Gold

Add Shiny Metal Exposure Add Shiny Metal Exposure One way to benefit from the global growth soft-patch is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. Since our Monday inception three days ago, this pair trade is already up 9%. The relative moves in the underlying commodities that serve as pricing power proxies are the key drivers of this share price ratio (top panel). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Meanwhile, global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel). Bottom Line: We initiated a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Please refer to this Monday’s Weekly Report for additional details.    

Highlights Portfolio Strategy Recession odds continue to tick higher, according to the NY Fed’s probability of recession model, at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. The souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. The global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Recent Changes Upgrade the S&P hypermarkets index to overweight, today. Initiate a long global gold miners/short S&P oil & gas exploration & production (E&P) pair trade, today Table 1 Divorced From Reality Divorced From Reality Feature Obsession with the Fed easing continues to trump all else, with the SPX piercing through the 3,000 mark to fresh all-time highs last week. However, it is unrealistic for the Fed to do all the heavy lifting for the equity market as we have argued recently (see Chart 3 from June 24),1 at a time when profit cracks are spreading rapidly. This should be cause for some trepidation. Since the Christmas Eve lows essentially all of the 26% return in equities is explained by valuation expansion. The forward P/E has recovered from 13.5 to nearly 17.2 (Chart 1). There is limited scope for further expansion as four interest rate cuts in the coming 12 months are already priced in lofty valuations. Now profits will have to do the heavy lifting. But on the eve of earnings season, more than half of the S&P 500 GICS1 sectors are forecast to have contracted profits last quarter, and three sectors could not lift revenue versus year ago comps, according to I/B/E/S data. Looking further out, there is a plethora of indicators that we highlighted last week that suggest that a profit recession is looming.2 Our sense is that once the euphoria around the looming Fed easing cycle settles, there will be a massive clash between perception and reality (Chart 2) that will likely propagate as a surge in volatility. Chart 1Multiple Expansion Explains All Of The SPX’s Return Multiple Expansion Explains All Of The SPX’s Return Multiple Expansion Explains All Of The SPX’s Return Chart 2Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence This addiction to low rates has come at a great cost to the non-financial corporate sector. As a reminder, this segment of the economy is where the excesses are in the current cycle as we have been highlighting in recent research.3 Using stock market related data for the non-financial ex-tech universe, net debt has increased by 70% to $4.2tn over the past five years, but cash flow has only grown 18% to $1.7tn. As a result, net debt-to-EBITDA has spiked from 1.7 to 2.5, an all-time high (Chart 3). While stocks are at all-time highs (top panel, Chart 3), the debt-saddled non-financials ex-tech universe will likely exert substantial downward pressure to these equities in the coming months (Chart 4). Chart 3Balance Sheet Degrading Balance Sheet Degrading Balance Sheet Degrading Chart 4Something’s Got To Give Something’s Got To Give Something’s Got To Give Moving on to the labor market, we recently noticed an interesting behavior between the unemployment rate and wage inflation since the early-1990s recession: a repulsive magnet-type property exists where like magnetic poles repel each other (middle panel, Chart 5). In other words, every time the falling unemployment rate has kissed off accelerating wage growth, a steep reversal ensued at the onset of recession during the previous three cycles. A repeat may be already taking place, as average hourly earnings (AHE) growth has been stuck in the mud since peaking in December 2018. Importantly, the AHE impulse is quickly losing steam and every time the Fed embarks on an aggressive easing cycle it typically marks the end of wage inflation (bottom panel, Chart 5). Chart 5Beware Of Repulsion Beware Of Repulsion Beware Of Repulsion Chart 6Waiting For Growth Waiting For Growth Waiting For Growth Meanwhile, BCA’s global manufacturing PMI diffusion index has cratered to below 40% (middle panel, Chart 6). Neither the G7 nor the EM aggregate PMIs are above the boom/bust line (top panel, Chart 6). Our breakdown of the Leading Economic Indicators into G7 and EM14 also signals that global growth is hard to come by, albeit EMs are showing some early signs of a trough (bottom panel, Chart 6). As the early-May announced increase in Chinese tariffs begin to take a toll, we doubt global growth can have a sustainable recovery for the rest of 2019, despite Chinese credit growth picking up. Now, even Japan and Korea are fighting it out and are erecting barriers to trade, dealing a further blow to these economically hyper-sensitive export-oriented economies. Netting it all out, the odds of recession by mid-2020 continue to tick higher according to the NY Fed’s model (NY Fed’s probability of recession shown inverted, top panel, Chart 5) at a time when global growth is waning, U.S. profit growth is contracting and the non-financial ex-tech corporate balance sheet is degrading rapidly. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. This week we are upgrading a consumer staples subgroup to overweight and initiating an intra-commodity market neutral trade. Time To Buy The Hype The tide is shifting and we are upgrading the S&P hypermarkets index to an above benchmark allocation. While valuations are stretched, trading at a 50% premium to the overall market on a 12-month forward P/E basis (not shown), our thesis is that these Big Box retailers will grow into their pricey valuations in the coming months.  The macro landscape is aligned perfectly with these defensive retailers. Consumer confidence has been falling all year long and now cracks are spreading to the labor market (confidence shown inverted, top panel, Chart 7). ADP small business payrolls declined for the second month in a row. Similarly, the NFIB survey shows that small business hiring plans are cooling (hiring plans shown inverted, middle panel, Chart 7). As a reminder, 2/3 of all new hiring typically occurs in the small and medium enterprise space. In the residential real estate market, the drop in interest rates that is now in its eighth month has yet to be felt, and house price inflation has ground to a halt. Historically, Costco membership growth has been inversely correlated with house prices (house price inflation shown inverted, bottom panel, Chart 7). Chart 7Deteriorating Macro Backdrop … Deteriorating Macro Backdrop … Deteriorating Macro Backdrop … Chart 8…Is A Boon To Hypermarkets… …Is A Boon To Hypermarkets… …Is A Boon To Hypermarkets… Chart 8 shows three additional macro variables that signal brighter times ahead for the relative share price ratio. The drubbing in the 10-year U.S. treasury yield reflects a souring macro backdrop, melting inflation and a steep fall in U.S. economic data surprises. The ISM manufacturing index that continues to decelerate and is now closing in on the boom/bust line corroborates the bond market’s grim message. Tack on the Fed’s expected four cuts in the coming 12 months, and factors are falling into place for a durable rally in relative share prices. This disinflationary backdrop along with the Fed’s looming easing interest rate cycle have put a solid bid under gold prices. Hypermarket equities and bullion traditionally move in lockstep, and the current message is to expect more gains in the former (top panel, Chart 9). On the trade front specifically, these Big Box retailers do source consumer goods from China, but up to now these imports have been nearly immune to the U.S./China trade dispute as prices have been deflating (import prices shown inverted, bottom panel, Chart 9). However, this does pose a risk going forward and we will be closely monitoring it for two reasons: First, because downward pressures may intensify on the greenback and second, President Trump may impose additional tariffs, both of which are negative for industry pricing power. Chart 9Profit Margins… Profit Margins… Profit Margins… Chart 10…Will Likely Expand …Will Likely Expand …Will Likely Expand Meanwhile, industry demand is on the rise and will likely offset the potential trade and U.S. dollar induced margin pressures. Hypermarket retail sales are climbing at a healthy clip outpacing overall retail sales (bottom panel, Chart 10). Already non-discretionary retail sales are outshining discretionary ones, which is a precursor to recession at a time when overall consumer outlays have sunk below 1% (real PCE growth shown inverted, top panel, Chart 10). The implication is that hypermarkets will continue to garner a larger slice of consumer outlays as the going gets tough. In sum, the souring macro backdrop coupled with a firming industry demand outlook signal that more gains are in store for hypermarket stocks. Bottom Line: Boost the S&P hypermarkets index to overweight. The ticker symbols for the stocks in this index are: BLBG – S5HYPC – WMT, COST. Initiate A Long Global Gold Miners/Short S&P Oil & Gas E&P Pair Trade One way to benefit from the global growth soft-patch and looming global liquidity injection is to go long global gold miners/short S&P oil & gas E&P stocks on a tactical three-to-six month basis. While this market neutral and intra-commodity pair trade has already enjoyed an impressive run, there is more upside owing to a favorable macro backdrop. The key determinant of this share price ratio is the relative move in the underlying commodities that serve as pricing power proxies (top panel, Chart 11). Given the massive currency debasement potential that has gripped Central Banks the world over, such a flush liquidity backdrop will boost the allure of the shiny metal more so than crude oil. Global manufacturing PMIs are foreshadowing recession and our diffusion index has plummeted to the lowest level since 2011 (diffusion shown inverted, middle panel, Chart 11). In the U.S. specifically there is a growth-to-liquidity handoff and the ISM manufacturing survey’s new order versus prices paid subcomponents confirms that global gold miners have the upper hand compared with E&P equities (bottom panel, Chart 11). Chart 11Global Soft-Patch… Global Soft-Patch… Global Soft-Patch… Chart 12…Disinflation… …Disinflation… …Disinflation… As a result of this growth scare that can easily morph into recession especially if the U.S./China trade war continues into next year, inflation is nowhere to be found. Unit labor costs are slumping (top panel, Chart 12), the NY Fed’s Underlying Inflation Gauge has rolled over decisively (not shown),4 and the GDP deflator is slipping (middle panel, Chart 12).      Parts of the yield curve first inverted in early-December and the 10-year/fed funds rate slope is still inverted, signaling that gold miners will continue to outperform oil producers (yield curve shown on inverted scale, bottom panel, Chart 13). The near 100bps dive in real interest rates since late-December ties everything together and is a boon to bullion (and gold producers) that yields nothing (TIPS yield shown inverted, top panel, Chart 13). Meanwhile, bond volatility has spiked of late and the bottom panel of Chart 14 shows that historically the MOVE index has been joined at the hip with relative share prices. Chart 13…Melting Real Yields And… …Melting Real Yields And… …Melting Real Yields And… Chart 14…The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers …The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers …The Spike In Bond Vol, All Favor Gold Miners Over Oil Producers On the relative demand front, we peer over to China to take a pulse of the marginal moves in these commodity markets. China (and Russia) has been aggressively shifting their currency reserves into gold, and bullion holdings are rising both in volume terms and as a percentage of total FX reserves. In marked contrast, oil demand is feeble and Chinese apparent diesel consumption that is closely correlated with infrastructure and manufacturing activity has tumbled. Taken together, the message is to expect additional gain in relative share prices (middle & bottom panels, Chart 15). Adding it all up, the global growth slowdown, declining real bond yields, missing inflation, rising policy uncertainty and a favorable relative demand backdrop suggest that there is an exploitable tactical trading opportunity in a long global gold miners/short S&P oil & gas E&P pair trade. Bottom Line: Initiate a tactical long global gold miners/short S&P oil & gas E&P pair trade on a three-to-six month time horizon with a stop at the -10% mark. The ticker symbols for the stocks in these indexes are: GDX:US and BLBG – S5OILP – COP, EOG, APC, PXD, CXO, FANG, HES, DVN, MRO, NBL, COG, APA, XEC, respectively. Chart 15Upbeat Relative Demand Backdrop Upbeat Relative Demand Backdrop Upbeat Relative Demand Backdrop   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 3      Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment” dated June 10, 2019, available at uses.bcaresearch.com. 4      https://www.newyorkfed.org/research/policy/underlying-inflation-gauge   Current Recommendations Size And Style Views Favor value over growth Favor large over small caps

Highlights The breakout in financial asset prices stands at odds with a deteriorating profit outlook. This suggests a high probability of a coiled-spring reversal in one of the two variables as we enter the thin summer trading months. We are maintaining a pro-cyclical currency stance, but are making a few portfolio tweaks in case we are caught offside during what could be a volatile summer. Maintain very tight stops on cable at 1.25, but look to sell EUR/GBP between 0.92 and 0.94. Our top pick for long positions are petrocurrencies, as geopolitical support is unlikely to ebb anytime soon. Buy a speculative basket of the Norwegian krone, Russian ruble, Mexican peso, and Colombian peso versus the euro. The latest RBA interest rate cut might be the ultimate insurance backstop needed to jumpstart the Australian economy. Remain long the Aussie dollar versus both the greenback and the kiwi, but with tight stops on the former. Any “flash crashes” are likely to favor the currencies of countries where tradeable bonds are in short supply. Remain short USD/JPY. Also, tactically sell gold bullion versus the yen. Feature Chart I-1The Markets And Data Diverge The Markets And Data Diverge The Markets And Data Diverge Financial markets are at an important crossroads as we head into the thin summer trading months. Asset prices have been reflated by plunging bond yields, with the S&P 500 hitting fresh highs this week. On the other hand, incoming manufacturing data across the major economies continue to deteriorate, suggesting the profit cycle remains in a downtrend. Either markets get better visibility into an improving profit outlook, or stock prices will succumb to the pressure of incoming data weakness (Chart I-1).    For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets flip the switch towards risk aversion. Our recommendations this week are threefold. First, maintain tight stops on tactical positions, especially those susceptible to summer volatility. Topping this list is our long position in the British pound. Second, our top pick for long positions are petrocurrencies, as geopolitical support is unlikely to ebb anytime soon. Finally, maintain portfolio insurance by being short the USD/JPY. Also, sell gold against the yen, given that relative sentiment has shifted in extreme favor of the former. A Summer Attack On The Pound? The episodes leading to the collapse of the pound in 1992 have important lessons for today.1 Britain entered the Exchange Rate Mechanism (ERM) in October of 1990 in an attempt to find a stable nominal anchor. In the years preceding entry into the ERM, inflation in the U.K. had been high and rising, leading to an appreciation in the real exchange rate. The rationale was that by adopting German interest rates, inflation would finally be tempered, and the real exchange rate would eventually be realigned. Most of the adjustment in the pound happened quickly, but a key difference from today is that exit from the ERM was unanticipated, unlike Brexit.  