor its stop-loss. The rolling 1-year win ratio now stands at 61 percent. Chart I-10EUR/CHF EUR/CHF EUR/CHF 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. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Source: Savills World Research. The last data point is $281 trillion at the end of 2017, but we conservatively estimate that the value has increased to above $300 trillion in the subsequent two years. Fractal Trading System The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time Cyclical Recommendations Structural Recommendations The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time The Greatest Asset-Price Inflation Of All Time 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 China’s economic rebound in Q1 will be delayed due to the coronavirus, which will have a larger negative hit than SARS. New stimulus measures will assist a rebound in demand later this year. Europe remains a geopolitical opportunity rather than a risk. As long as global growth rebounds this year, European equities can outperform their richly valued American counterparts. Emerging markets face a new headwind from the coronavirus. Emerging market performance relative to developed markets will be a key test of whether endogenous growth trends are taking shape. Tactically – over a 12-month horizon – we remain long industrial commodities; long Korean equities versus Taiwanese; and long Malaysian equities relative to emerging markets. Feature Global equities will ultimately push through the coronavirus and the Democratic Party primary election, but risks are elevated and Q1 looks to bring significant volatility. Last week we shifted to a tactically neutral stance on risk assets but we remain cyclically bullish. In this report we update our market-based GeoRisk indicators, which are almost all set to rise from low levels in the coming months as developed market equities and emerging market currencies face higher risk premiums. China: The Year Of The Rat Chart 1Markets Will Rebound Once Toll Of Virus Peaks Markets Will Rebound Once Toll Of Virus Peaks Markets Will Rebound Once Toll Of Virus Peaks The ink had hardly dried on our “Black Swan” report for 2020 when Chinese scientists confirmed human-to-human transmission of the Wuhan coronavirus (2019-nCoV), sending a wave of fear over China and the world. The number of new cases and new deaths is rising and economic activity will suffer as the Chinese New Year is extended, shoppers stay home, and international travel is canceled. The virus is likely to prove more troublesome than stock investors want to admit, at least in the short term. Too little is known to make confident assertions about promptly containing the virus or its impact on global economy and markets. The analogy with the SARS outbreak of 2003 is limited: it is not certain that this virus has a lower death rate, but it is certain that the Chinese economy is more vulnerable to disruption today than at that time – and much more influential on the global economy. The SARS episode is useful, however, in suggesting that the market will not rebound until the number of new cases and deaths turn down (Chart 1). Assuming the virus is ultimately contained – both in China and in neighboring Asian countries whose governments may not be as effective at quarantining the problem – regional consumption and production will bounce back. New stimulus measures will also take effect with a lag. Domestic political risk is structurally understated in China. Stimulus will indeed be the answer. First, the negative shock to consumer demand comes at a time when global trade is still relatively weak, thus presenting a two-pronged threat to China’s economy, which was only just stabilizing after the truce in the trade war. Second, China’s hundredth anniversary of the Communist Party, in 2021, will require the government to stabilize the economy now. The important political leadership reshuffle at the twentieth National Party Congress in 2022 is another imperative to avoid a deepening slump today (Chart 2). Chart 2China Will Stimulate To Avoid A Deepening Slump China Will Stimulate To Avoid A Deepening Slump China Will Stimulate To Avoid A Deepening Slump Beyond 2020, the Wuhan virus highlights our theme that domestic political risk is structurally understated in China. At the centennial celebration, China’s leaders aim to show that the country is a “moderately prosperous society in all respects,” emphasis added. For decades China’s leaders have emphasized industrial production to the detriment of other social and economic goals, such as food safety and a clean and safe environment for households to live in. The emergence of the middle class, writ broadly, as a majority of the population is a persistent source of pressure on leaders, as the limited opinion polling available from China demonstrates (Chart 3). In other emerging markets, a large middle class has led to social and political change when the government failed to meet growing middle class demands (Chart 4). Chart 3Chinese Social And Economic Conditions Are Source Of Pressure GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Chart 4Consumerism Encourages Democracy Consumerism Encourages Democracy Consumerism Encourages Democracy Chart 5China’s Government Is Behind The Curve GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Under General Secretary Xi Jinping, the government has cracked down on corruption and pollution as well as poverty, and has attempted to improve consumer safety and the health care system. The party officially aims to shift its policy focus from meeting the basic material needs of the population to improving quality of life. The problem is that China’s government is behind the curve (Chart 5). While it is making rapid progress – for instance, the communicable disease burden has dropped dramatically – and has unique authoritarian tools, acute problems of health, food safety, pollution, and public services will nevertheless persist. The government’s responses will inevitably fall short from time to time and heads will roll. Crisis events create the potential for the market to be surprised by the level of domestic political change or pushback, which will prove disruptive at times. Bottom Line: China’s economic rebound in Q1 will be delayed due to the coronavirus, which will have a larger negative hit than SARS. The SARS episode suggests that Chinese equities will be a tactical buy when the number of new cases and deaths begin falling. New stimulus measures will assist a rebound in demand later this year – underscoring our constructive cyclical view on Chinese and global growth. The episode highlights the challenges China faces in modernizing and improving regulations, health, and safety for the emerging middle class. Domestic political risk is understated. Europe: Political Risks Still Contained China’s near-term hit, and rebound later this year, will echo in Europe, where the economy and equity market are highly reliant on China’s credit cycle and import demand. Politically, however, Europe remains a geopolitical opportunity rather than a risk (Chart 6). Chart 6China's Hit Will Echo In Europe, But Political Risks Are Contained There GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat The final months of last year saw the biggest and most immediate political risk – a disorderly UK exit from the EU – removed. The Trump administration is not likely to slap large-scale tariffs – such as auto tariffs on a national security pretext – because Trump is constrained by the weak manufacturing sector in advance of his election. Meanwhile immigration and terrorism have declined since 2016, draining the fuel of Europe’s anti-establishment parties. Pound weakness during the Brexit transition period is an opportunity for investors to buy. Chart 7Immigration Is Ticking Up, But From Low Levels Immigration Is Ticking Up, But From Low Levels Immigration Is Ticking Up, But From Low Levels Chart 8Refugees Will Favor Western Route Across The Mediterranean Refugees Will Favor Western Route Across The Mediterranean Refugees Will Favor Western Route Across The Mediterranean Chart 9Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk Government Gridlock, Catalonia, And Poor Reform Momentum Will Pull Up Spanish Risk There are some signs of immigration numbers ticking up, but from very low levels (Chart 7). This uptick must be monitored for Spain (and France), as the renewed civil war in Libya is forcing refugees to shift to the western route across the Mediterranean (Chart 8). (Note that even peace in Libya opens the possibility of greater migrant flows as the country then becomes a viable transit route again). Our Spanish risk indicator is already ticking up due to government gridlock, the Catalonian conflict, and a declining commitment to structural economic reform (Chart 9). But this is not a major concern for global investors. The United Kingdom The UK will formally exit the European Union on January 31. The transition period – in which the UK remains fully integrated into the EU single market – expires on December 31, 2020. This is the official deadline for the two sides to negotiate a trade agreement – though it can, and likely will, be delayed. Chart 10British Political Risk Will Revive, But Not Dramatically British Political Risk Will Revive, But Not Dramatically British Political Risk Will Revive, But Not Dramatically The trade agreement is intended to minimize the negative economic impact of Brexit while ensuring that the UK reclaims its sovereignty and the EU retains the integrity of the single market. As negotiations get under way, the pound will face a new round of volatility and British political risk will revive somewhat, but we do not expect a dramatic increase (Chart 10). Ultimately we see pound weakness as an opportunity for investors to buy. The twin risks of no-deal Brexit or a socialist Jeremy Corbyn government have been decisively cast off. The end-of-year deadline can be extended and the two sides can find technical ways to compromise over regulations, tariffs, and border checks. Challenges to global growth only make an amicable solution more obtainable. Italy Our Italian GeoRisk indicator is collapsing as political risks proved yet again to be overstated (Chart 11). Chart 11Italian GeoRisk Indicator Is Collapsing Italian GeoRisk Indicator Is Collapsing Italian GeoRisk Indicator Is Collapsing The local election in Emilia-Romagna was hyped as a major populist risk, in which the chief anti-establishment players, Matteo Salvini and the League, would take power in a region viewed as the symbolic home of the Italian left wing. Instead, the League lost, the ruling Democratic Party won, and the current government coalition will survive. While the populists prevailed at another election in Calabria, this outcome was fully expected. The trend of recent provincial elections does not suggest a swell of Italian populism (Chart 12). Chart 12Recent Local Elections Do Not Suggest A Swell Of Italian Populism GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Chart 13The Italian Coalition Will Not Rush To Elections The Italian Coalition Will Not Rush To Elections The Italian Coalition Will Not Rush To Elections This local election is not the end of the coalition’s troubles. The left-wing, anti-establishment Five Star Movement is suffering in the polls as a result of its uninspiring, politically expedient pairing with the establishment Democrats. The Democrats may receive a boost from Emilia-Romagna but the Five Star’s leadership change – the resignation of party leader Luigi di Maio – will not be enough to revive its fortunes alone. A new Five Star leader will have to decide whether to collaborate more deeply with the Democrats or try to reclaim the party’s anti-establishment credentials. The latter would push the coalition toward an election before too long. But the Five Star’s weak polling – and the League’s persistent 10 percentage point lead over the Democratic Party in nationwide polling – suggests that the coalition will not rush to elections but will try to prepare by passing a new electoral law (Chart 13). What is clear is that the Five Star Movement will not court elections until they improve their polling. France In France, Emmanuel Macron and his ruling En Marche party have seen their popularity drop to new lows amid the historic labor strikes in opposition to Macron’s pension reforms (Chart 14). Macron’s current trajectory is dangerously close to that of his predecessor, Francois Hollande, and threatens to turn him into a lame duck. We doubt this is the case. Chart 14Macron’s Popularity Is On A Dangerous Trajectory GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat Diagram 1The ‘J-Curve’ Of Structural Reform GeoRisk Update: The Year Of The Rat GeoRisk Update: The Year Of The Rat We view Macron’s decline as another example of the “J-Curve of Structural Reform,” in which a leader’s political capital drops amid controversial reforms (Diagram 1). If the leader avoids an election during the trough of the curve, the danger zone, then his or her political capital may well revive after the benefits of the structural reform are recognized. In this case, the reform is neutral for France’s budget deficit – a cyclical positive – but it encourages an improvement in pension sustainability by incentivizing workers to work longer and postpone retirement – a structural positive. Chart 15France's Economy Is Holding Up France's Economy Is Holding Up France's Economy Is Holding Up Chart 16A Relatively Strong Economy Will Buffer Against Political Risk In France A Relatively Strong Economy Will Buffer Against Political Risk In France A Relatively Strong Economy Will Buffer Against Political Risk In France Municipal elections in March will not go Macron’s way, but the presidential and legislative elections are not until 2022. France’s GDP growth is holding up better than that of its neighbors, wages are rising, and confidence did not collapse amid the Christmas labor strike (Chart 15). Hence we expect the increase in political risk to be manageable (Chart 16), a boon for French equities. Germany German political risk is set to rise from today’s depths (Chart 17). The country faces a major shift: globalization is structurally declining and Chancellor Angela Merkel is stepping down. Merkel’s heir-apparent, Annegret Kramp-Karrenbauer (AKK), is floundering in the opinion polls (Chart 18). Chart 17German Political Risk Will Rise German Political Risk Will Rise German Political Risk Will Rise Chart 18Merkel's Heir-Apparent Is Floundering In The Opinion Polls Merkel's Heir-Apparent Is Floundering In The Opinion Polls Merkel's Heir-Apparent Is Floundering In The Opinion Polls Thus intra-party struggle, and conceivably even a rare early election, could emerge. But the US-China trade ceasefire offers a temporary reprieve. Next year will be different, with elections looming in the fall and the potential for a Trump reelection to trigger a second round of the US-China trade war or to shift to trade war with the EU and tariffs on German cars. The overall political trend in Germany is centrist and pro-Europe, and most of the parties are becoming more willing to upgrade fiscal policy over time. South Korea’s economic problems are priced in, while the market is dismissing Taiwan’s immense political risk. Bottom Line: The US election cycle is the chief source of policy risk and geopolitical risk in 2020, a stark contrast with the EU. European political risk will spike with a full-fledged recession, but for now it is contained. In fact the risks are largely to the upside in the short term as the countries turn slightly more fiscally accommodative. As long as global growth rebounds this year, European equities can outperform their richly valued American counterparts. Emerging Markets: Can They Outperform? With volatility likely in the near-term, Arthur Budaghyan of BCA Research’s Emerging Markets Strategy argues that the key test for emerging markets equities is whether they outperform their developed market counterparts. If they do not, then it suggests that investors still do not see endogenous growth, capital spending and profitability in emerging markets and therefore that they will lag their DM counterparts in the eventual equity upswing. Our long Korea / short Taiwan trade exploded out of the gate but has since fallen back in the face of the new headwind from the coronavirus. We have a high conviction in this trade because the difference in equity valuations faces a looming catalyst in the market’s mispricing of relative geopolitical risk: South Korea’s risk indicator is in a broad upswing while Taiwan’s has collapsed, despite the persistence of the diplomatic track with North Korea and Taiwan’s resounding reelection of both a pro-independence president and legislature (Chart 19). Mainland China will send both risk indicators upward in the near term, but South Korea’s economic problems are priced in and Trump’s diplomacy with North Korea is grounded in well-established constraints on Washington, Beijing, Pyongyang, and Seoul. By contrast the market is entirely dismissing Taiwan’s immense political risk, which does not depend on the outcome of the US election. In the coming 1-3 years, Beijing, Taipei, and Washington are all more likely to take self-interested actions that test the constraints in the Taiwan Strait, upsetting the market, before those constraints are reconfirmed (assuming they are). Beijing is likely to impose economic sanctions as Taipei’s demand for greater freedom and alliance with the US will agitate Chinese leaders who will seek to get the Kuomintang back into power. Brazilian political risk has failed to reach new highs, as anticipated, suggesting that President Jair Bolsonaro’s many problems are not driving investors to sell the real amid underlying indications of rebounding global growth and at least attempts at pro-market reform (Chart 20). Chart 19Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Markets Are Mispricing Geopolitical Risks In South Korea And Taiwan Chart 20Political Risks Remain Contained In Brazil Political Risks Remain Contained In Brazil Political Risks Remain Contained In Brazil Turkey’s military intervention into Libya’s civil war is another example of the foreign adventurism that we see as an outgrowth of populism and the need to distract the public’s attention from domestic mismanagement. We expect the risk indicator to rise or be flat and would remain short Turkish currency and risk assets. Bottom Line: Emerging markets face a new headwind from the coronavirus. Not only will China’s growth rebound sputter but Asian EMs will be exposed to the virus and may be less capable than China of dealing with it rapidly and effectively. With volatility looming, emerging market performance relative to developed markets will be a key test of whether endogenous growth trends are taking shape. Investment Conclusions Tactically we are closing our long GBP/JPY trade and UK curve steepener for negligible gains. We are also closing our long Egyptian sovereign bond trade for a gain of 5.59%. We remain long industrial commodities; long Korean equities versus Taiwanese; and long Malaysian equities relative to emerging markets. We expect these trades to perform well over a 12-month horizon. Strategically several of our recommendations will benefit from heightened volatility in the near term but face challenges later in the year as growth rebounds and risk sentiment revives. Nevertheless our time horizon is three-to-five years. In that span we remain long gold, long euro, long defense, short US tech, and short CNY-USD.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Section III: Geopolitical Calendar

Highlights The liquidity-driven rally will soon be followed by an acceleration in global growth. The economic recovery will bump up expectations of long-term profit growth. The dollar has downside, but the euro will not benefit much. Overweight stocks relative to bonds and bet on traditional cyclical sectors and commodities. The potential for outperformance of value relative to growth favors European equities. The probability of a tech mania is escalating: how should investors factor an expanding bubble into their portfolios? Feature Chart I-1A Bull Market In Stocks And Volatility? A Bull Market In Stocks And Volatility? A Bull Market In Stocks And Volatility? Despite all odds, the nCoV-2019 outbreak is barely denting the S&P 500’s frenetic rally. Plentiful liquidity, thawing Sino-US trade relations and improving economic activity in Asia, all have created ideal conditions for risk assets to appreciate on a cyclical basis. Stocks may look increasingly expensive and are primed to correct, but the bubble will expand further. After lifting asset valuations, monetary policy easing will soon boost worldwide economic activity. Consequently, earnings in the US and Europe will improve. As long as central bankers remain unconcerned about inflation, investors will bid up stocks. Investors should remember we are in the final innings of a bull market. Stocks can deliver outsized returns during this period, but often at the cost of elevated volatility, and the options market is not pricing in this uncertainty (Chart I-1). Moreover, timing the ultimate end of the bubble is extremely difficult. Hence, we prefer to look for assets that can still benefit from easy monetary conditions and rebounding growth, but are not as expensive as equities. Industrial commodities fit that description, especially after their recent selloff. The dollar remains a crucial asset to gauge the path of least resistance for assets. If it refuses to swoon, then it will indicate that global growth is in a weaker state than we foresaw. The good news is that the broad trade-weighted dollar seems to have peaked. Accommodative Monetary Conditions Are Here To Stay Easy liquidity has been the lifeblood of the S&P 500’s rally. The surge in the index coincided with the lagged impact of the rise in our US Financial Liquidity Index (Chart I-2). Low rates have allowed stocks to climb higher, yet earnings expectations remain muted. For example, since November 26, 2018, the forward P/E ratio for the S&P 500 has increased from 15.2 to 18.7, while 10-year Treasury yields have collapsed from 3.1% to 1.6%. Meanwhile, expectations for long-term earnings annual growth extracted from equity multiples using a discounted cash flow model have dropped from 2.4% to 1.2%. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Historically, easier monetary policy pushes asset prices higher before it lifts economic activity. Yet, stocks and risk assets normally continue to climb when the economy recovers. Even without any additional monetary easing, as long as policy remains accommodative, risk assets will generate positive returns. Expectations for stronger cash flow growth become the force driving asset prices higher. Policy will likely remain accommodative around the world. Within this framework, peak monetary easing is probably behind us, even though liquidity conditions remain extremely accommodative. Nominal interest rates remain very low, and real bond yields are still falling. Unlike in 2018 and 2019, dropping TIPs yields reflect rising inflation expectations (Chart I-3). Those factors together indicate that policy is reflationary, which is confirmed by the gold rally. Chart I-2A Liquidity Driven Rally A Liquidity Driven Rally A Liquidity Driven Rally Chart I-3Today, Lower TIPS Yields Are Reflationary Today, Lower TIPS Yields Are Reflationary Today, Lower TIPS Yields Are Reflationary   Chart I-4Economic Activity To Respond To Liquidity Economic Activity To Respond To Liquidity Economic Activity To Respond To Liquidity Based on the historical lags between monetary easing and manufacturing activity, the global industrial sector is set to mend (Chart I-4). Moreover, the liquidity-driven surge in stock prices, combined with low yields and compressed credit spreads, has eased financial conditions, which creates the catalyst for an industrial recovery. Where will the growth come from? First, worldwide inventory levels have collapsed after making negative contributions to growth since mid-2018 (Chart I-5). Thus, there is room for an inventory restocking. Secondly, auto sales in Europe and China have rebounded to 18.5% from -23% and to -0.1% from -16.4%, respectively. Thirdly, China’s credit and fiscal impulse has improved. The uptick in Chinese iron ore imports indicates that the pass-through from domestic reflation to global economic activity will materialize soon (Chart I-6). Finally, following the Phase One Sino-US trade deal, global business confidence is bottoming, as exemplified by Belgium’s business confidence, Switzerland KOF LEI, Korea's manufacturing business survey, or US CFO and CEO confidence measures. The increase in EM earnings revisions shows that US capex intentions should soon re-accelerate, which bodes well for investment both in the US and globally (Chart I-7). Chart I-5Room For Inventory Restocking Room For Inventory Restocking Room For Inventory Restocking Chart I-6China Points To Stronger Global Growth China Points To Stronger Global Growth China Points To Stronger Global Growth   Construction activity, a gauge of the monetary stance, is looking up across the advanced economies. In the US, housing starts – a leading indicator of domestic demand – have hit a 13-year high. A pullback in this volatile data series is likely, but it should be limited. Vacancies remain at a paltry 1.4%, household formation is solid and affordability is not demanding (Chart I-8). In Europe, construction activity has been relatively stable through the economic slowdown. Even in Canada and Australia, housing transactions have gathered steam quickly following declines in mortgage rates (Chart I-9). Chart I-7Capex Is Set To Recover Capex Is Set To Recover Capex Is Set To Recover Chart I-8US Housing Is Robust US Housing Is Robust US Housing Is Robust Chart I-9Even The Canadian And Australian Housing Markets Are Stabilizing Even The Canadian And Australian Housing Markets Are Stabilizing Even The Canadian And Australian Housing Markets Are Stabilizing Consumers will remain a source of strength for the global economy. The dichotomy between weak manufacturing PMIs and the stable service sector reflects a healthy consumer spending. December retail sales in Europe and the US corroborate this assessment. The stabilization in US business confidence suggests that household incomes are not in as much jeopardy as three months ago. As household net worth and credit growth improve further, a stable outlook for household income will underwrite greater gains in consumption. Policy will likely remain accommodative around the world. For the time being, US inflationary pressures are muted. The New York Fed’s Underlying Inflation Gauge has rolled over, hourly earnings growth has moved back below 3%, our pipeline inflation indicator derived from the ISM is weak, and core producer prices are flagging (Chart I-10). This trend is not US-specific. In the OECD, core consumer price inflation is set to decelerate due to the lagged impact of the manufacturing slowdown. Central banks are also constrained to remain dovish by their own rhetoric. The Fed's statement this week was a testament to this reality. Central banks are increasingly looking to set symmetrical inflation targets. After a decade of missing their targets, a symmetric target would imply keeping policy easier for longer, even if realized inflation moves back above 2%. A rebound in global growth and weak inflation should create a poisonous environment for the US dollar. Finally, fiscal policy will make a small positive contribution to growth in most major advanced economies in 2020, particularly in Germany and the UK (Table I-1). Chart I-10Limited Inflation Will Allow The Fed To Remain Easy Limited Inflation Will Allow The Fed To Remain Easy Limited Inflation Will Allow The Fed To Remain Easy Table I-1Modest Fiscal Easing In 2020 February 2020 February 2020   The Dollar And The Sino-US Phase One Deal At first glance, a rebound in global growth and weak inflation should create a poisonous environment for the US dollar (Chart I-11). As we have often argued, the dollar’s defining characteristic is its pronounced counter-cyclicality. Chart I-11A Painful Backdrop For The Greenback February 2020 February 2020 Deteriorating dollar fundamentals make this risk particularly relevant. US interest rates are well above those in the rest of the G10, but the gap in short rates has significantly narrowed. Historically, the direction of rates differentials and not their levels has determined the trend in the USD (Chart I-12). Moreover, real differentials at the long end of the curve support the notion that the maximum tailwinds for the dollar are behind us (Chart I-12, bottom panel). Furthermore, now that the US Treasury has replenished its accounts at the Federal Reserve, the Fed’s addition of excess reserves in the system will likely become increasingly negative for the dollar, especially against EM currencies. Likewise, relative money supply trends between the US, Europe, Japan and China already predict a decline in the dollar (Chart I-13). Chart I-12Interest Rate Differentials Do Not Favor The Dollar... Interest Rate Differentials Do Not Favor The Dollar... Interest Rate Differentials Do Not Favor The Dollar... Chart I-13...Neither Do Money Supply Trends ...Neither Do Money Supply Trends ...Neither Do Money Supply Trends   Chart I-14The Phase One Deal Is Ambitious February 2020 February 2020 The recent Sino-US trade agreement obscures what appears to be a straightforward picture. According to the Phase One deal signed mid-January, China will increase its US imports by $200 billion in the next two years vis-à-vis the high-water mark of $186 billion reached in 2017. This is an extremely ambitious goal (Chart I-14). Politically, it is positive that China has committed to buy manufactured goods and services in addition to commodities. However, the scale of the increase in imports of US manufactured goods is large, at $77 billion. China cannot fulfill this obligation if domestic growth merely stabilizes or picks up just a little, especially now that the domestic economy is in the midst of a spreading illness. It will have to substitute some of its European and Japanese imports with US goods. A consequence of this trade deal is that the euro’s gains will probably lag those recorded in normal business cycle upswings. Historically, European growth outperforms the US when China’s monetary conditions are easing and its marginal propensity to consume is rising (Chart I-15). However, given the potential for China to substitute European goods in favor of US ones, China’s economic reacceleration probably will not benefit Europe as much as it normally does. China may not ultimately follow through with as big of US purchases as it has promised, but it is likely, at least initially, to show good faith in the agreement. The euro’s gains will probably lag those recorded in normal business cycle upswings. While the trade agreement is a headwind for the euro, it is a positive for the Chinese yuan. The US output gap stands at 0.1% of potential GDP and the US labor market is near full employment. The US industrial sector does not possess the required spare capacity to fulfill additional Chinese demand. To equilibrate the market for US goods, prices will have to adjust to become more favorable for Chinese purchasers. The simplest mechanism to achieve this outcome is for the RMB to appreciate. Meanwhile, the euro is trading 16% below its equilibrium, which will allow European producers to fulfill US domestic demand. A widening US trade deficit with Europe would undo improvements in the trade balance with China. The probability that US equities correct further in the short-term is elevated. The implication for the dollar is that the broad trade-weighted USD will likely outperform the Dollar Index (DXY). The euro represents 18.9% of the broad trade-weighted dollar versus 57.6% of the DXY. Asian currencies, EM currencies at large, the AUD and the NZD, all should benefit from their close correlation with the RMB (Chart I-16). Chart I-15Europe Normally Wins When China Recovers Europe Normally Wins When China Recovers Europe Normally Wins When China Recovers Chart I-16EM, Asian, And Antipodean Exchange Rates Love A Strong RMB EM, Asian, And Antipodean Exchange Rates Love A Strong RMB EM, Asian, And Antipodean Exchange Rates Love A Strong RMB   Obviously, before the RMB and the assets linked to it can appreciate further, the panic surrounding the coronavirus will have to dissipate. However, the economic damage created by SARS was short lived. This respiratory syndrome resulted in a 2.4% contraction Hong-Kong’s GDP in the second quarter of 2003. The economy of Hong Kong recovered that loss quickly afterward. Investment Forecasts BCA continues to forecast upside in safe-haven yields. Global interest rates remain well below equilibrium and a global economic recovery bodes poorly for bond prices (Chart I-17). However, inflation expectations and not real yields will drive nominal yield changes. The dovish slant of global central banks and the growing likelihood that symmetric inflation targets will become the norm is creating long-term upside risks for inflation. Moreover, if symmetric inflation targets imply lower real short rates in the future, then they also imply lower real long rates today. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Easy monetary conditions, decreased real rates and an improvement in economic activity are also consistent with an outperformance of assets with higher yields. High-yield bonds, which offer attractive breakeven spreads, will benefit from this backdrop (Chart I-18). Furthermore, carry trades will likely continue to perform well. In addition to low interest rates across most of the G10, the low currency volatility caused by an extended period of easy policy will continue to encourage carry-seeking strategies. Chart I-17Bonds Are Still Expensive Bonds Are Still Expensive Bonds Are Still Expensive Chart I-18Where Is The Value In Credit? Where Is The Value In Credit? Where Is The Value In Credit?   An environment in which growth is accelerating and monetary policy is accommodative argues in favor of stocks. Our profit growth model for the S&P 500 has finally moved back into positive territory. As earnings improve, investors will likely re-rate depressed long-term growth expectations for cash flows (Chart I-19). The flip side is that equity risk premia are elevated, especially outside the US (Chart I-19). Hence, as long as accelerating growth (but not tighter policy) drives up yields, equities should withstand rising borrowing costs. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. The 400 point surge in the S&P 500 since early October complicates the picture. The probability that US equities correct further in the short-term is elevated, based on their short-term momentum and sentiment measures, such as the put/call ratio (Chart I-20). Foreign equities will continue to correct along US ones, even if they are cheaper. Chart I-19Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Elevated Stock Multiples Reflect Low Yields, Not Growth Exuberance Chart I-20Tactical Risks For Stocks Tactical Risks For Stocks Tactical Risks For Stocks   Chart I-21Buy Commodities/Sell Stocks? Buy Commodities / Sell Stocks? Buy Commodities / Sell Stocks? The coronavirus panic seems to be the catalyst for such a correction. When a market is overextended, any shock can cause a pullback in prices. Moreover, as of writing, medical professionals still have to ascertain the virus’s severity and potential mutations. Therefore, risk assets must embed a significant risk premium for such uncertainty, even if ultimately the infection turns out to be mild. However, that risk premium will likely prove to be short lived. During the SARS crisis in 2003, stocks bottomed when the number of reported new cases peaked. The tech sector has plentiful downside if the correction gathers strength. As indicated in BCA’s US Equity Sector Strategy, Apple, Microsoft, Google, Amazon and Facebook account for 18% of the US market capitalization, which is the highest market concentration since the late 1990s tech bubble. Investors should begin switching their risk assets into industrial commodity plays, especially after their recent selloff. Commodity prices are trading at a large discount to US equities. Moreover, the momentum of natural resource prices relative to stocks has begun to form a positive divergence with the price ratio of these two assets (Chart I-21). Technical divergences such as the one visible in the ratio of commodities to equities are often positive signals. Low real rates, an ample liquidity backdrop, a global economic recovery, a weak broad trade-weighted dollar and a strong RMB, all benefit commodities over equities. Tech stocks underperform commodities when the dollar weakens and growth strengthens. Moreover, our positive stance on the RMB justifies stronger prices for copper, oil and EM equities (Chart I-22). Chart I-22The Winners From A CNY Rebound February 2020 February 2020 Our US Equity Strategy Service has also reiterated its preference for industrials and energy stocks, and it recently upgraded materials stocks to neutral.1 All three sectors trade at significant valuation discounts to the broad market and to tech stocks in particular. They are also oversold in relative terms. Finally, their operating metrics are improving, a trend which will be magnified if global growth re-accelerates. Do not make these bets aggressively. A weakening broad trade-weighted dollar would allow for a rotation into foreign equities and an outperformance of value relative to growth stocks. The share of US equities in the MSCI All-Country World Index is a direct function of the broad trade-weighted dollar (Chart I-23). Moreover, since 1971, the dollar and the relative performance of growth stocks versus value stocks have exhibited a positive correlation (Chart I-24). Thus, the dollar’s recent strength has been a key component behind the run enjoyed by tech stocks. Chart I-23Global Stocks Love A Soft Dollar Global Stocks Love A Soft Dollar Global Stocks Love A Soft Dollar Chart I-24Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Value Stocks Needs A Weaker Dollar To Outperform Growth Stocks Despite the risks to the euro discussed in the previous section, European equities could still outperform US equities. Such a move would be consistent with value stocks beating growth equities (Chart I-24, bottom panel). This correlation exists because the euro area has a combined 17.7% weighting to tech and healthcare stocks compared with a 37.1% allocation in US benchmarks. Moreover, a cheap euro should allow European industrials and materials to outperform their US counterparts. Finally, the recent uptick in the European credit impulse indicates that an acceleration in European profit growth is imminent, a view that is in line with our preference for European financials (Chart I-25).2 Chart I-25Euro Area Profits Should Improve Euro Area Profits Should Improve Euro Area Profits Should Improve Bottom Line: The current environment remains favorable for risk assets on a 12-month investment horizon. As such, we expect stocks and bond yields to continue to rise in 2020. Moreover, a pick-up in global growth, along with a fall in the broad trade-weighted dollar, should weigh on tech and growth stocks, and boost the attractiveness of commodity plays, industrial, energy and materials stocks, as well as European and EM equities. Forecast Meets Strategy Liquidity-driven rallies, such as the current one, can carry on regardless of the fundamentals. As Keynes noted 90 years ago: “Markets can remain irrational longer than you can stay solvent.” The gap between forecast and strategy can be great. The use of passive investing and the prevalence of “closet indexers” accentuates the risk that a tech mania could blossom. We assign a substantial 30% probability to the risk of another tech mania. Outflows from equity ETFs and mutual funds have been large. Investors will be tempted to move back into those vehicles if stocks continue to rally on the back of plentiful liquidity and improving global growth (Chart I-26). In the process, the new inflows will prop up the over-represented, over-valued, and over-extended tech behemoths. Chart I-26Depressed Equity Flows Should Pick Up Depressed Equity Flows Should Pick Up Depressed Equity Flows Should Pick Up The current tech bubble can easily run a lot further. Based on current valuations, the NASDAQ trades at a P/E ratio of 31 compared with 68 in March 2000 (Chart I-27). Moreover, momentum is becoming increasingly favorable for the NASDAQ and other high-flying tech stocks. The NASDAQ is outperforming high-dividend stocks and after a period of consolidation, its relative performance is breaking out. Momentum often performs very well in liquidity-driven rallies. Chart I-27Where Is The Bubble? Where Is The Bubble? Where Is The Bubble? Chart I-28Debt Loads Are Already High Everywhere Debt Loads Are Already High Everywhere Debt Loads Are Already High Everywhere A full-fledged tech mania would make our overweight equities / underweight bonds a profitable call, but it would invalidate our sector and regional recommendations. Moreover, with a few exceptions in China and Taiwan, the major tech bellwethers are listed in the US. A tech bubble would most likely push our bearish dollar stance to the offside. Bubbles are dangerous: participating on the upside is easy, but cashing out is not. Moreover, financial bubbles tend to exacerbate the economic pain that follows the bust. During manic phases, capital is poorly invested and the economy becomes geared to the sectors that benefit from the financial excesses. These assets lose their value when the bubble deflates. Moreover, bubbles often result in growing private-sector indebtedness. Writing off or paying back this debt saps the economy’s vitality. Making matters worse, today overall indebtedness is unprecedented and central banks have little room to reflate the global economy once the bubble bursts (Chart I-28). Finally, US/Iran tensions will create additional risk in the years ahead. Matt Gertken, BCA’s Geopolitical Strategist, warns that the ratcheting down of tensions following Iran’s retaliation to General Soleimani’s assassination is temporary.3 As a result, the oil market remains a source of left-handed tail-risk. Section II discusses other potential black swans lurking in the geopolitical sphere. We continue to recommend that investors overweight industrials and energy, upgrade materials to neutral, Europe to overweight, and curtail their USD exposure as long as US inflation remains well behaved and the US inflation breakeven rate stays below the 2.3% to 2.5% range. However, do not make these bets aggressively. Moreover, some downside protection is merited. Due to our very negative view on bonds, we prefer garnering these hedges via a 15% allocation to gold and the yen. The yen is especially attractive because it is one of the few cheap, safe-haven plays (Chart I-29). Chart I-29The Yen Offers Cheap Portfolio Protection The Yen Offers Cheap Portfolio Protection The Yen Offers Cheap Portfolio Protection Mathieu Savary Vice President The Bank Credit Analyst January 30, 2020 Next Report: February 27, 2020   II. Five Black Swans In 2020 Our top five geopolitical “Black Swans” are risks that the market is seriously underpricing. With the “phase one” trade deal signed, Chinese policy could become less accommodative, resulting in a negative economic surprise. The trade deal may fall victim to domestic politics, raising the risk of a US-China military skirmish. A Biden victory at the Democratic National Convention or a Democratic takeover of the White House could trigger social unrest and violence in the US. A pickup in the flow of migrants to Europe would fundamentally undermine political stability there. Russia’s weak economy will add fuel to domestic unrest, risking an escalation beyond the point of containment. Over the past four years, BCA’s Geopolitical Strategy service has started off each year with their top five geopolitical “Black Swans.” These are low-probability events whose market impact would be significant enough to matter for global investors. Unlike the great Byron Wien’s perennial list of market surprises, we do not assign these events a “better than 50% likelihood of happening.” We offer risks that the market is seriously underpricing by assigning them only single-digit probabilities when we think the reality is closer to 10%-15%, a level at which a risk premium ought to be assigned. Some of our risks below are so obscure that it is not clear how exactly to price them. We exclude issues that are fairly probable, such as flare-ups in Indo-Pakistani conflict. The two major risks of the year – discussed in our Geopolitical Strategy’s annual outlook – are that either US President Donald Trump or Chinese President Xi Jinping overreaches in a major way. But what would truly surprise the market would be a policy-induced relapse in Chinese growth or a direct military clash between the two great powers. That is how we begin. Other risks stem from domestic affairs in the US, Europe, and Russia. Black Swan 1: China’s Financial Crisis Begins Chart II-1A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail A Crackdown On Financial Risk Could Cause China's Economy To Derail The risk of Xi Jinping’s concentration of power in his own person is that individuals can easily make mistakes, especially if unchecked by advisors or institutions. Lower officials will fear correcting or admonishing an all-powerful leader. Inconvenient information may not be relayed up the hierarchy. Such behavior was rampant in Chairman Mao Zedong’s time, leading to famine among other ills. Insofar as President Xi’s cult of personality successfully imitates Mao’s, it will be subject