During the ensuing years, pressure on the pound was relatively short-lived and could be quickly reversed by foreign exchange interventions or modest increases in interest rates. Meanwhile, the prospect of a European Monetary Union (EMU) also provided an anchor for expectations, since it would allow for more sound domestic policies. Problems began to surface in June 1992, when the Danes voted no in a referendum on the Maastricht Treaty that included a chapter on the EMU. This led to severe doubts about the progress made towards a union, especially as the outcome of the French referendum in September was expected to be close. Investors began to question where the shadow exchange rate for ERM currencies lay, especially where the Italian lira or the Spanish peseta were concerned. In August of that year, Britain began to massively step up interventions in the foreign exchange market, having to borrow excessively through the Very Short Term Financing facility (VSTF) to increase reserves. It also promised to raise interest rates from 10% to 12%, and later to 15%. But as an overvalued exchange rate had generated extremely sluggish GDP growth going into the 1990s, markets were not convinced the U.K. would tap into its unlimited borrowing facility or raise interest rates sufficiently to defend the pound. On black Wednesday in September 1992, Britain suspended membership to the ERM. There are a few important lessons that stand in stark contrast to a hard Brexit: Most of the adjustment in the pound happened quickly, but a key difference from today is that exit from the ERM was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly, usually with overshoots or undershoots. From its peak, GBP/USD depreciated by 24% by the end of October 1992. It subsequently fell to a low of 1.418 in February 1993 (Chart I-2). Peak to trough, cable has already fallen by 28%. Judging from the real effective exchange rate adjusted for consumer prices, the pound was overvalued as the U.K. entered the ERM. A persistent inflation differential between the U.K. and Germany had led to significant appreciation in the real rate. That gap is much narrower today (Chart I-3). Chart I-2The Pound Drop During ERM Was Quick And Violent The Pound Drop During ERM Was Quick And Violent The Pound Drop During ERM Was Quick And Violent Chart I-3Not Much Misalignment In##br## U.K. Prices Today Not Much Misalignment In U.K. Prices Today Not Much Misalignment In U.K. Prices Today The overvaluation of the pound meant that domestic growth was under tremendous pressure. Growth was already at recessionary levels entering into the ERM. Meanwhile, a bursting real estate bubble necessitated lower, not higher interest rates. This put to test the credibility of the peg. Today, U.K. growth is outpacing that of Germany, and will only improve if the pound drops further (Chart I-4). Productivity in the U.K. has kept pace with that of Germany over the last several years, suggesting the fall in the pound has been unwarranted. The Tory government runs a balanced budget and the Bank of England has much foreign exchange reserves to intervene in the market should confidence in the pound collapse. More importantly, the British currency is freely floating meaning there are less “hidden sins” compared to the fixed exchange rate period when it had to use the VSTF facility to boost reserves (Chart I-5). Chart I-4The U.K. Is Growing Faster Than The Eurozone's Engine The U.K. Is Growing Faster Than The Eurozone's Engine The U.K. Is Growing Faster Than The Eurozone's Engine Chart I-5Britain Has Lots Of ##br##FX Reserves Britain Has Lots Of FX Reserves Britain Has Lots Of FX Reserves A new conservative leadership is, at the margin, more negative for the pound (the assessment of our geopolitical strategists is that the odds of a hard Brexit have risen to 21% from 14%). However, our simple observation is that the pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union (Chart I-6). The pound is below where it was after the 2016 referendum results, yet more people are now in favor of staying in the union. This dichotomy might be the reason why in a speech this week, BoE Governor Mark Carney continued to highlight the growing divergence between market interest rate expectations (almost a 50% probability of a cut this year) and the central bank’s more hawkish bias. The experience of the ERM suggests it will be extremely destabilizing for the pound if the BoE is unable to anchor market interest rate expectations. This is especially true since the second quarter is likely to be a very weak one, leaving little time for data improvement until the October 31st Brexit deadline. Chart I-6More People In Favour Of The Union More People In Favour Of The Union More People In Favour Of The Union Chart I-7Cable Valuation Reflects Brexit Risk Cable Valuation Reflects Brexit Risk Cable Valuation Reflects Brexit Risk   Putting it all together, our bias is that if there is a hard Brexit, the pound could easily drop to the 1.10-1.15 zone. Part of this move will be an undershoot. The real effective exchange rate of the pound is now lower than where it was after the U.K. exited the ERM in 1992, with a drawdown that has been of similar magnitude (24% in both episodes) (Chart I-7). In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its (or above) historical real effective exchange rate range, which will pin it 15-20% higher, or at around 1.50. As for EUR/GBP, U.K. gilt yields stand at 108-basis-point over German bunds, an attractive spread should carry trades return in favor. Historically, such a spread has usually pinned the EUR/GBP much lower (Chart I-8). Yes, incoming data in the U.K. has softened, but employment growth has been holding up, wages are inflecting higher and the average U.K. consumer appears in decent shape. Investment and construction have been the weak spot in the U.K. economy, but may marginally improve on lower rates. Meanwhile, from a technical perspective, the pound is also oversold versus the euro (Chart I-9). Chart I-8EUR/GBP Is A Sell Long-Term EUR/GBP Is A Sell Long-Term EUR/GBP Is A Sell Long-Term Chart I-9EUR/GBP Is Overbought EUR/GBP Is Oversold EUR/GBP Is Oversold Bottom Line: Stay long the pound as we enter volatile summer trading, but maintain tight stops at 1.25. Sell EUR/GBP if 0.94 is touched. Buy A Speculative Basket Of Petrocurrencies Rising geopolitical tensions between the U.S. and Iran continue to support oil prices. Meanwhile, at its latest meeting, OPEC agreed to extend its production cuts to the first half of 2020. This will put upward pressure on forward curves, nudging oil near our Commodity & Energy Strategy service’s target of $75 per barrel.2 Should demand pick up later this year, it will supercharge the uptrend. More importantly, the risk of escalation between Iran and the U.S. is high, given that the former has been backed up into a corner on falling oil exports. Together with a weakening U.S. dollar, this will be categorically bullish for petrocurrencies. In our currency portfolio, we are long the NOK versus both the SEK and CAD as exposure to both crude oil prices and the Brent premium. This week, we are adding a speculative basket of the Colombian peso, Mexican peso and Russian ruble to benefit from any surge in the oil geopolitical risk premium. This basket is attractive for two reasons. First, the currencies are trading at a discount to what is implied by the oil price (Chart I-10). This discount could rapidly close if it becomes evident that oil supplies are at major risk. It is also beneficial that the shipping routes these supplies take categorically avoids the Straits of Hormuz, or the epicenter of the conflict. Second, the carry from the trade is attractive at 5%, which provides some cushion against downside risks. The risk of escalation between Iran and the U.S. is high. Together with a weakening U.S. dollar, this will be categorically bullish for petrocurrencies. The positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Meanwhile, Norwegian production has been falling for a few years. This is why it may be increasingly more profitable to be long a basket of petrocurrencies versus oil-consuming nations rather than the U.S. Going long versus the euro is also a cushion against a knee-jerk rally in the dollar. Also going long a basket of higher-yielding EM petrocurrencies versus DM ones is a good bet (Chart I-11). Chart I-10Petrocurrencies Are Attractive Petrocurrencies Are Attractive Petrocurrencies Are Attractive Chart I-11EM Versus DM Oil Basket EM Versus DM Oil Basket EM Versus DM Oil Basket Bottom Line: Buy a speculative basket of the Norwegian krone, Russian ruble, Mexican peso and Colombian peso versus the euro. Investors should also consider a basket of EM petrocurrencies versus DM ones. A Final Note On Gold The short-term technical picture for gold has become unfavorable. This suggests that investors could be caught offside in the interim holding gold as a hedge. We recommend swapping some gold bullion for yen to insure against this risk for three reasons: As both are safe-haven proxies, yen in gold terms has tended to mean revert since 2012, so as to maintain a stable ratio of 138,000 JPY per ounce of gold. Today, the yen is sitting at two standard deviations below this range (Chart I-12). Open interest for gold is surging towards new highs, while that of the yen is making fresh lows. In the case of a rush towards safe havens, the liquidity squeeze is likely to favor appreciation in the yen (Chart I-13). Chart I-12Sell Some Bullion For Yen Paper Sell Some Bullion For Yen Paper Sell Some Bullion For Yen Paper Chart I-13A Liquidity Squeeze Could Favor The Yen A Liquidity Squeeze Could Favor The Yen A Liquidity Squeeze Could Favor The Yen   Speculators are long gold but short the yen, which is attractive from a contrarian standpoint (Chart I-14). Chart I-14Speculators Are Long Gold And Short Yen Speculators Are Long Gold And Short Yen Speculators Are Long Gold And Short Yen Bottom Line: Remain short USD/JPY and sell a basket of gold versus some yen.    Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). 2 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Volatility Will Abate As Financial Conditions Ease,” dated July 4, 2019, available at ces.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been soft: Headline PCE fell to 1.5% year-on-year in May. Core PCE was unchanged at 1.6% year-on-year. Personal income growth was unchanged at 0.5% month-on-month in May, while personal spending fell to 0.4% month-on-month. Markit composite and manufacturing PMI both increased to 51.5 and 50.6 in June. However, ISM manufacturing and non-manufacturing PMI both decreased to 51.7 and 55.1 in June. Chicago purchasing managers’ index fell to 49.7 in June. Trade deficit widened to $55.5 billion in May. Factory orders contracted by 0.7% month-on-month in May. Also, durable goods orders fell by 1.3% month-on-month in May. DXY index increased by 0.4% this week. Our bond-to-gold indicator continues to point towards a weaker dollar. We believe that the combination of Chinese stimulus and the lagged effects from easing financial conditions should lift the global growth later this year, which would be a headwind for the dollar. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been mixed: Headline inflation was unchanged at 1.2% year-on-year in June, while core inflation increased to 1.1% year-on-year in June. Money supply (M3) grew by 4.8% year-on-year in May. Markit composite PMI increased to 52.2 in June. Manufacturing PMI fell to 47.6, while services PMI increased to 53.6. Unemployment rate fell to 7.5% in May. Producer price inflation fell to 1.6% year-on-year in May. Retail sales growth fell to 1.3% year-on-year in May. EUR/USD fell by 0.8% this week. IMF managing director Christine Lagarde was nominated to replace Mario Draghi as European Central Bank president this week. Analysts believe that she will likely maintain the ECB’s accommodative stance. This was confirmed by the plunge in 10-year bund yields to -40bps. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: The Tankan survey for Q2 was a mixed bag. The index for large manufacturers fell from 12 to 7. That for non-manufacturers increased from 21 to 23. Importantly, capex intentions rose from 1.2% to 7.4%. Housing starts contracted by 8.7% year-on-year in May. Construction orders continue to fall by 16.9% year-on-year in May. Nikkei composite PMI increased to 50.8 in June. Manufacturing PMI fell to 49.3, while services PMI increased to 51.9. Consumer confidence fell to 38.7 in June. USD/JPY has been flat this week. While Trump and Xi agreed to delay the trade talks during the G20 summit last weekend, there is no real progress toward a final trade agreement that could alleviate the tariffs. We continue to recommend the yen as a safe-haven hedge. Report Links: Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been negative: GDP growth was unchanged at 1.8% year-on-year in Q1. Current account deficit widened to £30 billion in Q1. Markit composite PMI fell to 49.7 in June. Manufacturing PMI decreased to 48; Construction PMI fell to 43.1; Services PMI fell to 50.2. Mortgage approvals fell to 65.4 thousand in May, while the Nationwide house price index was up 0.5% year-on-year. GBP/USD fell by 1% this week. BoE governor Carney warned in a speech this week that “a global trade war and a no deal Brexit remain growing possibilities not certainties.” Moreover, he stated that monetary policy must address the consequences of such uncertainty for the behavior of business, household, and financial markets. The probability of a BoE rate cut by the end of this year has thus increased from 21% to 46% following his speech. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly positive: The Markit manufacturing PMI increased from 51.7 to 52.0 Terms of trade remain in a powerful uptrend. HIA new home sales increased by 28.8% month-on-month in May. This is beginning to put a floor under building approvals. Trade surplus increased to A$5.8 billion in May, the highest on record. Retail sales increased by 0.1% month-on-month in May. AUD/USD increased by 0.3% this week. Following the rate cut last month, the RBA again cut interest rates by another 25 basis points to a historical low of 1% this week. During the policy statement, Governor Philip Lowe stated that this should support employment growth and provide greater confidence to achieve the inflation target. We continue to favor the Australian dollar from a contrarian perspective. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been positive: Consumer confidence increased by 2.8% month-on-month in June. Building permits increased by 13.2% month-on-month in May. NZD/USD fell by 0.3% this week. With its policy rate 50 basis points higher than its antipodean counterpart, the RBNZ is now under pressure to cut rates in the coming weeks. The market is currently pricing an 84% probability of a rate cut for the next policy meeting in August, and 94% chance rates will be cut before year-end. Should data disappoint in the interim, additional cuts could be priced in. Hold on to our long AUD/NZD and SEK/NZD positions. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been positive: GDP growth increased to 1.5% year-on-year in Q1. Bloomberg Nanos confidence continues to rise to 58.3 last week. This tends to lead GDP growth by a quarter or two. Markit manufacturing PMI increased to 49.2 in June. Exports and imports both increased to C$53.1 billion and C$52.3 billion in May. The trade balance turned positive to C$0.8 billion on surging exports to the U.S. USD/CAD fell by 0.5% this week. The BoC Business Outlook Survey published last Friday highlighted that business sentiment has slightly improved, and that hiring intentions continue to be healthy. This should underpin the loonie in the near-term. ­­­Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been negative: KOF leading indicator fell to 93.6 in June. Real retail sales contracted by 1.7% year-on-year in May. Manufacturing PMI fell to 47.7 in June. Headline inflation was unchanged at 0.6% year-on-year in June, while core inflation increased to 0.7% year-on-year in June. USD/CHF increased by 0.4% this week. The CHF/NZD cross has been correcting in recent weeks, and could eventually trigger our limit buy order at 1.45. Stay tuned. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mixed: Manufacturing PMI fell from 54.1 to 51.9 in June. Registered unemployment was unchanged at 2.1% in June. House prices are inflecting higher, to the tune of 2.6% year-on-year in June. USD/NOK fell by 0.5% this week. This week’s OPEC meeting extended the production cuts into 1Q20. Easing global financial conditions and Chinese stimulus should help revive oil demand. Our Commodity & Energy Strategy team continues to expect Brent to average $75/bbl by the end of this year. Stay long NOK/SEK and short CAD/NOK. Report Links: On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been negative: Retail sales fell by 0.5% year-on-year in May. Composite PMI fell to 50.5 in June. Manufacturing and services PMI both fell to 52 and 49.9. USD/SEK increased by 0.4% this week. The Riksbank held its interest rate unchanged at -0.25% this week as widely expected. However, the tone in the communique was hawkish. That said, the trade disputes between U.S. and China, and the Brexit chaos remain downside risks to the European economy, and the Riksbank might push the planned rate hike further down the road. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders   Closed Trades