to similar errors. If President Xi overreaches and makes a policy mistake this year, it could occur in economic policy or other policies. We begin with economic policy, as we have charted the risks of Xi’s crackdown on the financial system since early 2017 (Chart II-1). This year is supposed to be the third and final year of Xi Jinping’s “three battles” against systemic risk, pollution, and poverty. The first battle actually focuses on financial risk, i.e. China’s money and credit bubble. The regime has compromised on this goal since mid-2018, allowing monetary easing to stabilize the economy amid the trade war. But with a “phase one” trade deal having been signed, there is an underrated risk that economic policy will return to its prior setting, i.e. become less accommodative (Chart II-2). When Xi launched the “deleveraging campaign” in 2017, we posited that the authorities would be willing to tolerate an annual GDP growth rate below 6%. This would not only cull excesses in the economy but also demonstrate that the administration means business when it says that China must prioritize quality rather than quantity of growth. While Chinese authorities are most likely targeting “around 6%” in 2020, it is entirely possible that the authorities will allow an undershoot in the 5.5%-5.9% range. They will argue that the GDP target for 2020 has already been met on a compound growth rate basis (Chart II-3), as astute clients have pointed out. They may see less need for stimulus than the market expects. Chart II-2Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Easing Of Trade Tensions May Re-Incentivize Tighter Policy Chart II-3Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020 Chinese Authorities Might Tolerate A Growth Undershoot In 2020   Similarly, while urban disposable income is ostensibly lagging its target of doubling 2010 levels by 2020, China’s 13th Five Year Plan, which concludes in 2020, conspicuously avoided treating urban and rural income targets separately. If the authorities focus only on general disposable income, then they are on track to meet their target (Chart II-4). This would reduce the impetus for greater economic support. The Xi administration may aim only for stability, not acceleration, in the economy. There are already tentative signs that Chinese authorities are “satisfied” with the amount of stimulus they have injected: some indicators of money and credit have already peaked (Chart II-5). The crackdown on shadow banking has eased, but informal lending is still contracting. The regime is still pushing reforms that shake up state-owned enterprises. Chart II-4Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Lower Impetus For Economic Support Due To Improvements In National Income? Chart II-5Has China's Stimulus Peaked? chart 5 Has China's Stimulus Peaked? Has China's Stimulus Peaked?   An added headwind for the Chinese economy stems from the currency. The currency should track interest rate differentials. Beijing’s incremental monetary stimulus, in the form of cuts to bank reserve requirement ratios (RRRs), should also push the renminbi down over time (Chart II-6). However, an essential aspect of any trade deal with the Trump administration is the need to demonstrate that China is not competitively devaluing. Hence the CNY-USD could overshoot in the first half of the year. This is positive for global exports to China, but it tightens Chinese financial conditions at home. A stronger than otherwise justified renminbi would add to any negative economic surprises from less accommodative monetary and fiscal policy. Conventional wisdom says China will stimulate the economy ahead of two major political events: the centenary of the Communist Party in 2021 and the twentieth National Party Congress in 2022. The former is a highly symbolic anniversary, as Xi has reasserted the supremacy of the party in all things, while the latter is more significant for policy, as it is a leadership reshuffle that will usher in the sixth generation of China’s political elite. But conventional wisdom may be wrong – the Xi administration may aim only for stability, not acceleration, in the economy. It would make sense to save dry powder for the next US or global recession. The obvious implication is that China’s economic rebound may lose steam as early as H2 – but the black swan risk is that negative surprises could cause a vicious spiral inside of China. This is a country with massive financial and economic imbalances, a declining potential growth profile, and persistent political obstacles to growth both at home and abroad. Corporate defaults have spiked sharply. While the default rate is lower than elsewhere, the market may be sniffing out a bigger problem as it charges a much higher premium for onshore Chinese bonds (Chart II-7). Chart II-6CNY/USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions CNY-USD Overshoot Would Tighten Chinese Financial Conditions Chart II-7Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem? Is China's Bond Market Sniffing Out A Problem?   Bottom Line: Our view is that China’s authorities will remain accommodative in 2020 in order to ensure that growth bottoms and the labor market continues to improve. But Beijing has compromised its domestic economic discipline since 2018 in order to fight trade war. The risk now, with a “phase one” deal in hand, is that Xi Jinping returns to his three-year battle plan and underestimates the downward pressures on the economy. The result would be a huge negative surprise for the Chinese and global economy in 2020. Black Swan 2: The US And China Go To War In 2013, we predicted that US-China conflict was “more likely than you think.” This was not just an argument for trade conflict or general enmity that raises the temperature in the Asia-Pacific region – we included military conflict. At the time, the notion that a Sino-American armed conflict was the world’s greatest geopolitical threat seemed ludicrous to many of our clients. We published this analysis in October of that year, months after the Islamic State “Soldier’s Harvest” offensive into Iraq. Trying to direct investors to the budding rivalry between American and Chinese naval forces in the South China Sea amidst the Islamic State hysteria was challenging, to say the least. Chart II-8Americans’ Attitudes Toward China Plunged… February 2020 February 2020 The suggestion that an accidental skirmish between the US and China could descend into a full-blown conflict involved a stretch of the imagination because China was not yet perceived by the American public as a major threat. In 2014, only 19%of the US public saw China as the “greatest threat to the US in the future.” This came between Russia, at 23%, and Iran, at 16%. Today, China and Russia share the top spot with 24%. Furthermore, the share of Americans with an unfavorable view of China has increased from 52% to 60% in the six intervening years (Chart II-8). The level of enmity expressed by the US public toward China is still lower than that toward the Soviet Union at the onset of the Cold War in the 1950s (Chart II-9). However, the trajectory of distrust is clearly mounting. We expect this trend to continue: anti-China sentiment is one of the few sources of bipartisan agreement remaining in Washington, DC (Chart II-10). Chinese sentiment toward the United States has also darkened dramatically. The geopolitical rivalry is deepening for structural reasons: as China advances in size and sophistication, it seeks to alter the regional status quo in its favor, while the US grows fearful and seeks to contain China. Chart II-9…But Not Yet To War-Inducing Levels February 2020 February 2020 Chart II-10Distrust Of China Is Bipartisan February 2020 February 2020   Chart II-11Newfound American Concern For China’s Repression February 2020 February 2020 One example of rising enmity is the US public’s newfound concern for China’s domestic policies and human rights, specifically Beijing’s treatment of its Uyghur minority in Xinjiang. A Google Trends analysis of the term “Uyghur” or “Uyghur camps” shows a dramatic rise in mentions since Q2 of 2018, around the same time the trade war ramped up in a major way (Chart II-11). While startling revelations of re-education camps in Xinjiang emerged in recent years, the reality is that Beijing has used heavy-handed tactics against both militant groups and the wider Uyghur minority since at least 2008 – and much earlier than that. As such, the surge of interest by the general American public and legislators – culminating in the Uyghur Human Rights Policy Act of 2019 – is a product of the renewed strategic tension between the two countries. The same can be said for Hong Kong: the US did not pass a Hong Kong Human Rights and Democracy Act in 2014, during the first round of mass protests, which prompted Beijing to take heavy-handed legal, legislative, and censorship actions. It passed the bill in 2019, after the climate in Washington had changed. Why does this matter for investors? There are two general risks that come with a greater public engagement in foreign policy. First, the “phase one” trade deal between China and the US could fall victim to domestic politics. This deal envisions a large step up in Sino-American economic cooperation. But if China is to import around $200 billion of additional US goods and services over the next two years – an almost inconceivable figure – the US and China will have to tamp down on public vitriol. This is notably the case if the Democratic Party takes over the White House, given its likely greater focus on liberal concerns such as human rights. And yet the latest bills became law under President Trump and a Republican Senate, and we fully expect a second Trump term to involve a re-escalation of trade tensions to ensure compliance with phase one and to try to gain greater structural concessions in phase two. Second, mounting nationalist sentiment will make it more difficult for US and Chinese policymakers to reduce tensions following a potential future military skirmish, accidental or otherwise. While our scenario of a military conflict in 2013 was cogent, the public backlash in the United States was probably manageable.3 Today we can no longer guarantee that this is the case. The “phase one” trade deal risks falling victim to domestic politics due to greater public engagement in foreign policy. China has greater control over the domestic narrative and public discourse, but the rise of the middle class and the government’s efforts to rebuild support for the single-party regime have combined to create an increase in nationalism. Thus it is also more difficult for Chinese policymakers to contain the popular backlash if conflict erupts. In short, the probability of a quick tamping down of public enmity is actively being reduced as American public vilification of China is closing the gap with China’s burgeoning nationalism at an alarming pace. Another of our black swan risks – Taiwan island – is inextricably bound up in this dangerous US-China dynamic. To be clear, Washington will tread carefully, as a conflict over Taiwan could become a major war. Nevertheless Taiwan’s election, as we expected, has injected new vitality into this already underrated geopolitical risk. It is not only that a high-turnout election (Chart II-12) gave President Tsai Ing-wen a greater mandate (Chart II-13), or that her Democratic Progressive Party retained its legislative majority (Chart II-14). It is not only that the trigger for this resounding victory