Highlights Portfolio Strategy Business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. The souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Waiting For Godot Waiting For Godot Feature The SPX fell from all-time highs last week on the eve of the G20 Trump-Xi meeting, the outcome of which will dominate trading this week. The “three hopes” rally, as we have coined it predicated upon a U.S./China trade deal, Chinese massive reflation and a fresh Fed easing cycle, is at risk of disappointment as all the good news is likely already priced into stocks. Stocks may suffer a buy the rumor sell the news setback as they did back in early-December right after the Argentina G20 meeting. Following up from last week’s charts 3-6 that generated higher-than-usual responses from clients, we were encouraged to broaden out these eighteen indicators and try to include some positive ones as it appeared that we may be cherry picking the data.1 Put differently, there must be some economic data series that would offset the grim U.S. macro backdrop we painted and likely aid the Fed in its looming easing cycle. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. With regard to the 2018 stock market related fiscal easing boost, neither corporate tax rates would drop further in 2019 nor would buybacks hit the $1tn mark this year. Already, the Standard & Poor’s reported preliminary data that showed buybacks contracted sequentially by 7.7% in Q1/2019 (top panel, Chart 1).2 Retail sales and personal consumption expenditures (PCE) are indeed expanding, however retail sales have decelerated lately (top & second panels, Chart 2). In contrast, consumer sentiment and consumer confidence are contracting on a year-over-year (yoy) basis and the U.S. leading economic indicator is steeply decelerating near 2%/annum from almost 7% at the beginning of the year (middle, fourth & bottom panels, Chart 2). Chart 1Buybacks Are Decelerating Buybacks Are Decelerating Buybacks Are Decelerating Chart 2Retail Sales And PCE Are Expanding Retail Sales And PCE Are Expanding Retail Sales And PCE Are Expanding   The mortgage application purchase index is gaining momentum courtesy of the 125bps drop in interest rates over the past eight months. But, equity market internals suggest that some of these applications may not convert into home sales: relative homebuilders share price momentum is contracting (Chart 3). As a reminder we recently monetized relative gains of 10% in the S&P homebuilding index, since inception.3  Sticking with housing, new median single family home prices remain 10% below their 2017 zenith, and the Case-Shiller 20-city index growth rate hit the zero line recently on a month-over-month basis. New home sales are in contraction territory (Chart 4). Chart 3Are Cracks Forming… Are Cracks Forming… Are Cracks Forming… Chart 4…In The Housing Market? …In The Housing Market? …In The Housing Market?   On the labor front, while the unemployment rate and unemployment insurance claims are both at generationally low levels, it will be extremely difficult for either of these labor market series to fall significantly from current levels. In contrast, there are rising odds that the deteriorating credit quality backdrop will soon infect the labor market (top & second panels, Chart 5). Already, “jobs are hard to get” confirming that the unemployment rate cannot fall much further from current levels (middle panel, Chart 5). Not only is credit quality deteriorating at the margin, but also loan growth is decelerating with our credit impulse diffusion indicator falling below the boom/bust line (fourth & bottom panels, Chart 5). U.S. manufacturing, the most cyclical part of the U.S. economy, is under intense pressure. The U.S./China trade tussle is the culprit. Industrial production and capacity utilization petered out last year in September and November, respectively (top & second panels, Chart 6). Chart 5Could The Labor Market Sour Next? Could The Labor Market Sour Next? Could The Labor Market Sour Next? Chart 6Manufacturing Has No… Manufacturing Has No… Manufacturing Has No…   Chart 7…Pulse …Pulse …Pulse Durable goods orders are not showing any signs of a turnaround with overall orders flirting with the zero line and core orders contracting (third panel, Chart 6). Total business sales-to-inventories are stuck in the contraction zone (bottom panel, Chart 6). Manufacturing survey data series are all in a synchronous meltdown. Seven regional Fed manufacturing surveys are all sinking (Chart 7). Such broad-based weakness bodes ill for the upcoming ISM manufacturing survey print (we went to print on Friday after the market close, and as a reminder we observed Canada Day yesterday).   The ISM manufacturing new orders-to-inventories ratio sits right at one, warning that more profit trouble looms for the SPX (bottom panel, Chart 1). Keep in mind that typically the ISM manufacturing survey pulls down the ISM services one, as the former represents the most cyclical parts of the U.S. economy. Both are currently contracting on a yoy basis (Chart 8). Adding it all up, the negative economic data clearly dominate and only a handful of data series remain standing. The final tally on these indicators is fifteen negative and five positive (Chart 9). We are still awaiting a turn in the majority of the data to confirm the economy is on a solid footing. Chart 8ISM Services Survey Is Contracting ISM Services Survey Is Contracting ISM Services Survey Is Contracting Chart 9 Chart 10Heed The Message From The GS Current Activity Indicator Heed The Message From The GS Current Activity Indicator Heed The Message From The GS Current Activity Indicator Goldman Sachs’ Current Activity Indicator (GSCAI, a first principal component of 37 weekly and monthly data series) does an excellent job in capturing all these forces. Currently, the GSCAI is steeply decelerating, warning that SPX profit growth will surprise to the downside in coming quarters (top panel, Chart 10).  Thus, we reiterate that a cyclically (3-12 month horizon) cautious equity market stance is still warranted. This is U.S. Equity Strategy’s view, which stands in contrast to the sanguine equity BCA House View. This week we update our corporate pricing power table, highlight a safe haven materials subgroup, and an industrials bulletproof subindex. Corporate Pricing Power Update U.S. Equity Strategy’s corporate sector pricing power proxy has sunk further since our last update three months ago, and is now deflating 1.1%/annum. Chart 11 shows that the last time the business sector was mired in deflation was during the 2015/16 manufacturing recession. Chart 11Profit Margin Trouble To Persist Profit Margin Trouble To Persist Profit Margin Trouble To Persist However, the big difference between now and 2015/16 is that wages are currently expanding at a healthy clip, warning that the corporate sector margin squeeze will not abate any time soon. Granted, unit labor costs are indeed contracting on the back of a surge in productivity, and may thus provide a partial offset. SPX margins have been contracting for two consecutive quarters and sell-side analysts forecast that they will contract for another two. Our margin proxy corroborates this grim sell-side profit margin expectation, and similar to the 2015/2016 episode is firing a margin squeeze warning shot (bottom panel, Chart 11). Digging beneath the surface, our corporate pricing power proxy is revealing. As a reminder, we calculate industry group pricing power from the relevant CPI, PPI, PCE and commodity growth rates for each of the 60 industry groups we track. Table 2 also highlights shorter term pricing power trends and each industry's spread to overall inflation. Two thirds of the industries we cover are lifting selling prices, but only a quarter are raising prices at a faster clip than overall inflation. On a selling price inflation trend basis, 81% of the industries we cover are either flat or in a downtrend (Table 2). Table 2Industry Group Pricing Power Waiting For Godot Waiting For Godot There is only one commodity-related industry in the top ten, a sea change from our late-March update when the commodity complex dominated the top ranks occupying six spots (Table 2). Interestingly, industrials have a healthy showing in the top sixteen spots with five entries. On the flip side, energy-related industries continue to populate the bottom of the ranks as WTI crude oil is still deflating from the October 2018 peak. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. In sum, business sector selling price inflation is sinking like a stone following the bond market’s melting inflation expectations, at a time when wage inflation continues to expand smartly. There are good odds that profit margins have already peaked for the cycle, and we reiterate our cyclically cautious overall equity market view. Glittering Gold On March 4th, 2019 we reiterated our view that it still made sense to hold an above benchmark allocation to gold equities as a portfolio hedge.4 While our overweight position is in the red since inception, it has recouped 15% versus the broad market since our early-March update, and more gains are in store in the coming months. When global growth is in retreat investors bid up the price of the safe-haven shiny metal which in turn pulls global gold miners higher. The opposite is also true. Chart 12 shows this inverse relationship gold mining equities have with global growth. In more detail, relative share prices move inversely with the global manufacturing PMI (PMI shown inverted, Chart 12). Chart 12Gold Miners Benefit From… Gold Miners Benefit From… Gold Miners Benefit From… Currently, economists, tracked by Bloomberg, have been aggressively decreasing their estimates for 2019 global real GDP growth, down 50bps year-to-date to 3.3% (bottom panel, Chart 13). Similarly, the global ZEW economic sentiment survey has collapsed to levels last hit during the great recession (top panel, Chart 14). Chart 13…Global Growth… …Global Growth… …Global Growth… Chart 14…Slowdown …Slowdown …Slowdown   Tack on the sustained increase in global policy uncertainty with trade wars, Iranian sanctions, Brexit and Italian politics to name a few, and global gold miners are in the pole position (top panel, Chart 13). As a result, global equity risk premia have come out of hibernation and signal that the gold mining rally has more legs (middle panel, Chart 14). This souring global macro backdrop has dealt a blow to global real yields that are melting. Given that gold equities sport a low dividend yield, they are primary beneficiaries of this disinflationary global economic backdrop (real yield shown inverted, middle panel, Chart 13). Chart 15Negative Yielding Bonds Boost Global Gold Miners Negative Yielding Bonds Boost Global Gold Miners Negative Yielding Bonds Boost Global Gold Miners Meanwhile, investors have been piling into global bonds and currently negative yielding bonds have surpassed the $13tn mark. Such a stampede into negative yielding bonds has been a boon to global gold mining stocks (Chart 15). This investor risk aversion is also evident in the total return stock-to-bond (S/B) ratio: bonds have been outperforming equities since late-September 2018. Since the early 1990s, relative share prices have been moving in the opposite direction of the S/B ratio, and the current message is to expect more gains in the former (S/B ratio shown inverted, Chart 16). Chart 16When Bonds Outperform Stocks, Buy Gold Miners When Bonds Outperform Stocks, Buy Gold Miners When Bonds Outperform Stocks, Buy Gold Miners Chart 17A Tad Overbought, But Still Cheap A Tad Overbought, But Still Cheap A Tad Overbought, But Still Cheap Meanwhile, the Fed is about to embark on an easing cycle courtesy of a softening economic backdrop and any insurance interest rate cuts will likely put a further dent in the dollar. The upshot is that gold is priced in U.S. dollars similar to the broad commodity complex and tends to rise in price when the greenback depreciates and vice versa. A lower trade-weighted dollar will also boost relative share prices (U.S. dollar shown inverted, bottom panel, Chart 14). Finally, while relative share prices are slightly overbought, relative valuations remain in the neutral zone (Chart 17). In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. Bottom Line: We remain overweight the global gold mining index. The ticker symbol for the global gold mining exchange traded fund is: GDX: US. Defense Delivers Recent M&A news in the aerospace & defense sector with UTX bidding for RTN was initially cheered by investors, but President Trump signaled that such a deal would decrease competition in the sector and U.S. regulators would block it. Irrespective of the outcome of this deal, we remain overweight the pure-play BCA Defense Index on a structural basis and also reiterate its high-conviction overweight status. Three key pillars will sustain the upbeat sales and profit backdrop for defense stocks. In sum, the souring global macro backdrop, rising policy uncertainty, melting real yields and a stampede into bonds all signal that it still pays to hold global gold miners as a portfolio hedge. First, the global arms race is alive and well and any governments seeking to augment their defense capabilities have to solicit the U.S. defense manufacturers. U.S. defense spending is rising at a healthy clip representing the major source of revenue growth for the industry (Chart 18). Defense capital goods orders have taken off and backlogs are at the highest level since 2012. The industry’s shipments-to-inventories ratio is also probing decade highs and weapons exports are near all-time highs (Chart 19). Chart 18Defense Spending Remains Upbeat Defense Spending Remains Upbeat Defense Spending Remains Upbeat Chart 19Healthy Operating Metrics Healthy Operating Metrics Healthy Operating Metrics   Second, there is a space race going on with China and India working on manned missions to the moon, but recently President Trump signaled that he would like to beat both of these countries to the moon and in outer space. The defense industry also benefits when global space related demand is on the rise. Finally, cyber security remains a global threat and governments are serious about fighting it off decisively given the sensitivity of the data that cyber criminals are after. While defense stocks are not pure-play software outfits combating cyber criminals, recent industry tuck in acquisitions include such software companies in order for defense contractors to offer one-stop shop solutions to governments. Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. With regard to the financial health of the sector, balance sheets are pristine with net debt-to-EBITDA registering below the broad non-financial equity market and below 2x. Interest coverage is sky high at over 10x, again trumping the broad market. On the return on equity (ROE) front, defense stocks have the upper hand trading at an all-time high ROE of 39% or more than twice the broad market ROE (Chart 20). Looking at the valuation backdrop, relative valuations have corrected recently and defense equities no longer command a premium versus the overall market on both an EV/EBITDA and P/E basis (second & bottom panels, Chart 21). Chart 20Excellent Financial Standing Excellent Financial Standing Excellent Financial Standing Chart 21Valuations Have Corrected Valuations Have Corrected Valuations Have Corrected   Netting it all up, three key defense manufacturers’ demand drivers – global rearmament, a space race and cyber security – remain upbeat and will continue to underpin relative industry profitability. Bottom Line: The BCA Defense Index remains a secular overweight and a high-conviction overweight. The ticker symbols for the stocks in the BCA Defense Index are: LLL, LMT, NOC, GD and RTN. Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com          Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Cracks Forming” dated June 24, 2019, available at uses.bcaresearch.com. 2      https://us.spindices.com/documents/index-news-and-announcements/2019062… 3      Please see BCA U.S. Equity Strategy Insight Report, “Locking In Homebuilder Gains” dated May 22, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “The Good, The Bad And The Ugly,” dated March 4, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Image Highlights Fed policy is likely to proceed in two stages: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage, which will end in late 2021, will be heaven for risk assets. The subsequent stage, which will feature a global recession, will be hell. In the end, we expect the fed funds rate to reach 4.75%, representing thirteen more 25-basis point hikes than implied by current market pricing. For the time being, investors should maintain a pro-risk stance: Overweight global equities and high-yield credit relative to government bonds and cash. Regardless of what happens to the trade negotiations, China is stimulating its economy, which will benefit global growth. As a countercyclical currency, the dollar will weaken over the next 12 months. Cyclical stocks will outperform defensives. We expect to upgrade European and EM stocks this summer. Feature Dear Client, In lieu of next week’s report, I will be hosting a webcast on Wednesday, July 3rd at 10:00 AM EDT, where I will be discussing the major investment themes and views I see playing out for the rest of the year and beyond. Best regards, Peter Berezin, Chief Global Strategist Macro Outlook Right On Stocks, Wrong On Bonds We turned structurally bullish on global equities following December’s sell-off, having temporarily moved to the sidelines last June. This view has generally played out well. In contrast, our view that bond yields would rise this year as stocks recovered has been one gigantic flop. What went wrong with the bond view? The answer is that central banks are reacting to incoming news and data differently than in the past. As we discuss below, this has monumental implications for investment strategy. A Not So Recessionary Environment If one had been told at the start of the year that investors would be expecting the fed funds rate to fall to 1.5% by mid-2020 – with a 93% chance that the Fed would cut rates at least twice and a 62% chance it will cut rates three times in 2019 – one would probably have assumed that the U.S. had teetered into recession and that the stock market would be down on the year (Chart 1). Chart 1 Instead, the S&P 500 is near an all-time high, while credit spreads have narrowed by 145 bps since the start of the year. Outside the manufacturing sector, the economy continues to grow at an above-trend pace and the unemployment rate is below most estimates of full employment. According to the Atlanta Fed, real final domestic demand is set to increase by 2.8% in Q2, up from 1.6% in Q1. Real personal consumption expenditures are tracking to rise at a 3.7% annualized pace (Chart 2). Chart 2 So why is the Fed telegraphing rate cuts when real interest rates are barely above zero? A few reasons stand out: Global growth has slowed (Chart 3). The trade war has heated up again following President Trump’s decision to further increase tariffs on Chinese goods. Inflation expectations have fallen in the U.S. as well as around the world (Chart 4). Chart 3Global Growth Has Slowed Global Growth Has Slowed Global Growth Has Slowed Chart 4Inflation Expectations Have Fallen Around The World Inflation Expectations Have Fallen Around The World Inflation Expectations Have Fallen Around The World   There’s More To The Story As important as they are, these three factors, even taken together, would not be enough to justify rate cuts were it not for an additional consideration: The Fed, like most other major central banks, has become increasingly worried that the neutral rate of interest – the rate consistent with full employment and stable inflation – is extremely low. This has resulted in a major shift in its reaction function. Nobody really knows exactly where the neutral rate is. According to the widely-cited Laubach Williams (L-W) model, the nominal neutral rate stands at 2.2% in the United States. This is close to current policy rates (Chart 5). The range for the longer-term interest rate dot in the Summary of Economic Projections is between 2.4% and 3.3%, which is higher than the L-W estimate. However, the range has trended lower since it was introduced in 2014 (Chart 6). Chart 5The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral The Fed Thinks Rates Are Close To Neutral Chart 6 A Fundamental Asymmetry Given that inflation expectations are quite low and there is considerable uncertainty over the level of the neutral rate, it does make some sense for policymakers to err on the side of being too dovish rather than too hawkish. This is because there is an asymmetry in monetary policy in the current environment. If the neutral rate turns out to be higher than expected and inflation starts to accelerate, central banks can always raise rates. In contrast, if the neutral rate turns out to be very low, the decision to hike rates could plunge the economy into a downward spiral. Historically, the Fed has cut rates by over five percentage points during recessions (Chart 7). At the present rate of inflation, the zero-lower bound on interest rates would be quickly reached, at which point monetary policy would become largely impotent. Chart 7The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The asymmetry described above argues in favor of letting the economy run hot in order to allow inflation to rise. A higher inflation rate going into a recession would let a central bank push real rates deeper into negative territory before the zero bound is reached. In addition, a higher inflation rate would facilitate wage adjustments in response to economic shocks. Firms typically try to reduce costs when demand for their products and services declines, but employers are often wary of cutting nominal wages. Even though it is not fully rational, workers get more upset when they are told that their wages will fall by 2% when inflation is 1% than when they are told their wages will rise by 1% when inflation is 3%. More controversially, a modestly higher inflation rate could improve financial stability. In a low-inflation, low-nominal-rate environment, risky borrowers are likely to be able to roll over loans for an extended period of time. This could lead to the proliferation of bad debt. Chart 8Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher Underlying Inflation Can Cushion Nominal Asset Price Declines Higher inflation can also cushion the blow from a burst asset bubble. For example, the Case-Shiller 20-City Composite Index fell by 34% between 2006 and 2012, or 41% in real terms. If inflation had averaged 4% over this period and real home prices had fallen by the same amount, nominal home prices would have declined by only 26%, resulting in fewer underwater mortgages (Chart 8). A New Reaction Function It is usually a mistake to base market views on an opinion about what policymakers should do rather than what they will do. On rare occasions, however, the opposite is true. And, where our Fed call is concerned, this seems to be the case. Where we fumbled earlier this year was in assuming the Fed would follow a more traditional, Taylor Rule-based monetary framework, which calls for raising rates as the output gap shrinks. Instead, the Fed has adopted a risk-based approach of the sort described above, reminiscent in many ways of the optimal control framework that Janet Yellen set out in 2012. The New Normal Becomes The New Consensus Chart 9 If one is going to conduct monetary policy in a way that errs on the side of letting the economy overheat, one should not be too surprised if the economy does overheat. Yet, the implied rate path from the futures curve suggests that investors are not taking this risk seriously. Chart 9 shows that investors are assigning a mere 5% chance that U.S. short-term rates will be above 3.5% in mid-2022. Why isn’t the market assigning more of a risk to an inflation overshoot? We suspect that most investors have bought into the consensus view that the real neutral rate is zero. According to this view, U.S. monetary policy had already turned restrictive last year when the 10-year Treasury yield climbed above 3%. If this view is correct, the recent decline in yields may stave off a recession, but it will not be enough to cause the economy to overheat. Many of the same investors also believe that deep-seated structural forces ranging from globalization, automation, demographics, to the waning power of trade unions, will all prevent inflation from rising much over the coming years even if the unemployment rate continues to fall. In other words, the Phillips curve is broken and destined to stay that way. But are these views correct? We think not.  Where Is Neutral? There is a big difference between arguing that the neutral rate may be low – and taking preemptive steps to remedy it – and arguing that it definitely is low. We subscribe to the former view, but not the latter. Our guess is that in the end, we will discover that the neutral rate is lower than in the past, but not nearly as low as investors currently think. Probably closer to 1.5% in real terms than 0%. As we discussed in detail two weeks ago, while a deceleration in trend growth has pushed down the neutral rate, other forces have pushed it up.1 These include looser fiscal policy (especially in the U.S.), a modest revival in private-sector credit demand, and dwindling labor market slack.  Since the neutral rate cannot be observed directly, the best we can do is monitor the more interest rate-sensitive sectors of the economy to see if they are cooling in a way that would be expected if monetary policy had become restrictive. For example, housing is a long-lived asset that is usually financed through debt. Hence, it is highly sensitive to changes in mortgage rates. History suggests that the recent decline in mortgage rates will spur a rebound in home sales and construction later this year (Chart 10). The fact that homebuilder confidence has bounced back this year and purchase mortgage applications have reached a cycle high is encouraging in that regard. The same goes for the fact that the vacancy rate is near an all-time low, housing starts have been running well below the rate of household formation, and the quality of mortgage lending has been quite strong (Chart 11). Chart 10Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Declining Yields Bode Well For Housing Chart 11U.S. Housing: No Oversupply Problem, While Demand Is Firm U.S. Housing: No Oversupply Problem, While Demand Is Firm U.S. Housing: No Oversupply Problem, While Demand Is Firm     Nevertheless, if the rebound in housing activity fails to materialize, it would provide evidence that other factors, such as job security concerns among potential homebuyers, are overwhelming the palliative effects of lower mortgage rates.  Have Financial Markets “Trapped” Central Banks? An often-heard argument is that central banks can ill-afford to raise rates for fear of unsettling financial markets. Proponents of this argument often mention that the value of all equities, corporate bonds, real estate and other risk assets around the world exceeds $400 trillion, five times greater than global GDP. There are at least two things wrong with this argument. First, an increase in financial wealth should translate into more spending, and hence a higher neutral rate of interest. Second, as we discussed earlier this year, the feedback loop between asset prices and economic activity tends to kick in only when monetary policy has already become restrictive.2  When policy rates are close to or above neutral, further rate hikes threaten to push the economy into recession. Corporate profits inevitably contract during recessions, which hurts risk asset prices. A vicious spiral can develop where falling asset prices lead to less spending throughout the economy, leading to lower profits and even weaker asset prices. In contrast, when interest rates are below their neutral level, as we believe is the case today in the major economies, an increase in policy rates will simply reduce the odds that the economy will overheat, which is ultimately a desirable outcome. U.S. Imbalances Are Modest Chart 12U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm U.S. Corporate Debt (I): No Cause For Alarm Recessions usually occur when rising rates expose some serious imbalances in the economy. In the U.S. at least, the imbalances are fairly modest. As noted above, housing is on solid ground, which means that mortgage rates would need to rise substantially before the sector crumbles. Equities are pricey, but far from bubble territory. Moreover, unlike in the late 1990s, the run-up in stock prices over the past five years has not led to a massive capex overhang. Corporate debt is the weakest link in the financial system, but we should keep things in perspective. Even after the recent run-up, net corporate debt is only modestly higher than it was in the late 1980s, a period where the fed funds rate averaged nearly 10% (Chart 12). Thanks to low interest rates and rapid asset accumulation, the economy-wide interest coverage ratio is above its long-term average, while the ratio of debt-to-assets is below its long-term average (Chart 13). The corporate sector financial balance – the difference between what businesses earn and spend – is still in surplus. Every recession during the past 50 years has begun when the corporate sector financial balance was in deficit (Chart 14). Chart 13U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm U.S. Corporate Debt (II): No Cause For Alarm Chart 14U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm U.S. Corporate Debt (III): No Cause For Alarm     The Dollar, The Neutral Rate, and Global Growth In a globalized economy, capital flows can equalize, at least partially, neutral rates across countries. If any one central bank tries to raise rates – while others are standing pat or even cutting rates – the currency of the economy where rates are rising will shoot up, causing net exports to shrink and growth to slow.  In the case of the U.S. dollar, there is an additional issue to worry about, which is that there is about $12 trillion in overseas dollar-denominated debt. A stronger greenback would make it difficult for external borrowers to service their debts, leading to increased bankruptcies and defaults. Since financial and economic imbalances are arguably larger outside the U.S., a rising dollar would probably pose more of a problem for the rest of the world than for the United States. Although this is a serious risk, it is unlikely to materialize over the next 12-to-18 months, given our assumption that the dollar will weaken over this period. The U.S. dollar trades as a countercyclical currency, which is another way of saying that it tends to weaken whenever global growth strengthens (Chart 15). While the U.S. benefits from faster global growth, the rest of the world benefits even more. This stems from the fact that the U.S. has a smaller manufacturing base and a larger service sector than most other economies, which makes the U.S. a “low beta” economy. Hence, stronger global growth tends to cause capital to flow from the U.S. to the rest of the world, putting downward pressure on the greenback. Right now, China is stimulating its economy. The stimulus is a reaction to both slowing domestic growth, as well as worries about the potential repercussions of a trade war. It also reflects the fact that Chinese credit growth had sunk to a level only modestly above nominal GDP growth late last year. With the ratio of credit-to-GDP no longer rising quickly, the authorities had the luxury of suspending the deleveraging campaign (Chart 16). Chart 15The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 16Chinese Deleveraging Campaign Has Now Been Put On The Backburner Chinese Deleveraging Campaign Has Now Been Put On The Backburner Chinese Deleveraging Campaign Has Now Been Put On The Backburner   The combination of Chinese stimulus, the lagged effects from lower bond yields, and a turn in the global manufacturing cycle should all lift global growth in the back half of this year. This should cause the dollar to weaken. Trade War Worries Needless to say, this rosy outlook is predicated on the assumption that the trade war does not get out of hand. Our baseline envisions a “muddle through” scenario, where some sort of deal is hatched that allows the U.S. to bring down existing tariffs over time in exchange for a binding agreement by the Chinese to improve market access for U.S. companies and better secure intellectual property rights. The specifics of the deal are less important than there being a deal – any deal – that avoids a major escalation. Ultimately, the distinction between a “small” trade war and a “moderate” trade war is a function of how high tariffs end up being. Tariffs are taxes, and while no one likes to pay taxes, they are a familiar part of the global capitalist system. Chart 17 What is less familiar, and much more dangerous to global finance, are nontariff barriers that effectively bar countries from accessing critical inputs and technologies. Most global trade is in the form of intermediate goods (Chart 17). If a company cannot access the global supply chain, there is a good chance it may not be able to function at all. The current travails of Huawei is a perfect example of this. A full-blown trade war would create a lot of stranded capital. The stock market represents a claim on the existing capital stock, not the capital stock that would emerge after a trade war has been fought. Stocks would plunge in this scenario, with the U.S. and most other economies succumbing to a recession. Enough voters would blame Donald Trump that he would lose the election. While such an outcome cannot be entirely dismissed, it is precisely its severity that makes it highly unlikely. Inflation: Waiting For Godot? Global monetary policy is highly accommodative at present, and will only become more so if the Fed and some other central banks cut rates. Provided that the trade war does not boil over, global growth should accelerate, putting downward pressure on the U.S. dollar. A weaker dollar will further ease global financial conditions. In such a setting, global growth is likely to remain above trend, leading to a further erosion of labor market slack. Among the major economies, the U.S. is the closest to exhausting all remaining spare capacity (Chart 18). The unemployment rate has fallen to 3.6%, the lowest level since 1969. The number of people outside the labor force who want a job as a share of the working-age population is below the level last seen in 2000. The quits and job opening rates remain near record highs. Given the erosion in slack, why has inflation not taken off? To some extent, the answer is that the Phillips curve is “kinked.” A decline in the unemployment rate from say, 8% to 5%, does little to boost inflation because even at 5%, there are enough jobless workers keen to accept what employment offers they get. It is only once the unemployment rate falls well below NAIRU that inflation starts to kick in. In the 1960s, it was not before the unemployment rate fell two percentage points below NAIRU that inflation broke out (Chart 19). Chart 18U.S. Is Back To Full Employment U.S. Is Back To Full Employment U.S. Is Back To Full Employment Chart 19Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy Inflation Took Off In The 1960s Amid An Overheated Economy   Wage growth has picked up. However, productivity growth has risen as well. As a result, unit labor costs – the ratio of wages-to-productivity – have actually decelerated over the past 18 months. Unit labor cost inflation tends to lead core inflation by up to one year (Chart 20).  Chart 20No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral No Imminent Threat Of A Wage-Price Inflationary Spiral As the unemployment rate continues to drop, wage growth is likely to begin outstripping productivity gains. A wage-price spiral could develop. This is not a major risk for the next 12 months, but could become an issue thereafter. Could structural forces related to globalization, automation, demographics, and waning union power prevent inflation from rising even if labor markets tighten significantly further? We think that is unlikely. Globalization Regardless of what happens to the trade war, the period of hyperglobalization, ushered in by the fall of the Berlin Wall and China’s entry into the WTO, is over. As a share of global GDP, trade has been flat for more than ten years (Chart 21).  Chart 21Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Granted, it is not just the change in globalization that matters for inflation. The level matters too. In a highly globalized world, excess demand in one economy can be satiated with increased imports from another economy. However, this is only true if other economies have enough spare capacity. Even outside the United States, the unemployment rate in the G7 economies is approaching a record low (Chart 22). Chart 22The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows The Unemployment Rate In The U.S. And Elsewhere Is Near Record Lows In any case, for a fairly closed economy such as the U.S., where imports account for only 15% of GDP, relative prices would need to shift a lot in order to incentivize households and firms to purchase substantially more goods from abroad. In the absence of dollar appreciation, this would require that the prices of U.S. goods increase in relation to the prices of foreign goods. In other words, U.S. inflation would still have to rise above that of the rest of the world. Automation Everyone likes to think that they are living in a special age of technological innovation. Yet, according to the productivity statistics, U.S. productivity has grown at a slower pace over the last decade than during the 1970s (Chart 23). As we argued in a past report, this is unlikely to be the result of measurement error.3  Perhaps the recent pickup in productivity growth will mark the start of a new structural trend. Maybe, but it could also just reflect a temporary cyclical revival. As labor has become less plentiful, companies have started to invest in more capital. Chart 24 shows that productivity growth and capital spending are highly correlated over the business cycle. Chart 23 Chart 24U.S. Productivity Growth And Capex Move In Lock-Step U.S. Productivity Growth And Capex Move In Lock-Step U.S. Productivity Growth And Capex Move In Lock-Step   It is less clear whether total factor productivity (TFP) growth — which reflects such things as technological know-how and business practices – has turned the corner. Over the past two centuries, TFP growth has accounted for over two-thirds of overall productivity growth. Recent data suggests TFP growth in the U.S. and around the world has remained sluggish (Chart 25). Chart 25ATotal Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Chart 25BTotal Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets Total Factor Productivity Remains Muted Across Developed Markets     Even if TFP growth does accelerate, it is not obvious that this will end up being deflationary. Increased productivity means more income, but more income means more potential spending. To the extent that stronger productivity growth expands aggregate supply, it also has the potential to raise aggregate demand. Thus, while faster productivity growth in one sector will cause relative prices in that sector to fall, this will not necessarily reduce the overall price level. Chart 26Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Rising Labor Share Of Income Occurring Alongside Labor Market Tightening Chart 27 True, faster productivity growth has the ability to shift income from poor workers to rich capitalists. Since the former spend more of their income than the latter, this could slow aggregate demand growth. However, the recent trend has been in the other direction, as a tighter labor market has pushed up labor’s share of income (Chart 26). Among workers, wage growth is now higher at the bottom end of the income distribution than at the top (Chart 27). Demographics For several decades, slower population growth has reduced the incentive for firms to expand capacity. Population aging has also shifted more people into their prime saving years. The combination of lower investment demand and higher desired savings pushed down the neutral rate on interest. Chart 28The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally The Worker-To-Consumer Ratio Has Peaked Globally Now that baby boomers are starting to retire, they are moving from being savers to dissavers. Chart 28 shows that ratio of workers-to-consumers globally has begun to decline as the post-war generation leaves the labor force. As more people stop working, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The Waning Power Of Unions The declining influence of trade unions is often cited as a reason for why inflation will remain subdued. There are a number of problems with this argument. First, unionization rates in the U.S. peaked in the mid-1950s, more than a decade before inflation began to accelerate. Second, while the unionization rate continued to decline in the U.S. during the 1980s and 1990s, it remained elevated in Canada. Yet, this did not prevent Canadian inflation from falling as rapidly as it did in the United States (Chart 29). The widespread use of inflation-linked wage contracts in the 1970s appears mainly to have been a consequence of rising inflation rather than the cause of it (Chart 30). Chart 29Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Inflation Fell In Canada, Despite A High Unionization Rate Chart 30Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around Higher Inflation Led To More Inflation-Indexed Wage Contracts, Not The Other Way Around   Ultimately, the price level cannot increase on a sustained basis independent of other things such as the level of the money supply. Unions have influence over wages, but in the long run, central banks play the decisive role. Alt-Right Or Ctrl-Left, The Result Is Usually Inflation In a speech to the Council on Foreign Relations this week, Jay Powell noted that “The Fed is insulated from short-term political pressures – what is often referred to as our ‘independence’.”4 The operative words in his remarks were “short-term”. Powell knows full well that the Fed’s independence is not cast in stone. Even if Trump cannot legally fire or demote him, the President can choose who to nominate to the Fed’s Board of Governors. Early on in his tenure, Trump showed little interest in the workings of the Federal Reserve. He even went so far as to nominate Marvin Goodfriend – definitely no good friend of easy money – to the Fed board. Trump’s last two candidates, Stephen Moore and Herman Cain, were both political flunkies, happy to ditch their previous commitments to hard money in favor of Trump’s desire to see lower interest rates. Neither made it as far as the Senate confirmation process. Recent media reports have suggested that Trump will nominate Judy Shelton, a previously unknown economist whose main claim to fame is the promulgation of a bizarre theory about why the Fed should not pay interest on excess reserves (which, conveniently, would imply that overnight rates would need to fall to zero immediately).5  It is not clear whether Trump’s attempt to stack the Fed with lackeys will succeed. But one thing is clear: Countries with independent central banks tend to end up with lower inflation rates than countries where central banks are not independent (Chart 31). Chart 31 Whether it be Trump-style right-wing populism or left-wing populism (don’t forget, MMT is a product of the left, not the right), the result is usually the same: higher inflation. Investment Recommendations Overall Strategy The discussion above suggests the Fed will proceed along a two-stage path: An initial stage characterized by a highly accommodative monetary policy, followed by a second stage where the Fed is raising rates aggressively in response to galloping inflation. The first stage will be heaven for risk assets. The subsequent stage will be hell. The big question is when the transition from stage one to stage two will occur. Inflation is a highly lagging indicator. It usually does not peak until a recession has begun and does not bottom until a recovery is well under way (Chart 32). Chart 32 While some measures of U.S. core inflation such as the Dallas Fed’s “trimmed mean” have moved back up to 2%, this follows a prolonged period of sub-target inflation. For now, the Fed wants both actual inflation and inflation expectations to increase. Thus, we doubt that inflation will move above the Fed’s comfort zone before 2021, and it will probably not be until 2022 that monetary policy turns contractionary. It will take even longer for inflation to rise meaningfully in the euro area and Japan. Recessions rarely happen if monetary policy is expansionary. Sustained equity bear markets in stocks, in turn, almost never happen outside of recessionary periods (Chart 33). As such, a pro-risk asset allocation, favoring global equities and high-yield credit over safe government bonds and cash, is warranted at least for the next 12 months. Chart 33Recessions And Equity Bear Markets Usually Overlap Recessions And Equity Bear Markets Usually Overlap Recessions And Equity Bear Markets Usually Overlap The key market forecast charts on the first page of this report graphically lay out our baseline forecasts for equities, bonds, currencies, and commodities. Broadly speaking, we expect a risk-on environment to prevail until the end of 2021, followed by a major sell-off in equities and credit. Equities Stocks tend to peak about six months before the onset of a recession. In the 13-to-24 month period prior to the recession, returns tend to be substantially higher than during the rest of the expansion (Table 1). We are approaching that party phase. Table 1Too Soon To Get Out Third Quarter 2019 Strategy Outlook: The Long Hurrah Third Quarter 2019 Strategy Outlook: The Long Hurrah Global equities currently trade at 15-times forward earnings. Unlike last year, earning growth estimates are reasonably conservative (Chart 34). Chart 34Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Global Stocks Are Not That Expensive Outside the U.S., stocks trade at a respectable 13-times forward earnings. Considering that bond yields are negative in real terms in most economies – and negative in nominal terms in Japan and many parts of Europe – this implies a sizable equity risk premium.  We have yet to upgrade EM and European stocks to overweight, but expect to do so some time this summer, once we see some evidence that global growth is accelerating. International stocks should do especially well in common-currency terms over the next 12 months, if the dollar continues to trend lower, as we expect will be the case.  We are less enthusiastic about Japanese equities. First, there is still the risk that the Japanese government will needlessly raise the consumption tax in October. Second, as a risk-off currency, the yen is likely to struggle in an environment of strengthening global growth. Investors looking for exposure to Japanese stocks should favor the larger multinational exporters. At the global sector level, cyclicals should outperform defensives in an environment of stronger global growth, a weaker dollar, and ongoing Chinese stimulus. We particularly like industrials and energy. Financials should catch a bid in the second half of this year. According to the forwards, the U.S. yield curve will steepen by 38 bps over the next six months (Chart 35). Worries about an inverted yield curve will taper off. Curves will also likely steepen outside the U.S. as growth prospects improve. A steeper yield curve is manna from heaven for banks. Euro area banks trade at an average dividend yield of 6.4% (Chart 36). We are buying them as part of a tactical trade recommendation. Chart 35 Chart 36Euro Area Banks Are A Buy Euro Area Banks Are A Buy Euro Area Banks Are A Buy     Fixed Income The path to higher rates is lined with lower rates. The longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. The Fed’s dovish turn means that rates will stay lower for longer, but will ultimately go higher than we had originally envisioned. As a result, we are increasing our estimate of the terminal fed funds rate for this cycle by 50 bps to 4.75% and initiating a new trade going short the March 2022 Eurodollar futures contract. Our terminal fed funds rate projection assumes a neutral real rate of 1.5% and a peak inflation rate of 2.75%. Rates will rise roughly 50 basis points above neutral in the first half of 2022, enough to generate a recession later that year. The 10-year Treasury yield will peak at 4% this cycle. While the bulk of the increase will happen in 2021/22, yields will still rise over the next 12 months, as U.S. growth surprises on the upside. Thus, a short duration stance is warranted even in the near-to-medium term. The German 10-year yield will peak at 1.5% in 2022. We expect the U.S.-German spread to narrow modestly through to end-2021 and then widen somewhat as U.S. inflation accelerates relative to German inflation. The spread between Italian and German yields will decline in the lead-up to the global recession in 2022 and widen thereafter. U.K. gilt yields are likely to track global bond yields, although Brexit remains a source of downside risk for yields. Our base case is either no Brexit or a very soft Brexit, given that popular opinion has turned away from leaving the EU (Chart 37). Chart 37U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win U.K.: In The Case Of A Do-Over, The Remain Side Would Likely Win Chart 38U.S. Default Losses Will Remain In Check U.S. Default Losses Will Remain In Check U.S. Default Losses Will Remain In Check   We expect only a very modest increase in Japanese yields over the next five years. Japanese long-term inflation expectations are much lower than in the other major economies, which will require an extended period of near-zero rates to rectify. We expect corporate credit to outperform government bonds over the next 12 months. While spreads are not likely to narrow much from present levels, the current yield pickup is high enough to compensate for expected bankruptcy risk. Our U.S. fixed-income strategists expect default losses on the Bloomberg Barclays High-Yield index on the order of 1.25%-1.5% over the next 12 months (Chart 38). In that scenario, the junk index offers 224 bps – 249 bps of excess spread, a solid positive return that is only slightly below the historical average of 250 bps.  Currencies And Commodities The two-stage Fed cycle described above will govern the trajectory of the dollar over the next few years. In the initial stage, where global growth is accelerating and the Fed is falling ever further behind the curve in normalizing monetary policy, the dollar will depreciate. Dollar weakness will be especially pronounced against the euro and EM currencies. Commodities and commodity currencies will see solid gains. Our commodity strategists are particularly bullish on oil, as they expect crude prices to benefit from both stronger global demand and increasingly tight supply conditions. The Chinese yuan will start strengthening again if a detente is reached in the trade talks. Even if a truce fails to materialize, the Chinese authorities will likely step up the pace of credit stimulus, rather than trying to engineer a significant, and possibly disorderly, devaluation.   In the second stage, where the Fed is desperately hiking rates to prevent inflation expectations from becoming unmoored, the dollar will soar. The combination of higher U.S. rates and a stronger dollar will cause global equities to crash and credit spreads to widen. The resulting tightening in financial conditions will lead to slower global growth, which will further turbocharge the dollar. Only once the Fed starts cutting rates again in late 2022 will the dollar weaken anew. Gold should do well in the first stage of the Fed cycle and at least part of the second stage. In the first stage, gold will benefit from a weaker dollar. In the initial part of the second stage, gold prices will continue to rise as inflation fears escalate. Gold will probably weaken temporarily once real interest rates reach restrictive territory and a recession becomes all but inevitable. We recommended buying gold on April 17, 2019. The trade is up 10.8% since then. Stick with it.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A Two-Stage Fed Cycle,” dated June 14, 2019. 2      Please see Global Investment Strategy Weekly Report, “Low Odds Of An FCI Doom Loop,” dated January 4, 2019. 3      Please see Global Investment Strategy Special Report, "Weak Productivity Growth: Don't Blame The Statisticians," dated March 26, 2016. 4      Please see “Powell Emphasizes Fed’s Independence,” The New York Times, June 25, 2019. 5      Heather Long, “Trump’s potential Fed pick Judy Shelton wants to see ‘lower rates as fast as possible’,” The Washington Post, June 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 39 Tactical Trades Strategic Recommendations Closed Trades