was the revolt in Hong Kong and the Taiwanese people’s rejection of the “one country, two systems” formula for Taiwan. It is also that Tsai followed up with a repudiation of the mainland by declaring, “We don’t have a need to declare ourselves an independent state. We are an independent country already and we call ourselves the Republic of China, Taiwan.” Chart II-12Tsai Ing-Wen Enjoys A Greater Mandate On Higher Turnout… February 2020 February 2020 Chart II-13…Popular Support… February 2020 February 2020 Chart II-14…And A Legislative Majority February 2020 February 2020 This statement is not a minor rhetorical flourish but will be received as a major provocation in Beijing: the crystallization of a long-brewing clash between Beijing and Taipei. Additional punitive economic measures against Taiwan are now guaranteed. Saber-rattling could easily ignite in the coming year and beyond. Taiwan is the epicenter of the US-China strategic conflict. First, Beijing cannot compromise on its security or its political legitimacy and considers the “one China principle” to be inviolable. Second, the US maintains defense relations with Taiwan (and is in the process of delivering on a relatively large new package of arms). Third, the US’s true willingness to fight a war on Taiwan’s behalf is in doubt, which means that deterrence has eroded and there is greater room for miscalculation. Bottom Line: A US-China military skirmish has been our biggest black swan risk since we began writing the BCA Geopolitical Strategy. The difference between then and now, however, is that the American public is actually paying attention. Political ideology – the question of democracy and human rights – is clearly merging with trade, security, and other differences to provoke Americans of all stripes. This makes any skirmish more than just a temporary risk-off event, as it could lead to a string of incidents or even protracted military conflict. Black Swan 3: Social Unrest Erupts In America There are numerous lessons that one can learn from the ongoing unrest in Hong Kong, but perhaps the most cogent one is that Millennials and Generation Z are not as docile and feckless as their elders think. Images of university students and even teenagers throwing flying kicks and Molotov cocktails while clad in black body armor have shocked the world. Perhaps all those violent video games did have a lasting impact on the youth! What is surprising is that so few commentators have made the cognitive leap from the ultra-first world streets of Hong Kong to other developed economies. Perhaps what is clouding analysts’ minds is the idiosyncratic nature of the dispute in Hong Kong, the “one China” angle. However, Hong Kong youth are confronted with similar socio-economic challenges that their peers in other advanced economies face: overpriced real estate and a bifurcated service-sector labor market with few mid-tier jobs that pay a decent wage. There is a risk of rebellion from Trump’s most ardent supporters if he loses the White House. In the US, Millennials and Gen Z are also facing challenges unique to the US. First, their debt burden is much more toxic than that of the older cohorts, given that it is made up of student loans and credit card debt (Chart II-15). Second, they find themselves at odds – demographically and ideologically – with the older cohorts (Chart II-16). Chart II-15Younger American Cohorts Plagued By Toxic Debt February 2020 February 2020 Chart II-16Younger And Older Cohorts At Odds Demographically February 2020 February 2020   Chart II-17Massive Turnout To The 2016 Referendum On Trump February 2020 February 2020 The adage that the youth are apolitical and do not turn out to vote may have ended thanks to President Trump. The 2018 midterm election, which the Democratic Party successfully turned into a referendum on the president, saw the youth (18-29) turnout nearly double from 20% to 36% (the 30-44 year-old cohort also saw a jump in turnout from 35.6% to 48.8%). The election saw one of the highest turnouts in recent memory, with a 53.4% figure, just two points off the 2016 general election figure (Chart II-17). Despite the high turnout in 2018, the-most-definitely-not-Millennial Vice President Joe Biden continues to lead the Democratic Party in the polls. His probability of winning the nomination is not overwhelming, but it is the highest of any contender. In recent polls, Biden comes third place in Millennial/Gen-Z vote preferences (Chart II-18). Yet he is hardly out of contention, especially for the 30-44 year-old cohort. The view that “Uncle Joe” does not fit the Democratic Party zeitgeist has become so entrenched in the Democratic Party narrative that it became conventional wisdom last year, pulling oddsmakers and betting markets away from the clear frontrunner (Chart II-19). Chart II-18Biden Unpopular Among Young American Voters February 2020 February 2020 Chart II-19Bookies Pulled Down 'Uncle Joe’s' Odds, Capturing Democratic Party Zeitgeist February 2020 February 2020     As such, a Biden victory at the Democratic National Convention in Milwaukee, Wisconsin on July 13-16 may come as an affront to the left-wing activists who will surely descend on the convention. This will particularly be the case if Biden wins despite the progressive candidates amassing a majority of overall delegates, which is possible judging by the combined progressive vote share in current polling (Chart II-20). He would arrive in Milwaukee without clearing the 1990 delegate count required to win on the first ballot. On the second ballot, his presidency would then receive a boost from “superdelegates” and those progressives who are unwilling to “rock the boat,” i.e. unify against an establishment candidate with the largest share of votes. This is also how Mayor Michael Bloomberg could pull off a surprise win. Chart II-20Progressives Come Closest To Victory February 2020 February 2020 Such a “brokered” – or contested – convention has not occurred since 1952. However, several Democratic Party conventions came close, including 1968, 1972, and 1984. The 1968 one in Chicago was notable for considerable violence and unrest. Even if the Milwaukee Democratic Party convention does not produce unrest, it could sow the seeds for unrest later in the year. First, a breakout Biden performance in the primaries is unlikely. As such, he will likely need to pledge a shift to the left at the convention, including by accepting a progressive vice-presidential candidate. Second, an actual progressive may win the primary. Chart II-21Zealots In Both Parties Perceive Each Other As A National Threat February 2020 February 2020 It is likely that either of the two options would be seen as an existential threat to many of Trump’s loyal supporters across the United States. President Trump’s rhetoric often paints the scenario of a Democratic takeover of the White House in apocalyptic terms. And data suggests that the zealots in both parties perceive each other as a “threat to the nation’s wellbeing” (Chart II-21). The American Civil War in the nineteenth century began with the election of a president. This is not just because Abraham Lincoln was a particularly reviled figure in the South, but because the states that ultimately formed the Confederacy saw in his election the demographic writing-on-the-wall. The election was an expression of a general will that, from that point onwards, was irreversible. Given demographic trends in the US today, it is possible that many would see in Trump’s loss a similar fait accompli. If one perceives progressive Democrats as an existential threat to the US constitution, rebellion is the obvious and rational response. Bottom Line: Year 2020 may be a particularly violent one for the US. First, left wing activists may be shocked and angered to learn that Joe Biden (or Bloomberg) is the nominee of the Democratic Party come July. With so much hype behind the progressive candidates throughout the campaign, Biden’s nomination could be seen as an affront to what was supposed to be “the big year” for left-wing candidates. Second, investors have to start thinking about what happens if Biden – or a progressive candidate – goes on to defeat President Trump in the general election. While liberal America took Trump’s election badly, it has demographics – and thus time – on its side. Trump’s most ardent supporters may conclude that his defeat means the end of America as they know it. Black Swan 4: Europe’s Migration Crisis Restarts It is a testament to Europe’s resilience that we do not have a Black Swan scenario based on an election or a political crisis set on the continent in 2020. Support for the common currency and the EU as a whole has rebounded to its highest since 2013. Even early elections in Germany and Italy are unlikely to produce geopolitical risk. The populists in the former are in no danger of outperforming whereas the populists in the latter barely deserve the designation. But what if one of the reasons for the surge in populism – unchecked illegal immigration – were to return in 2020? Chart II-22Decline In Illegal Immigration Dampened European Populism February 2020 February 2020 The data suggests that the risk of migrant flows has massively subsided. From its peak of over a million arrivals in 2015, the data shows that only 125,472 migrants crossed into Europe via land and sea routes in the Mediterranean last year (Chart II-22). Why? There are five reasons that we believe have checked the flow of migrants: Supply: The civil wars in Syria, Iraq, and Libya have largely subsided. Heterogenous regions, cities, and neighborhoods have been ethnically cleansed and internal boundaries have largely ossified. It is unlikely that any future conflict will produce massive outflows of refugees as the displacement has already taken place. These countries are now largely divided into armed, ethnically homogenous, camps. Enforcement: The EU has stepped up border enforcement since 2015, pouring resources into the land border with Turkey and naval patrols across the Mediterranean. Individual member states – particularly Italy and Hungary – have also stepped up border enforcement policy. While most EU member states have publicly chided both for “draconian” policies, there is no impetus to force Rome and Budapest to change policy. Libyan Imbroglio: Conflict in Libya has flared up in 2019 with military warlord Khalifa Haftar looking to wrest control from the UN-backed Government of National Accord led by Fayez al-Serraj. The Islamic State has regrouped in the country as well. Ironically, the conflict is helping stem the flow of migrants as African migrants from sub-Saharan countries dare not cross into Libya as they did in 2015 when there was a brief lull in fighting. Turkish benevolence: Ankara is quick to point out that it is the only thing standing between Europe and a massive deluge of migrants. Turkey is said to host somewhere between two and four million refugees from various conflicts in the Middle East. Fear of the crossing: If crossing the Mediterranean was easy, Europe would have experienced a massive influx of migrants throughout the twentieth century. Not only is it not easy, it is costly and quite deadly, with thousands lost each year. Furthermore, most migrants are not welcomed when they arrive to Europe, many are held in terrible conditions in holding camps in Italy and Greece. Over time, migrants who made it into Europe have reported these dangers and conditions, reducing the overall demand for illegal migration. We do not foresee these five factors changing, at least not all at once. However, there are several reasons to worry about the flow of migrants in 2020. US-Iran tensions have sparked outright military action, while unrest is flaring up across Iran’s sphere of influence. Going forward, Iran could destabilize Iraq or fuel Shia unrest against US-backed regimes. Second, Afghanistan has been the source of most migrants to Europe via sea and land Mediterranean routes – 19.2%. The conflict in the country continues and may flare up with President Trump’s decision to formally withdraw most US troops from the country in 2020. Third, a break in fighting in Libya may encourage sub-Saharan migrants to revisit routes to Europe. Migrants from Guinea, Cote d’Ivoire, and the Democratic Republic of Congo make up over 10% of migrants to Europe. Finally, Turkish relationship with the West could break up further in 2020, causing Ankara to ship migrants northward. We highly doubt that President Erdogan will risk such a break, given that 50% of Turkish exports go to Europe. A European embargo on Turkish exports – which would be a highly likely response to such an act – would crush the already decimated Turkish economy. Bottom Line: While we do not see a return to the 2015 level of migration in 2020, we flag this risk because it would fundamentally undermine political stability in Europe. Black Swan 5: Russia Faces A “Peasant Revolt” Our fifth and final black swan risk for the year stems from Russia. This risk may seem obvious, since the US election creates a dynamic that revives the inherent conflict in US-Russian relations. Russia could seek to accomplish foreign policy objectives – interfering in US elections, punishing regional adversaries. The Trump administration may be friendly toward Russia but Trump is unlikely to veto any sanctions passed by the House and Senate in an election year, should an occasion for new sanctions arise. Conversely Russia could anticipate greater US pressure if the Democrats win in November. Yet it is Russia’s domestic affairs that represent the real underrated risk. Putin’s fourth term as president has been characterized by increased focus on domestic political control and stability as opposed to foreign adventurism. The creation of a special National Guard in 2016, reporting directly to Putin and responsible for quelling domestic unrest, symbolizes the shift in focus. So too does Russia’s adherence to the OPEC 2.0 regime of production control to keep oil prices above their budget breakeven level. Meanwhile Putin’s courting of Europe for the Nordstream II pipeline, and his slight peacemaking efforts with Ukraine, has suggested a slightly more restrained international posture. Strategically it makes little sense for Russia to court negative attention at a time when the US and Europe are at odds over trade and the Middle East, the US is preoccupied with China and Iran, and Russia itself faces mounting domestic problems. The domestic problems are long in coming. The central bank has maintained a stringent monetary policy for the better part of the decade. Despite cutting interest rates recently, monetary and credit conditions are still tight, hurting domestic demand. Moscow has also imposed fiscal austerity, namely by cutting back on state pensions and hiking the value added tax. Real wage growth is weak (Chart II-23), retail sales are falling, and domestic demand looks to weaken further, as Andrija Vesic of BCA Emerging Markets Strategy observes in a recent Special Report. The effect of Russia’s policy austerity has been a drop in public approval of the administration (Chart II-24). Protests erupted in 2019 but were largely drowned out by the larger and more globally significant protests in Hong Kong. These were met by police suppression that has not removed their underlying cause. Putin’s first major decision of the new year was to reshuffle the government, entailing Prime Minister Dmitri Medvedev’s transfer to a new post and the appointment of a new cabinet. This move reveals the need to show some accountability to reduce popular pressure. While Moscow now has room to cut interest rates and ease fiscal policy, it is behind the curve and the weak economy will add fuel to domestic unrest. Chart II-23Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Sluggish Wage Growth Threatens Russian Stability Chart II-24Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia Austerity Weighed On The Administration's Popularity In Russia   Meanwhile Putin’s efforts to alter the Russian constitution so he can stay in power beyond current term limits, effectively becoming emperor for life, like Xi Jinping, should not be dismissed merely because they are expected. They reflect a need to take advantage of Putin’s popular standing to consolidate domestic political power at a time when the ruling United Russia party and the federal government face discontent. They also ensure that strategic conflict with the United States will take on an ideological dimension. Russia's recent cabinet shakeup is positive from the point of view of economic reform. And the country's monetary and fiscal room provide a basis for remaining overweight equities within EM, as our Emerging Markets Strategy recommends. However, Russian equities have rallied hard and the political risk is understated. Chart II-25Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Russian Political Risk Is Unsustainably Low Bottom Line: It is never easy predicting Putin’s next international move. Our market-based indicators of Russian political risk have hit multi-year lows, but both the domestic and international context suggest that these lows will not be sustained (Chart II-25). A new bout of risk can emanate from Putin, or from changes in Washington, or from the Russian people themselves. What would take the world by surprise would be domestic unrest on a larger scale than Russia can easily suppress through the police force. Housekeeping We are closing our long European Union / short Chinese equities strategic trade with a 1.61% loss since inception on May 10, 2019. Dhaval Joshi of BCA’s European Investment Strategy downgraded the Eurostoxx 50 to underweight versus the S&P 500 and the Nikkei 225 this week. He makes the point that the Euro Area bond yield 6-month impulse hit 100 bps – a critical technical level – and will be a strong headwind to growth. We will look to reopen this trade at a later date when the euphoria over the “phase one” trade deal subsides, as we still favor European equities and DM bourses over EM. We will reinstitute our long Brent crude H2 2020 versus H2 2021 tactical position, which was stopped out on January 9, 2020. We remain bullish on oil fundamentals and expect Middle East instability to add a political risk premium. China's stimulus and the oil view also give reason for us to reinitiate our long Malaysian equities relative to EM as a tactical position. The Malaysian ringgit will benefit as oil prices move higher, helping Malaysian companies make payments on their large pile of dollar-denominated debt and improving household purchasing power. Higher oil prices also correlate with higher equity prices, while China's stimulus and the US trade ceasefire will push the US dollar lower and help trade revive in the region. Marko Papic Chief Strategist, Clocktower Group Matt Gertken Geopolitical Strategist   III. Indicators And Reference Charts The S&P 500 rally looks increasingly vulnerable from a tactical perspective. The US benchmark is overbought, and the percentage of NYSE stocks above their 30-week and 10-week moving averages is rolling over at elevated levels. Additionally, the number of NYSE new highs minus new lows has moved in a parabolic fashion and has hit levels that in previous years have warned of an imminent correction. The spread of nCoV-2019 is likely to be the catalyst to a pullback that could cause the S&P 500 to retest its October 2019 breakout. An improving outlook for global growth, limited inflationary pressures and global central banks who maintain an accommodative monetary stance bode well for stocks. Therefore, the anticipated equity correction will not morph into a bear market. For now, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator has strengthened. Additionally, our BCA Composite Valuation index suggests that stocks are expensive, but not so much as to cancel out the supportive monetary and technical backdrop. Finally, our Speculation Indicator is elevated, but is not so high as to warn of an imminent market top. This somewhat muted level of speculation is congruent with the expectation of low long-term growth rates for profits embedded in equity prices. In contrast to our Revealed Preference Indicator, our Willingness-to-Pay (WTP) is moving in accordance with our constructive cyclical stance for stocks. Indeed, the WTP for the US, Japan and Europe continues to improve. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. This broad-based improvement therefore bodes well for equities. Meanwhile, net earnings revisions appear to be forming a trough. 10-year Treasury yields remain extremely expensive. Moreover, according to our Composite Technical Indicator, T-Note prices are losing momentum. The fear surrounding the spread of the new coronavirus has cause bonds to rally again, but this is likely to be the last hurrah for the Treasury markets before a major reversal takes hold. The rising risk premia linked to the coronavirus is also helping the dollar right now, but signs that global growth is bottoming, such as the stabilization in the global PMIs, the pick-up in the German ZEW and Belgium’s Business Confidence surveys, or the improvement in Asia’s export growth, point to a worsening outlook for the counter-cyclical US dollar. Moreover, the dollar trades at a large premium of 24.5% relative to its purchasing-power parity equilibrium. Additionally, the negative divergence between the dollar and our Composite Momentum Indicator suggests that the dollar is technically vulnerable. In fact, the very modest pick-up in the dollar in response to the severe fears created by the spreading illness in China argues that dollar buying might have become exhausted. Finally, commodity prices have corrected meaningfully in response to the stronger dollar and the growth fears created by the spread of the coronavirus. However, they have not pulled back below the levels where they traded when they broke out in late 2019. Moreover, the advance/decline line of the Continuous Commodity Index remains at an elevated level, indicating underlying strength in the commodity complex. Natural resources prices will likely become the key beneficiaries of both the eventual pullback in virus-related fears and the weaker dollar.   EQUITIES: Chart III-1US Equity Indicators US Equity Indicators US Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3US Equity Sentiment Indicators US Equity Sentiment Indicators US Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5US Stock Market Valuation US Stock Market Valuation US Stock Market Valuation Chart III-6US Earnings US Earnings US 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-9US Treasurys And Valuations US Treasurys And Valuations US Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected US Bond Yields Selected US Bond Yields Selected US Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13US Corporate Bonds And Health Monitor US Corporate Bonds And Health Monitor US 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-16US Dollar And PPP US Dollar And PPP US Dollar And PPP Chart III-17US Dollar And Indicator US Dollar And Indicator US Dollar And Indicator Chart III-18US Dollar Fundamentals US Dollar Fundamentals US 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-28US And Global Macro Backdrop US And Global Macro Backdrop US And Global Macro Backdrop Chart III-29US Macro Snapshot US Macro Snapshot US Macro Snapshot Chart III-30US Growth Outlook US Growth Outlook US Growth Outlook Chart III-31US Cyclical Spending US Cyclical Spending US Cyclical Spending Chart III-32US Labor Market US Labor Market US Labor Market Chart III-33US Consumption US Consumption US Consumption Chart III-34US Housing US Housing US Housing Chart III-35US Debt And Deleveraging US Debt And Deleveraging US Debt And Deleveraging   Chart III-36US Financial Conditions US Financial Conditions US 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   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1 Please see US Equity Strategy Weekly Report "Three EPS Scenarios," dated January 13, 2020, available at uses.bcaresearch.com; US Equity Strategy Insight Report "Bombed Out Energy," dated January 8, 2020, available at uses.bcaresearch.com; US Equity Strategy Special Report "Industrials: Start Your Engines," dated January 21, 2020, available at uses.bcaresearch.com 2  Please see The Bank Credit Analyst Monthly Report "January 2020," dated December 20, 2019 available at bca.bcaresearch.com; The Bank Credit Analyst Monthly Report "OUTLOOK 2020: Heading Into The End Game," dated November 22, 2019 available at bca.bcaresearch.com 3 Please see Geopolitical Strategy "A Reprieve Amid The Bull Market In Iran Tensions," dated January 8, 2020, available at gps.bcaresearch.com 4 Observe how little attention the public paid to US-China saber-rattling around China’s announcement of an Air Defense Identification Zone in the East China Sea that year.

Highlights The coronavirus scare is the catalyst for the recent correction, not the cause. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. Bond yields will stay depressed for (at least) the first half of 2020. Long-term investors should use corrections to overweight equities versus bonds, provided bond yields stay near or below current levels. The pound and UK-exposed investments will come under near-term pressure as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy a major leg up later this year if both the UK and EU blink. Feature Chart of the WeekThe Next Up-Leg In The Pound And UK-Exposed Investments Will Occur Later In 2020 The Next Up-Leg In The Pound And UK-Exposed Investments Will Occur Later in 2020 The Next Up-Leg In The Pound And UK-Exposed Investments Will Occur Later in 2020 Corrections, Catalysts, And Coronavirus Markets have suffered a correction, begging the question: what caused it? The question is a good one, because identifying the cause can help to inform our response. Yet the danger is that the knee-jerk narrative pinpoints the catalyst rather than the true cause. In which case our response will be wrong too. For example, consider the following two narratives: Tree foliage collapses because of 40 mph winds. Tree foliage collapses because it is autumn. The first narrative is exciting, satisfying, and headline grabbing, but it only pinpoints the catalyst for the foliage collapse: the puff of wind. The second explanation is dull and less newsworthy, but it pinpoints the true cause: in autumn, tree foliage is unstable. Likewise, the coronavirus scare is the catalyst for the recent correction. The true cause is that the stock market had reached a point of groupthink-triggered instability and therefore needed the slightest catalyst to correct. The catalyst could have come from anywhere at any time. If it hadn’t been the coronavirus scare, it would have been the next worry… or the one after that. On January 9 in Markets Are Fractally Fragile we warned that usually cautious value investors had become momentum traders – undermining market liquidity and stability. When this happens, there is a two in three chance of a tactical reversal (Chart I-2). Chart I-2When Markets Are Fractally Fragile, There Is A 2 In 3 Chance Of A Tactical Reversal When Markets Are Fractally Fragile, There Is A 2 In 3 Chance Of A Tactical Reversal When Markets Are Fractally Fragile, There Is A 2 In 3 Chance Of A Tactical Reversal We also warned that the bond yield 6-month impulse – the change in the change – had recently become a severe 100 bps headwind to growth. At this severity of headwind, there is a nine in ten chance that bond yields have reached a near-term peak (Chart I-3). Chart I-3When The Bond Yield 6-Month Impulse Becomes A Severe Headwind, There Is A 9 In 10 Chance Of A Near-Term Peak In Yields When The Bond Yield 6-Month Impulse Becomes A Severe Headwind, There Is A 9 In 10 Chance Of A Near-Term Peak In Yields When The Bond Yield 6-Month Impulse Becomes A Severe Headwind, There Is A 9 In 10 Chance Of A Near-Term Peak In Yields In combination, we warned that equities would underperform bonds by about 4 percent on a tactical horizon. Now that this anticipated correction has happened, what next? Long-term investors should use corrections to overweight equities versus bonds.  First, irrespective of coronavirus – or any other catalyst – the recent severe headwind to growth from the bond yield impulse suggests that bond yields will stay depressed for (at least) the first half of 2020. Second, the good news is that the ultra-low bond yields justify and underpin the valuation of equities. Hence, at the current level of bond yields, long-term investors should use corrections to overweight equities versus bonds. Brexit Is “Done”. Or Is It? Rumour has it that Boris Johnson will banish the word Brexit from the UK government lexicon after January 31, because Brexit is now “done”. Good luck with that. When Britain wakes up bleary-eyed on Saturday February 1, what will have changed? Not a lot. The UK will have lost its voice and votes in the EU decision making institutions. Yet in practical terms nothing will have changed, because the UK and EU will enter an 11-month ‘standstill’ transition period in which existing arrangements will continue: the free movement of people, financial contributions, and full access to the single market without tariffs or customs checks. The Conservative government made a manifesto pledge not to extend the 11-month transition, so the more important question is: what will change when the standstill period ends on December 31? The answer depends on what sort of trade deal the UK and EU can negotiate in the limited space of 11 months. Or indeed whether they can negotiate a trade deal at all. Therein lies the problem. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’. If the UK wants to diverge on food standards, environmental protection, labour rights, and state aid – as the Brexit purists yearn – then there is zero chance that the EU will agree to a free trade deal.  This leaves two options, neither of which is appealing. The first is for the UK to end the 11-month standstill period without a trade deal. Technically, this would not be ‘no deal’ because the withdrawal agreement would still bind both sides on citizens’ rights, financial contributions, and arrangements for Northern Ireland. A free trade deal with the EU will require a mutual commitment to a ‘level playing field’.  However, for UK companies, the option of ending the standstill period without a trade deal would constitute a painful dislocation from the single market involving tariffs and customs checks. It would also hurt the EU economies most exposed to the UK, notably Ireland and the Netherlands. Moreover, a full customs and tariff border in the Irish Sea would endanger the very existence of a ‘United’ Kingdom which included Northern Ireland.   The second option is for the UK to accept a trade deal on EU terms, recognising that the EU is the larger and more economically powerful party in the negotiation. The EU will offer the UK a tariff-free and quota-free trade deal conditional on strict level playing field conditions where the UK chooses to diverge from EU standards, combined with a mechanism to adjudicate on any level playing field disputes. Though economically better than no trade deal at all, the Brexit purists would claim it isn’t Brexit. Meanwhile, even without tariffs and quotas, UK companies whose just-in-time supply chains depended on the EU would still suffer disruption, as the level playing field was policed at every border crossing. So this option would satisfy nobody in the UK. The bigger practical problem is a lack of time to leave the EU regulatory orbit smoothly. Nobody believes that eleven months is enough time to implement a system in Northern Ireland that prevent a hard border in the Irish Sea; or indeed to implement a new UK immigration system if free movement were to end at the end of 2020. So what’s the resolution? The answer is the same as it has always been for Brexit – a gradual ratcheting up of tension ahead of a hard deadline to focus minds and force progress. Followed by a ‘fudged resolution’ at the eleventh hour in which both sides blink – because neither side is prepared to go over the cliff-edge. Recall that to get the withdrawal agreement over the line, the UK blinked by allowing Northern Ireland to be treated differently; but the EU also blinked by allowing the withdrawal agreement to be reopened. And once this happened, the pound and UK-exposed investments enjoyed a major leg up (Chart I-1 and Chart I-4-Chart I-7). Chart I-4The FTSE 250 Is A UK-Exposed ##br##Investment The FTSE 250 Is A UK-Exposed Investment The FTSE 250 Is A UK-Exposed Investment Chart I-5The FTSE 100 Is Not A UK-Exposed Investment The FTSE 100 Is Not A UK-Exposed Investment The FTSE 100 Is Not A UK-Exposed Investment Chart I-6UK General Retail Is A UK-Exposed Investment UK General Retail Is A UK-Exposed Investment UK General Retail Is A UK-Exposed Investment Chart I-7UK Clothing And Accessories Is Not A ##br##UK-Exposed Investment UK Clothing And Accessories Is Not A UK-Exposed Investment UK Clothing And Accessories Is Not A UK-Exposed Investment In the next fudged resolution, the UK could blink by retaining full regulatory alignment with the EU in most areas for a little while longer, and where it doesn’t the EU could blink by becoming flexible in its interpretation of ‘level playing field’. Obviously, nobody would call this an extension to the transition, but the UK would, in most practical terms, still be in the single market on January 1 2021. UK-exposed investments will enjoy their next major leg up later this year In this playbook, the pound and UK-exposed investments will come under near-term pressure, as UK/EU trade deal tensions ratchet up. But ultimately, UK-exposed investments will enjoy their next major leg up later this year if both the UK and the EU blink (Chart I-8). Chart I-8The Pound Still Has A Brexit Discount The Pound Still Has A Brexit Discount The Pound Still Has A Brexit Discount Fractal Trading System* There are no new trades this week. The rolling 1-year win ratio now stands at 62 percent. Chart I-9EUR/GBP EUR/GBP EUR/GBP 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. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated   December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word   Cyclical Recommendations Structural Recommendations Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word Don't Mention The C-Word Or The B-Word 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