Highlights The sharp fall in the bond-to-gold ratio is an important signal to pay heed to. It might suggest that confidence in the U.S. dollar is finally waning. If correct, the sharp rally in crypto currencies over the past few months warrants monitoring. We are maintaining a pro-cyclical currency stance, while cognizant of the fact that many growth barometers remain in freefall. Oil and petrocurrencies are being supported by geopolitical risk, but a rebound in underlying demand could supercharge the uptrend. We are looking to buy a speculative basket of the Russian ruble and Colombian peso versus the U.S. dollar or Japanese yen. The Norges Bank remains the most hawkish G10 central bank. Hold long NOK/SEK positions. Meanwhile, North Sea crude should continue trading at a premium to WTI, while Norway should also outperform Canada domestically. Remain short CAD/NOK at current levels. Feature Chart I-1Major Peak In The Bond-To-Gold Ratio Major Peak In The Bond-To-Gold Ratio Major Peak In The Bond-To-Gold Ratio Gold continues to outperform Treasurys, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the Bretton Woods agreement broke the gold/dollar link in the early ‘70s, bullion has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick for tick. With the Federal Reserve’s dovish shift, we may just have triggered one of the necessary catalysts for a selloff in the U.S. dollar (Chart I-1).   The implications for currency strategy could be far and wide, especially vis-à-vis our procyclical stance. For example, one of the crosses we are watching fervently is the AUD/JPY exchange rate, since the Aussie tends to be a high-beta currency among G10 FX traders, while the yen tends to be the lowest. More importantly, the AUD/JPY cross is bouncing off an important technical level, having failed to punch below the critical 72-74 zone. In our eyes, the recent bounce could be the prologue to a reflationary rally. On Gold One beneficiary from a lower U.S. dollar is gold. Gold may be breaking out to multi-year highs, but the important takeaway for macro traders is that we may be entering a seismic shift in the investment landscape. Almost every major economy now has or is inching towards negative real interest rates. So, investors who are worried about the U.S. twin deficits and the crowded trade of being long Treasurys will shift into gold, given other major bond markets are getting perilously expensive. Gold has a long-standing relationship with negative interest rates, though the correlation has shifted over time (Chart I-2). The intuition behind falling real rates and rising gold prices is that low rates reduce the opportunity cost of holding non-income generating assets such as gold. And while odds are that yields may creep higher from current low levels, this will still be bullish for gold, if driven by rising inflation expectations. Gold tends to be a “Giffen good” meaning physical demand tends to increase as prices rise.  Support for the dollar is fraying at the edges, judging from relative interest rate differentials, international flows and balance-of-payment dynamics. Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. At the same time, foreign central banks have been amassing tremendous gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart I-3). The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fading. Chart I-2Gold And Real ##br##Yields Gold And Real Yields Gold And Real Yields Chart I-3Central Banks Are Absorbing Most Gold Production Central Banks Are Absorbing Most Gold Production Central Banks Are Absorbing Most Gold Production   Gold tends to be a “Giffen good” meaning physical demand tends to increase as prices rise. Ever since the gold bubble burst in 2011, both financial and jewelry demand has evaporated. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different (Chart I-4). For all the talk about flexible exchange rate regimes, it seems as if the world’s major central banks have been fixing their exchange rates to the gold price (Chart I-5). This suggests that gold price risks could be asymmetric to the upside, at least for now. A fall in prices encourages accumulation by EM central banks as a way to diversify out of their dollar reserves, while a rise in prices encourages financial demand and jewelry consumption. Chart I-4Gold Is A Giffen Good Gold Is A Giffen Good Gold Is A Giffen Good Chart I-5Fixed Exchange Rates Versus Gold? Fixed Exchange Rates Versus Gold? Fixed Exchange Rates Versus Gold?   The explosive rise in cryptocurrency prices highlights that the world is becoming flush again with liquidity, but also signals trepidation against global monetary policy settings (Chart I-6). In its basic function, money should be a store of value, a unit of account and a medium of exchange. Bitcoin’s high price volatility violates its function as a unit of account, but so do other currencies such as the Venezuelan peso or the Turkish Lira. In all, this boosts the demand for alternative assets, including gold. Bottom Line: Interest rate differentials are moving against the dollar, but our important takeaway – that gold continues to outperform Treasurys – is an ominous sign. This is bullish for pro-cyclical currency trades and gold. Chart I-6Confidence In The Dollar Is Waning Confidence In The Dollar Is Waning Confidence In The Dollar Is Waning On Oil Oil prices have been supported by rising geopolitical tensions between the U.S. and Iran, but will be supercharged if demand bottoms later this year. The view of our Geopolitical strategists is that the risk of escalation between the two factions is high, given Iran has been pinned into a corner with falling oil exports.1 Together with a falling U.S. dollar, this will be categorically bullish for petrocurrencies. In the cases of Canada and Norway, petroleum represents around 20% and 60% of total exports, so it is easy to see why a big fluctuation in the price of oil can have deep repercussions for their external balances. Our baseline still calls for Brent prices to touch $75/bbl by year-end. Oil demand tends to follow the ebbs and flows of the business cycle, and demand is contracting along with the slowdown in global trade (Chart I-7). But there is rising evidence of more and more activity along sea routes, judging from the Baltic Dry and Harpex shipping indexes. With over 60% of global petroleum consumed fueling the transportation sector, this is positive. This obviously hinges critically on a resolution to the trade war between the U.S. and China. However, with Chinese and Indian oil imports still growing healthily, this should also put a floor under global demand growth (Chart I-8). Chart I-7Global Oil Demand Has Been Weak Global Oil Demand Has Been Weak Global Oil Demand Has Been Weak Chart I-8Oil Demand Green Shoots Oil Demand Green Shoots Oil Demand Green Shoots Any increase in oil demand will materialize at a time when OPEC spare capacity is low. Global spare capacity cannot handle the loss of both Venezuelan and Iranian exports. Unplanned outages wiped off about 1.5% of supply in 2018, and lost output from both countries is nudging the oil market dangerously close to a negative supply shock (Chart I-9). The explosive rise in cryptocurrency prices signals trepidation against global monetary policy settings. In terms of petrocurrencies, there remains a gaping wedge that has opened vis-à-vis the price of oil (Chart I-10). While it is true that the landscape for oil production is rapidly shifting with the U.S. shale revolution grabbing market share from both OPEC and non-OPEC members, terms of trade still matter for petrocurrencies. Chart I-9A New Oil Baron A New Oil Baron A New Oil Baron Chart I-10Opportunity Or Regime Shift? Opportunity Or Regime Shift? Opportunity Or Regime Shift?   The positive correlation between petrocurrencies and oil has been gradually eroded as the U.S. economy has become less and less of an oil importer. Meanwhile, Norwegian production has been falling for a few years. In statistical terms, petrocurrencies had a near-perfect positive correlation with oil around the time U.S. production was about to take off (Chart I-11). Since then, that correlation has fallen from around 0.8 to roughly 0.3. This is why it may be increasingly more profitable to be long petrocurrencies versus a basket of oil-consuming nations, rather than the U.S. Chart I-11Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Shifting Landscape For Petrocurrencies Bottom Line: Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian and Mexican pesos. That said, a loss of global market share has hurt the oil sensitivity of many petrocurrencies. Transportation bottlenecks for Canadian crude and falling production in Norway are also added negatives. Remain Long NOK/SEK And Short CAD/NOK The Norges Bank remains the most hawkish G10 central bank, having hiked interest rates to 1.25% at last week’s meeting. Governor Øystein Olsen signaled further rate increases later this year – at a time when global central banks are turning dovish. This will continue to put upward pressure under the Norwegian krone. Our recommendation is to stay long NOK/SEK and short CAD/NOK. Both the CAD and NOK remain positively correlated with oil. So do the Russian ruble and the Colombian and Mexican pesos.  The Norwegian economy remains closely tied to oil, with the bottom in oil prices in 2016 having jumpstarted employment growth, business confidence and wage growth. With inflation near the central bank’s target and our expectation for oil prices to grind higher, we agree with the central bank’s assessment that the future path of interest rates is likely higher (Chart I-12). Short CAD/NOK positions are an excellent way to play U.S. dollar downside (Chart I-13). The 6.50-6.60 level for the CAD/NOK has proven to be a formidable resistance since 2015. Chart I-12The Norwegian Economy Will Rebound The Norwegian Economy Will Rebound The Norwegian Economy Will Rebound Chart I-13Sell USD Via CAD/NOK Sell USD Via CAD/NOK Sell USD Via CAD/NOK At $20/bbl, the discount between Western Canadian Select crude oil and Brent has narrowed, but remains wide. This has usually pinned CAD/NOK around the 6.30 level (Chart I-14). The NOK tends to outperform the SEK when oil prices are rising. This trade also benefits from a positive carry. Both the Canadian and Norwegian housing markets continue to be frothy, but in the latter it has been concentrated in Oslo, with Bergen and Trondheim having had more muted increases. In Canada, the rise in house prices could rotate to smaller cities, as macro-prudential measures implemented in Toronto and Vancouver nudge investors away from those markets. The Canadian government has decided to provide residents with a potential line of credit in exchange for equity stakes of up to 10% in residential homes. While this does little to improve the affordability of houses in expensive cities, it almost guarantees that those in competitive markets will be bid up. This will encourage a continued buildup of household leverage, which is a long-term negative for the Canadian dollar (Chart I-15). Chart I-14Oil Differentials Will Weigh On CAD/NOK Oil Differentials Will Weigh On CAD/NOK Oil Differentials Will Weigh On CAD/NOK Chart I-15The CAD Looks Vulnerable Longer-Term The CAD Looks Vulnerable Longer-Term The CAD Looks Vulnerable Longer-Term Bottom Line: Remain short CAD/NOK and long NOK/SEK for a trade. Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, titled “Escalation … Everywhere,” dated June 21, 2019, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly negative: The Markit composite PMI fell to 50.6 in June. Both manufacturing and services fell to 50.1 and 50.7 respectively. On the housing market front, existing home sales increased by 2.5% month-on-month in May. However, new home sales contracted by 7.8% month-on-month. The house price index increased by 0.4% month-on-month in April. Both Dallas and Richmond Fed Manufacturing indices fell to -12.1 and 3 in June. Advanced goods trade balance fell to $74.55 billion in May.  Final annualized Q1 GDP was unchanged at 3.1% quarter-on-quarter, and core PCE increased by 1.2% quarter-on-quarter in Q1. DXY index has been flat this week. As we mentioned in last week’s report, we are closely monitoring the bond-to-gold ratio to gauge the direction of the U.S. dollar. Gold prices continue to soar this week by 5% due to safe-haven buying, the Fed’s dovish pivot, and rising inflation expectations. Our bias is that the balance of forces are moving away from the U.S. dollar. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area remain negative: The Markit composite PMI increased to 52.1 in June. The manufacturing PMI increased slightly to 47.8, and services PMI increased to 53.4. Sentiment remains depressed in June: Business climate fell to 0.17; Industrial confidence decreased to -5.6; Economic sentiment dropped to 103.3; Services sentiment came in at 11; Consumer confidence declined to -7.2. EUR/USD has been flat this week. The dovish message by Mario Draghi last week has limited the upside for the euro recently. However, in the long term, the dovish contest by global central banks will support a global economic recovery. That said, the trade war remains one of the biggest downside risks to our baseline scenario. Any deal or no-deal coming out of the G20 summit will likely re-shape expectations for the global economy and the euro. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Headline and core CPI fell to 0.7% and 0.5% year-on-year respectively in May. The Nikkei manufacturing PMI declined to 49.5 in June.  The leading economic index increased to 95.9 in April. The coincident index rose to 102.1 in April. Retail sales grew by 1.2% year-on-year in May. USD/JPY rose by 0.2% this week. The BoJ published the monetary policy meetings minutes this week, highlighting the upside and downside risk factors to their forecast. Close attention is being paid to outside economic developments and the scheduled consumption tax hike for the fiscal year 2019, and peaking-out of Olympic games-related demand and IT sector developments for the fiscal year 2020. Besides that, the BoJ members agree that the accommodative monetary policy should be sustained for an extended period. Report Links: Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been negative: Public sector net borrowing fell to £4.5 billion in May. CBI retailing survey fell to -42 in June, from a previous reading of -27. GBP/USD fell by 0.4% this week. The probability of a “no-deal” Brexit has increased as a result of the new leadership contest. However, during the inflation report hearings this week, BoE Governor Carney highlighted that unless the next PM makes a “no-deal” Brexit their preferred policy, additional dovishness might not be warranted. We continue to favor the pound but will respect the stop loss at 1.25 if triggered. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been positive: CBA composite PMI increased to 53.1 in June. Manufacturing and services PMI increased to 51.7 and 53.3 respectively. ANZ Roy Morgan weekly consumer confidence increased slightly from 114.2 to 114.3. AUD/USD increased by 1% this week, now trading around 0.6996. Any good news coming out of the trade deal during the G20 summit could support the Aussie dollar and put a floor under this cross. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Exports and imports both increased to NZ$5.81 billion and NZ$5.54 billion in May. The total trade balance fell to NZ$264 million in May. ANZ activity outlook fell to 8 in June, and business confidence fell to -38.1. NZD/USD increased by 1.7% this week. On Wednesday, the RBNZ kept interest rates unchanged at 1.5% and the market is currently pricing a 71.6% probability of rate cuts for the next policy meeting in August. Our bias remains that while the kiwi will benefit from broad dollar weakness, it will underperform its antipodean counterpart. We remain long AUD/NZD and SEK/NZD. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly positive: Retail sales growth slowed down to 0.1% month-on-month in April. Wholesale trade sales soared by 1.7% month-on-month in April. Bloomberg Nanos weekly confidence index rose to 57.8. CFIB business barometer increased to 61.5 in June. USD/CAD fell by 0.8% this week. The Canadian dollar continues to strengthen on the back of positive data surprises and recovering oil prices. U.S. EIA reported falling commercial crude oil inventories for last week. The tension continues between the U.S. and Iran. Moreover, OPEC is likely to cut their oil supply during the next meeting beginning in July. All these factors point to higher oil prices and will likely lift the loonie. ­­­Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 There is little data from Switzerland this week: ZEW expectations index fell to -30 in June. USD/CHF has been flat this week. We remain overweight the franc in the long run due to solid Swiss economic fundamentals, including a high savings rate, rising productivity, and current account surplus. It also serves as a perfect hedge to any downside risks, both economic and geopolitical. The long CHF/NZD recommendation in our April 26 weekly report remains valid, though we do not have this trade on. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 There is little data from Norway this week: Retail sales contracted by 1.3% in May. USD/NOK has been flat this week. The Norwegian krone remains one of our favorite currencies due to the rising oil prices and widening interest rate differentials. The front section of this bulletin reinforces our bullish petrocurrency view. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mostly positive: Producer price inflation fell to 3.5% year-on-year in May. Trade balance increased to 8.3 billion SEK in May. USD/SEK fell by 0.8% this week. As we mentioned before, the Swedish exports could be a very powerful leading indicator of the global economy. In May, the Swedish exports increased to 137 billion SEK from 129 billion SEK in April. Hold on to our long SEK/NZD position. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights U.S. consumption remains robust despite the recent intensification of global growth headwinds. The G-20 meeting will not result in an escalation nor a major resolution of Sino-U.S. tensions. Kicking the can down the road is the most likely outcome. China’s reflationary efforts will intensify, impacting global growth in the second half of 2019. Fearful of collapsing inflation expectations, global central banks are easing policy, which is supporting global liquidity conditions and growth prospects. Bond yields have upside, especially inflation expectations. Equities have some short-term downside, but the cyclical peak still lies ahead. The equity rally will leave stocks vulnerable to the inevitable pick-up in interest rates later this cycle. Gold stocks may provide an attractive hedge for now. A spike in oil prices creates a major risk to our view. Stay overweight oil plays. Feature Global growth has clearly deteriorated this year, and bond yields around the world have cratered. German yields have plunged below -0.3% and U.S. yields briefly dipped below 2%. Even if the S&P 500 remains near all-time highs, the performance of cyclical sectors relative to defensive ones is corroborating the message from the bond market. Bonds and stocks are therefore not as much in disagreement as appears at first glance. To devise an appropriate strategy, now more than ever investors must decide whether or not a recession is on the near-term horizon. Answering yes to this question means bond prices will continue to rise, the dollar will rally further, stocks will weaken, and defensive stocks will keep outperforming cyclical ones. Answering no, one should sell bonds, sell the dollar, buy stocks, and overweight cyclical sectors. The weak global backdrop can still capsize the domestic U.S. economy. We stand in the ‘no’ camp: We do not believe a recession is in the offing and, while the current growth slowdown has been painful, it is not the end of the business cycle. Logically, we are selling bonds, selling the dollar and maintaining a positive cyclical stance on stocks. We also expect international equities to outperform U.S. ones, and we are becoming particularly positive on gold stocks. Oil prices should also benefit from the upcoming improvement in global growth. Has The U.S. Economy Met Its Iceberg? Investors betting on a recession often point to the inversion of the 3-month/10-year yield curve and the performance of cyclical stocks. However, we must also remember Paul Samuelson’s famous quip that “markets have predicted nine of the five previous recessions.” In any case, these market moves tell us what we already know: growth has weakened. We must decide whether it will weaken further. A simple probit model based on the yield curve slope and the new orders component of the ISM Manufacturing Index shows that there is a 40% probability of recession over the next 12 months. We need to keep in mind that in 1966 and 1998, this model was flagging a similar message, yet no recession followed over the course of the next year (Chart I-1). This means we must go back and study the fundamentals of U.S. growth. Chart I-1The Risk Of A Recession Has Risen, But It Is Not A No Brainer The Risk Of A Recession Has Risen, But It Is Not A No Brainer The Risk Of A Recession Has Risen, But It Is Not A No Brainer Chart I-2Lower Rates Will Help Residential Investment Lower Rates Will Help Residential Investment Lower Rates Will Help Residential Investment On the purely domestic front, the U.S. economy is not showing major stresses. Last month, we argued that we are not seeing the key symptoms of tight monetary policy: Homebuilders remain confident, mortgage applications for purchases are near cyclical highs, homebuilder stocks have been outperforming the broad market for three quarters, and lumber prices are rebounding.1 Moreover, the previous fall in mortgage yields is already lifting existing home sales, and it is only a matter of time before residential investment follows (Chart I-2). Households remain in fine form. Real consumer spending is growing at a 2.8% pace, and despite rising economic uncertainty, the Atlanta Fed GDPNow model expects real household spending to expand at a 3.9% rate in the second quarter (Chart I-3). This is key, as consumers’ spending and investment patterns drive the larger trends in the economy.2 Chart I-3Consumers Are Spending Consumers Are Spending Consumers Are Spending Chart I-4The Labor Market Is Still Doing Fine... The Labor Market Is Still Doing Fine... The Labor Market Is Still Doing Fine... Going forward, we expect consumption to stay the course. Despite its latest dip, consumer confidence remains elevated, household debt levels have fallen from 134% of disposable income in 2007 to 99% today, and debt-servicing costs only represent 9.9% of after-tax income, a multi-generational low. In this context, stronger household income growth should support spending. The May payrolls report is likely to have been an anomaly. Layoffs are still minimal, initial jobless claims continue to flirt near 50-year lows, the Conference Board’s Leading Credit index shows no stress, and the employment components of both the manufacturing and non-manufacturing ISM are at elevated levels (Chart I-4). If these leading indicators of employment are correct, both the employment-to-population ratio for prime-age workers and salaries have upside (Chart I-5), especially as productivity growth is accelerating. Despite these positives, the weak global backdrop can still capsize the domestic U.S. economy, and force the ISM non-manufacturing PMI to converge toward the manufacturing index. If global growth worsens, the dollar will strengthen, quality spreads will widen and stocks will weaken, resulting in tighter financial conditions. Since economic and trade uncertainty is still high, further deterioration in external conditions will cause U.S. capex to collapse. Employment would follow, confidence suffer and consumption fall. Global growth still holds the key to the future. Chart I-5 Following The Chinese Impulse As the world’s foremost trading nation, Chinese activity lies at the center of the global growth equation. The China-U.S. trade war remains at the forefront of investors’ minds. The meeting between U.S. President Donald Trump and Chinese President Xi Jinping over the next two days is important. It implies a thawing of Sino-U.S. trade negotiations. However, an overall truce is unlikely. An agreement to resume the talks is the most likely outcome. No additional tariffs will be levied on the remaining $300 billion of untaxed Chinese exports to the U.S., but the previous levies will not be meaningfully changed. Removing this $300 billion Damocles sword hanging over global growth is a positive at the margin. However, it also means that the can has been kicked down the road and that trade will remain a source of headline risk, at least until the end of the year. Chart I-6The Rubicon Has Been Crossed The Rubicon Has Been Crossed The Rubicon Has Been Crossed Trade uncertainty will nudge Chinese policymakers to ease policy further. In previous speeches, Premier Li Keqiang set the labor market as a line in the sand. If it were to deteriorate, the deleveraging campaign could be put on the backburner. Today, the employment component of the Chinese PMI is at its lowest level since the Great Financial Crisis (Chart I-6). This alone warrants more reflationary efforts by Beijing. Adding trade uncertainty to this mix guarantees additional credit and fiscal stimulus. More Chinese stimulus will be crucial for Chinese and global growth. Historically, it has taken approximatively nine months for previous credit and fiscal expansions to lift economic activity. We therefore expect that over the course of the summer, the imports component of the Chinese PMI should improve further, and the overall EM Manufacturing PMI should begin to rebound (Chart I-7, top and second panel). More generally, this summer should witness the bottom in global trade, as exemplified by Asian or European export growth (Chart I-7, third and fourth panel). The prospect for additional Chinese stimulus means that the associated pick-up in industrial activity should have longevity. Global central banks are running a brand new experiment. We are already seeing one traditional signpost that Chinese stimulus is having an impact on growth. Within the real estate investment component of GDP, equipment purchases are growing at a 30% annual rate, a development that normally precedes a rebound in manufacturing activity (Chart I-8, top panel). We are also keeping an eye out for the growth of M1 relative to M2. When Chinese M1 outperforms M2, it implies that demand deposits are growing faster than savings deposits. The inference is that the money injected in the economy is not being saved, but is ready to be deployed. Historically, a rebounding Chinese M1 to M2 ratio accompanies improvements in global trade, commodities prices, and industrial production (Chart I-8, bottom panel). Chart I-7The Turn In Chinese Credit Will Soon Be Felt Around The World The Turn In Chinese Credit Will Soon Be Felt Around The World The Turn In Chinese Credit Will Soon Be Felt Around The World Chart I-8China's Stimulus Is Beginning To Have An Impact China's Stimulus Is Beginning To Have An Impact China's Stimulus Is Beginning To Have An Impact   To be sure, China is not worry free. Auto sales are still soft, global semiconductor shipments remain weak, and capex has yet to turn the corner. But the turnaround in credit and in the key indicators listed above suggests the slowdown is long in the tooth. In the second half of 2019, China will begin to add to global growth once again. Advanced Economies’ Central Banks: A Brave New World Chart I-9The Inflation Expectations Panic The Inflation Expectations Panic The Inflation Expectations Panic While China is important, it is not the only game in town. Global central banks are running a brand new experiment. It seems they have stopped targeting realized inflation and are increasingly focused on inflation expectations. The collapse in inflation expectations is worrying central bankers (Chart I-9). Falling anticipated inflation can anchor actual inflation at lower levels than would have otherwise been the case. It also limits the downside to real rates when growth slows, and therefore, the capacity of monetary policy to support economic activity. Essentially, central banks fear that permanently depressed inflation expectations renders them impotent. The change in policy focus is evident for anyone to see. As recently as January 2019, 52% of global central banks were lifting interest rates. Now that inflation expectations are collapsing, other than the Norges Bank, none are doing so (Chart I-10). Instead, the opposite is happening and the RBA, RBNZ and RBI are cutting rates. Moreover, as investors are pricing in lower policy rates around the world, G-10 bond yields are collapsing, which is easing global liquidity conditions. Indeed, as Chart I-11 illustrates, when the share of economies with falling 2-year forward rates is as high as it is today, the BCA Global Leading Indicator rebounds three months later. Chart I-10Central Banks Are In Easing Mode, Everywhere Central Banks Are In Easing Mode, Everywhere Central Banks Are In Easing Mode, Everywhere The European Central Bank stands at the vanguard of this fight. As we argued two months ago, deflationary pressures in Europe are intact and are likely to be a problem for years to come.3 The ECB is aware of this headwind and knows it needs to act pre-emptively. Four months ago, it announced a new TLRTO-III package to provide plentiful funding for stressed banks in the European periphery. On June 6th, ECB President Mario Draghi unveiled very generous financing terms for the TLTRO-III. Last week, at the ECB’s Sintra conference in Portugal, ECB Vice President Luis de Guindos professed that the ECB could cut rates if inflation expectations weaken. The following day, Draghi himself strongly hinted at an upcoming rate cut in Europe and a potential resumption of the ECB QE program. These measures are starting to ease financial conditions where Europe needs it most: Italy. An important contributor to the contraction in the European credit impulse over the past 21 months was the rapid tightening in Italian financial conditions that followed the surge in BTP yields from May 2018. Now that the ECB is becoming increasingly dovish, Italian yields have fallen to 2.1%, and are finally below the neutral rate of interest for Europe. BTP yields are again at accommodative levels. Chart I-11This Much Of An Easing Bias Boosts Growth Prospects This Much Of An Easing Bias Boosts Growth Prospects This Much Of An Easing Bias Boosts Growth Prospects With financial conditions in Europe easing and exports set to pick up in response to Chinese growth, European loan demand should regain some vigor. Meanwhile, the TLTRO-III measures, which are easing bank funding costs, should boost banks’ willingness to lend. The European credit impulse is therefore set to move back into positive territory this fall. European growth will rebound, and contribute to improving global growth conditions. The Fed’s Patience Is Running Out Chart I-12 The Federal Reserve did not cut interest rates last week, but its intentions to do so next month were clear. First, the language of the statement changed drastically. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” Second, the fed funds rate projections from the Summary of Economic Projections were meaningfully revised down. In March, 17 FOMC participants expected the Fed to stay on hold for the remainder of 2019, while six foresaw hikes. Today, eight expect a steady fed funds rate, but seven are calling for two rate cuts this year. Only one member is still penciling in a hike. Moreover, nine out of 17 participants anticipate that rates will be lower in 2020 than today (Chart I-12). The FOMC’s unwillingness to push back very dovish market expectations signals an imminent interest rate cut. Like other advanced economy central banks, the Fed’s sudden dovish turn is aimed at reviving moribund inflation expectations (Chart I-13). In order to do so, the Fed will have to keep real interest rates at low levels, at least relative to real GDP growth. Even if the real policy rate goes up, so long as it increases more slowly than GDP growth, it will signify that money supply is growing faster than money demand.4 TIPS yields are anticipating these dynamics and will likely remain soft relative to nominal interest rates. Chart I-13...As Inflation Expectations Plunge ...As Inflation Expectations Plunge ...As Inflation Expectations Plunge Since the Fed intends to conduct easy monetary policy until inflation expectations have normalized to the 2.3% to 2.5% zone, our liquidity gauges will become more supportive of economic activity and asset prices over the coming two to three quarters: Our BCA Monetary indicator has not only clearly hooked up, it is now above the zero line, in expansionary territory (see Section III, page 41). Excess money growth, defined as money-of-zero-maturity over loan growth, is once again accelerating. This cycle, global growth variables such as our Global Nowcast, BCA’s Global Leading Economic Indicator, or worldwide export prices have all reliably followed this variable (Chart I-14). After collapsing through 2018, our U.S. Financial Liquidity Index is rebounding sharply, and the imminent end of the Fed’s balance sheet runoff will only solidify this progress. This indicator gauges how cheap and plentiful high-powered money is for global markets. Its recovery suggests that commodities, globally-traded goods prices, and economic activity are all set to improve (Chart I-15). Chart I-14Excess Money Has Turned Up Excess Money Has Turned Up Excess Money Has Turned Up Chart I-15Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up... Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up... Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up...   The dollar is losing momentum and should soon fall, which will reinforce the improvement in global liquidity conditions. A trough in our U.S. Financial Liquidity Index is often followed by a weakening dollar (Chart I-16). Moreover, the Greenback’s strength has been turbocharged by exceptional repatriations of funds by U.S. economic agents (Chart I-17). The end of the repatriation holiday along with a more dovish Fed and the completion of the balance sheet runoff will likely weigh on the dollar. Once the Greenback depreciates, the cost of borrowing for foreign issuers of dollar-denominated debt will decline, along with the cost of liquidity, especially if the massive U.S. repatriation flows are staunched. This will further support global growth conditions. Chart I-16...And That The Dollar Will Turn Down... ...And That The Dollar Will Turn Down... ...And That The Dollar Will Turn Down... Trade relations are unlikely to deteriorate further, China is likely to stimulate more aggressively; and easing central banks around the world, including the Fed, are responding to falling inflation expectations. This backdrop points to a rebound in global growth in the second half of the year. As a corollary, the deflationary patch currently engulfing the world should end soon after. As a result, this growing reflationary mindset should delay any recession until late 2021 if not 2022. However, as the business cycle extends further, greater inflationary pressures will build down the road and force the Fed to lift rates – even more than it would have done prior to this wave of easing. Chart I-17...Especially If Repatriation Flows Slow ...Especially If Repatriation Flows Slow ...Especially If Repatriation Flows Slow Investment Implications Bonds BCA’s U.S. Bond Strategy service relies on the Golden Rule of Treasury Investing. This simple rule states that when the Fed turns out to be more dovish than anticipated by interest rate markets 12 months prior, Treasurys outperform cash. If the Fed is more hawkish than was expected by market participants, Treasurys underperform (Chart I-18). Today, the Treasury market’s outperformance is already consistent with a Fed generating a very dovish surprise over the next 12 months. However, the interest rate market is already pricing in a 98% probability of two rates cuts this year, and the December 2020 fed funds rate futures imply a halving of the policy rate. The Fed is unlikely to clear these very tall dovish hurdles as global growth is set to rebound, the fed funds rate is not meaningfully above neutral and the household sector remains resilient. Chart I-18Treasurys Already Anticipate Large Dovish Surprises Treasurys Already Anticipate Large Dovish Surprises Treasurys Already Anticipate Large Dovish Surprises Reflecting elevated pessimism toward global growth, the performance of transport relative to utilities stocks is as oversold as it gets. The likely rebound in this ratio should push yields higher, especially as foreign private investors are already aggressively buying U.S. government securities (Chart I-19). As occurred in 1998, Treasury yields should rebound soon after the Fed begins cutting rates. Moreover, with all the major central banks focusing on keeping rates at accommodative levels, the selloff in bonds should be led by inflation breakevens, also as occurred in 1998 (Chart I-20), especially if the dollar weakens. Chart I-19Yields Will Follow Transportation Relative To Utilities Stocks Yields Will Follow Transportation Relative To Utilities Stocks Yields Will Follow Transportation Relative To Utilities Stocks Chart I-201998: Yields Rebounded As Soon As The Fed Began Cutting 1998: Yields Rebounded As Soon As The Fed Began Cutting 1998: Yields Rebounded As Soon As The Fed Began Cutting     Equities A global economic rebound should provide support for equities on a cyclical horizon. The tactical picture remains murky as the stock market may have become too optimistic that Osaka will deliver an all-encompassing deal. However, this short-term downside is likely to prove limited compared to the cyclical strength lying ahead. This is particularly true for global equities, where valuations are more attractive than in the U.S. Chart I-21Easier Liquidity Conditions Lead To Higher Stock Prices Easier Liquidity Conditions Lead To Higher Stock Prices Easier Liquidity Conditions Lead To Higher Stock Prices Even if the S&P 500 isn’t the prime beneficiary of the recovery in global growth, it should nonetheless generate positive absolute returns on a cyclical horizon. As Chart I-21 illustrates, a pickup in our U.S. Financial Liquidity Index often precedes a rally in U.S. stocks. Since the U.S. Financial Liquidity Index has done a superb job of forecasting the weakness in stocks over the past 18 months, it is likely to track the upcoming strength as well. A weaker dollar should provide an additional tailwind to boost profit growth, especially as U.S. productivity is accelerating. This view is problematic for long-term investors. The cheapness of stocks relative to bonds is the only reason why our long-term valuation index is not yet at nosebleed levels Chart I-22). If we are correct that the current global reflationary push will build greater inflationary pressures down the road and will ultimately result in even higher interest rates, this relative undervaluation of equities will vanish. The overall valuation index will then hit near-record highs, leaving the stock market vulnerable to a very sharp pullback. Long-term investors should use this rally to lighten their strategic exposure to stocks, especially when taking into account the risk that populism will force a retrenchment in corporate market power, an issue discussed in Section II. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” In this environment, gold stocks are particularly attractive. Central banks are targeting very accommodative policy settings, which will limit the upside for real rates. Moreover, generous liquidity conditions and a falling dollar should prove to be great friends to gold. These fundamentals are being amplified by a supportive technical backdrop, as gold prices have broken out and the gold A/D line keeps making new highs (Chart I-23). Chart I-22Beware What Will Happen To Valuations Once Rates Rise Again Beware What Will Happen To Valuations Once Rates Rise Again Beware What Will Happen To Valuations Once Rates Rise Again Chart I-23Strong Technical Backdrop For The Gold Strong Technical Backdrop For The Gold Strong Technical Backdrop For The Gold   Structural forces reinforce these positives for gold. EM reserve managers are increasingly diversifying into gold, fearful of growing geopolitical tensions with the U.S. (Chart I-24). Meanwhile, G-10 central banks are not selling the yellow metal anymore. This positive demand backdrop is materializing as global gold producers have been focused on returning cash to shareholders instead of pouring funds into capex. This lack of investment will weigh on output growth going forward. Chart I-24EM Central Banks Are Diversifying Into Gold EM Central Banks Are Diversifying Into Gold EM Central Banks Are Diversifying Into Gold This emphasis on returning cash to shareholders makes gold stocks particularly attractive. Gold producers are trading at a large discount to the market and to gold itself as investors remain concerned by the historical lack of management discipline. However, boosting dividends, curtailing debt levels and only focusing on the most productive projects ultimately creates value for shareholders. A wave of consolidation will only amplify these tailwinds. Our overall investment recommendation is to overweight stocks over bonds on a cyclical horizon while building an overweight position in gold equities. Our inclination to buy gold stocks transcends our long-term concerns for equities, as rising long-term inflation should favor gold as well. The Key Risk: Iran The biggest risk to our view remains the growing stress in the Middle East. BCA’s Geopolitical Strategy team assigns a less than 40% chance that tensions between the U.S. and Iran will deteriorate into a full-fledged military conflict. The U.S.’s reluctance to respond with force to recent Iranian provocations may even argue that this probability could be too high. Nonetheless, if a military conflict were to happen, it would involve a closing of the Strait of Hormuz, a bottleneck through which more than 20% of global oil production transits. In such a scenario, Brent prices could easily cross above US$150/bbl. Chart I-25Oil Inventories Are Set To Decline Oil Inventories Are Set To Decline Oil Inventories Are Set To Decline To mitigate this risk, we recommend overweighting oil plays in global portfolios. Not only would such an allocation benefit in the event of a blow-up in the Persian Gulf, oil is supported by positive supply/demand fundamentals and Brent should end the year $75/bbl. After five years of limited oil capex, Wood Mackenzie estimates that the supply of oil will be close to 5 million barrels per day smaller than would have otherwise been the case. Moreover, OPEC and Russia remain disciplined oil producers, which is limiting growth in crude output today. Meanwhile, in light of the global growth deceleration, demand for oil has proved surprisingly robust. Demand is likely to pick up further when global growth reaccelerates in the second half of the year. As a result, BCA’s Commodity and Energy Strategy currently expects additional inventory drawdowns that will only push oil prices higher in an environment of growing global reflation (Chart I-25). A falling dollar would accentuate these developments.   Mathieu Savary Vice President The Bank Credit Analyst June 27, 2019 Next Report: July 25, 2019   II. The Productivity Puzzle: Competition Is The Missing Ingredient Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Deleveraging Hurts Productivity Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. Chart II-3 The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. The collapse in new business formation in the U.S. is another fascinating development. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. This is pure market power, and it helps explain the gap between wages and productivity. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Chart II-6A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity A Multifaceted Decline In Productivity Pushing The Production Frontier Is Increasingly Hard Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Chart II-7 Chart II-8Demographics Are Hurting Productivity Demographics Are Hurting Productivity Demographics Are Hurting Productivity Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-9 Chart II-10The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses A Dearth Of New Businesses A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years. The X Factor: Growing Market Concentration Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor Wide Profit Margins: A Testament To The Weakness Of Labor The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector. Chart II-13 Chart II-14     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II- Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Chart II-16 Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. Chart II-17 In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat? How To Build A Moat? How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity. Chart II-20 Chart II-   Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22). Chart II-21 Chart II-22     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts Over the past two weeks, the ECB has made a dovish pivot, President Trump announced he would meet President Xi, and the Fed telegraphed a rate cut for July. In response, the S&P 500 made marginal new highs before softening anew. This lack of continuation after such an incredible alignment of stars shows that the bulls lack conviction. These dynamics increase the probability that the market sells off after the G-20 meeting, as we saw last December following the supposed truce in Buenos Aires. The short-term outlook remains dangerous. Our Revealed Preference Indicator (RPI) confirms this intuition. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if stong market momentum is not supported by valuation and policy, investors should lean against the market trend. Cheaper valuations, a pick-up in global growth or an actual policy easing is required before stocks can resume their ascent. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat in Europe. 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. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips. Our Monetary Indicator is moving deeper into stimulative territory, supporting our cyclically constructive equity view. The Fed and the ECB are set to cut rates while other global central banks have been opening the monetary spigots. This will support global monetary conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator remains above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are now expensive. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Additionally, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Considering this technical backdrop, BCA’s economic view implies minimal short-term downside for yields, but significant downside for Treasury prices over the upcoming year. On a PPP basis, the U.S. dollar remains very expensive. Additionally, after forming a negative divergence with prices, our Composite Technical Indicator is falling quickly. Being a momentum currency, the dollar could suffer significant downside if this indicator falls below zero. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 2       Please see Global Investment Strategy Special Report "Give Credit Where Credit Is Due," dated November 27, 2015, available at gis.bcaresearch.com 3       Please see The Bank Credit Analyst Special Report "Europe: Here I Am, Stuck In A Liquidity Trap," dated April 25, 2019, available at bca.bcaresearch.com 4       Money demand is mostly driven by the level of activity and wealth. If the price of money – interest rates – is growing more slowly than money demand, the most likely cause is that money supply is increasing faster than money demand and policy is accommodative. 5       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 6       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 7       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 8       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 9     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 10     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 11     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 12    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 13     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 14     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 15     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 16     Productivity can be written as: Image 17     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: