Labor Market

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom An Employment Boom An Employment Boom Chart 2Recovery Is Broad-Based Recovery Is Broad-Based Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently Wages Stagnated Until Recently Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Wage Pressures Should Mount Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Confidence Will Be Key For Any Recovery Confidence Will Be Key For Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Low Rates Should Help Housing Low Rates Should Help Housing Chart 11Cost-Push Inflation Cost-Push Inflation Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 15...And Compared To ##br##Global Peers ...And Compared To Global Peers ...And Compared To Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources A Misallocation of Resources A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 22A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. 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. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993).

Highlights The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. However, even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending, and anemic productivity. The net result is an economy with lower trend growth, a structurally weaker exchange rate, and relatively high domestic inflation. Brexit will be delayed beyond October 31. No-deal Brexit is an overstated risk unless an early election strengthens Boris Johnson’s hand. That is unlikely. The investment outlook for the British pound and U.K. gilts is highly binary: a “smooth” Brexit is bullish for the pound and bearish for gilts, while no-deal Brexit would push both the pound and gilt yields even lower. Feature Ever since the United Kingdom voted in 2016 to exit the European Union, the outlook for the economy and financial assets has been tied to the binary outcome of whether or not an exit would be orderly. This has been a tremendous source of uncertainty, putting the Bank of England (BoE) in one of the most inconvenient positions ever faced by a central bank. In this week’s report, we look to address a few high-level questions. First, has the slowdown in the U.K. economy been run of the mill, given the global manufacturing recession? Or has it been unduly protracted given heightened political uncertainty? If the latter, what are the prospects of a rebound should anything other than a “no-deal” Brexit prevail? Finally, has there been irreparable damage already done to the economy because of delayed investment, with longer-term ramifications irrespective of the relationship outcome with the E.U.? An Employment Boom The U.K. is currently experiencing the best jobs recovery since the Second World War. 4.2 million new jobs have been created over the past decade, nudging the employment-to-population ratio to the highest level in almost 50 years. What is remarkable is that this recovery looks even more impressive than that of the U.S., where labor market conditions have been very robust. For example, in the U.S., the employment rate stands at 60.9%, just a nudge below the U.K. but still nearly four percentage points below its pre-crisis peak (Chart 1). Compared to the eurozone, the outperformance of the U.K. labor market has been very evident. Despite this recovery, the pickup in wages has been the most tepid since the Boer War. The quality of jobs has also been stellar – full-time job creation has outpaced part-time and female participation rates are soaring. The jobs bonanza has also been broad across regions and industries. Yes, the manufacturing sector has seen some measure of volatility, but aside from the East Midland region, unemployment rates continue to converge downward across the United Kingdom (Chart 2) Chart 1An Employment Boom An Employment Boom An Employment Boom Chart 2Recovery Is Broad-Based Recovery Is Broad-Based Recovery Is Broad-Based     Despite this recovery, the pickup in wages has been the most tepid since the Boer War. In a July speech, the BoE’s chief economist, Andy Haldane, rightly noted that the lost decade of pay has been an equal-opportunity disaster across the major U.K. regions. From the 1950s until the Great Recession, real pay in the U.K. grew by about 2% per annum. Since the Great Recession, real pay has stagnated at a rate of -0.4% per year (Chart 3).1 Chart 3Wages Stagnated Until Recently Wages Stagnated Until Recently Wages Stagnated Until Recently There have been a few reasons for this. First, there has been strong growth in self-employment, zero-hours contracts and agency work. So even though the share of full-time work has been rising during the post-crisis period, it remains well below its pre-crisis highs. This has increased the fluidity of the labor market, lowering the cost of doing business in the process. Compensation of self-employed or zero-hours contract workers lies significantly below their permanent counterparts. The silver lining is that this phenomenon is not specific to the U.K., but is happening worldwide, especially in Europe where structural reform has disentangled rigidities in the labor market. The key question going forward is whether the nascent rise in wages will continue. Over a cyclical horizon, our contention is that should positive employment trends continue, the U.K. could begin to experience significantly stronger wage pressures. There are four fundamental reasons for this: Job offers continue to outpace the number of seekers. Depending on the measure used, there are 20%-40% more jobs than there are applicants (Chart 4). This impasse cannot easily be resolved by a higher employment rate (it is at a secular high) or lower unemployment. The BoE estimates NAIRU in the U.K. is at 4.4%, which means that the unemployment rate is firmly below its structural level. Business surveys continue to suggest that a shortage of skilled labor is among the top problems firms are facing. The Phillips curve in the U.K. has flattened in the last few years, but wage growth has started to inflect higher of late. Like many other countries, the Phillips curve in the U.K. is kinked, whereby the convexity of wage growth increases as the unemployment gap closes.  The velocity of circulation in the jobs market, also known as the job-to-job flow, has picked up. This has historically been positive for wage growth (Chart 5). This is also mirrored by the quits rate, which has been accelerating since 2012. Chart 4Wage Pressures Should Mount Wage Pressures Should Mount Wage Pressures Should Mount Chart 5Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising Velocity Of U.K. Employment Rising At the moment, the transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow on longer-term hiring plans. For example, for all the talk of the U.K. being a financial center, attrition in banking and insurance employment remains entrenched (Chart 6). The U.K. continues to attract a significant amount of financial business, especially in the foreign exchange market, but there was a clear hit to volumes in 2016, the year the Brexit referendum was held (Chart 7). Meanwhile, for the manufacturing sector, it will take a while to rekindle animal spirits and re-attract foreign direct investment. Chart 6Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Attrition In Manufacturing And Finance Employment Chart 7The U.K. Is An Important Financial Center United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? That said, the U.K. economy remains mostly driven by services, meaning wages will still face some measure of upward pressure. Service sector wage growth has been robust and unless the manufacturing recession grows deeper and starts to infect other sectors of the U.K. economy, the path of least resistance for wages remains up. Bottom Line: The U.K. economy has been holding up fairly well, despite the overhang of political uncertainty. Virtuous Circle Of Spending While the U.K. income pie could grow, a lack of confidence is nonetheless constraining spending. Chart 8 shows that U.K. consumer confidence has negatively diverged from trends in both the U.S. and the euro area. There have been a few offsetting factors at play suggesting that once the clouds of Brexit uncertainty lift, spending could re-accelerate higher. The transmission mechanism from a tight labor market to higher wages is being impeded by political uncertainty, which will continue to cast a near-term shadow. A big driver for retail sales in the U.K. is tourist arrivals and the weaker pound is likely to keep attracting an influx of visitors (Chart 9). Chart 8Confidence Will Be Key For ##br##Any Recovery Confidence Will Be Key For Any Recovery Confidence Will Be Key For Any Recovery Chart 9The Cheap Pound Will Encourage ##br##Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The Cheap Pound Will Encourage Foreign Shoppers The U.K. commands many of the world’s leading brands that will benefit from a cheap currency. The household deleveraging process is well advanced, and the tentative recovery in borrowing and mortgage applications is helping to cushion the fall in U.K. house prices. This is underpinned by the fact that mortgage-borrowing costs in the U.K. have collapsed along with yields (Chart 10). That said, any rise is borrowing will be mitigated by the fact that household debt-to-GDP in the U.K. remains higher than in many other developed economies. Chart 10Low Rates Should Help Housing Low Rates Should Help Housing Low Rates Should Help Housing Chart 11Cost-Push Inflation Cost-Push Inflation Cost-Push Inflation Inflation expectations are blasting upward, partly in response to the weaker currency. What is remarkable is that the pound has plummeted by a lot more than is warranted on a fundamental PPP basis. This will bring about imported inflation (Chart 11). Bottom Line: The big risk to the U.K. economy is that it enters into stagflation. A BoE survey pins the loss to output in the event of a no-deal Brexit at around 3% of GDP, but these are estimates since the bulk of the economic adjustment might occur through the exchange rate. The range of estimates for the economic impact of a no-deal (Table 1), perhaps not coincidentally, mirrors the range of Britain’s recessions in the 20th century (Chart 12). This puts the BoE in a particularly uncomfortable “wait and see” mode. For example, if a hard exit leads to a fall in the pound and a rise in inflation expectations, it is not clear the BoE’s Monetary Policy Committee would cut rates if it were to meet its inflation mandate. Table 1Wide Range Of Estimates For Impact ##br##Of No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 12Past British Recessions Offer Guidelines ##br##For No-Deal Impact United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Brexit Uncertainty Has Already Caused Lasting Damage To U.K. Growth A major drag on U.K. economic growth over the past three years has been the collapse in business confidence and associated contraction in capital spending (Chart 13). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%, according to the BoE (Chart 14). While some of the softness seen in 2019 can also be attributable to slowing global economic growth and uncertainty related to the U.S.-China trade war, U.K. capital spending has been far weaker than that of other advanced economies (Chart 15). Since the 2016 Brexit vote, business investment has been substantially weaker than at similar points in previous U.K. business cycles – by a cumulative 26%. This is a critical point to consider when judging the long-run damage that has already been inflicted on the U.K. economy just from the uncertainty of Brexit. The best way to evaluate this damage is through the lens of capital spending, the growth of which is highly correlated to changes in productivity and potential economic growth (Chart 16). Chart 13Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Gloomy U.K. Businesses Have Stopped Investing Chart 14Massive Underperformance Of U.K. Capex Compared To History ... United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 15...And Compared To ##br##Global Peers ...And Compared To Global Peers ...And Compared To Global Peers Chart 16A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty A Lasting Hit To The U.K. Economy From Brexit Uncertainty     An important research paper published by the BoE last month – co-authored by two current members of the BoE Monetary Policy Committee, Ben Broadbent and Silvana Tenreyro – discusses the linkages between Brexit uncertainty, capital spending and U.K. productivity.2 The authors concluded that the economic effects of the Brexit referendum result can be categorized as a response to an anticipated, persistent decline in productivity growth for the tradeable sectors of the U.K. economy. In that framework, the following chain of events would occur after the “news” of weaker expected productivity (i.e. the Brexit referendum result) is announced: Chart 17A Misallocation of Resources A Misallocation of Resources A Misallocation of Resources An immediate and permanent fall in the relative price of non-tradeable output relative to tradeable output, i.e. the real exchange rate. Resources shift to the tradeable sector to take advantage of the higher relative price, leading to an increase in output and a rise in exports. Productivity growth in the tradeable sector then falls, as heralded by the “news” of the Brexit vote, leading to a shift in economic resources back towards the higher productivity non-tradeable sectors. U.K. interest rates fall relative to the world, as financial markets discount the expected relatively slower path of U.K. productivity. Aggregate business investment growth slows, but overall employment growth remains resilient. This is exactly how the U.K. economy has evolved since the 2016 Brexit vote: The BoE’s trade-weighted index for the pound has fallen in both nominal and real terms. The export share of U.K. real GDP rose from 27% to 30%, while the investment share of real GDP declined from 10% to 9% (Chart 17, top panel). Annual employment growth in U.K. services (non-tradeable) fell from 2.1% to zero by the end of 2018, but has since begun to recover; manufacturing (tradeable) employment growth initially increased from 0.5% to 2.7% within a year of the Brexit vote, before slowing back to 0% in 2018, and is also starting to move higher (Chart 17, third panel). Productivity growth has declined from 1.9% to nil, even as wage growth has accelerated due to the steady pace of labor demand at a time of low unemployment (Chart 17, bottom panel). On a sectoral level, the worst growth rates of realized productivity growth are occurring in tradeable industries like metal products and financial services, while the highest productivity growth is seen in non-tradeable industries like professional services and retail (Chart 18).3 Chart 18Latest U.K. Productivity Growth Rates, By Industry United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Summing it all up, according to the analytic framework of the BoE research paper, the Brexit referendum result essentially created a signal, manifested by the plunge in the British pound, for the misallocation of U.K. resources away from higher-productivity non-tradeable industries to lower productivity tradeable sectors. If true, we would also expect to see the following: Chart 19Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Inflationary Consequences of Brexit Uncertainty Much higher inflation rates in more domestically-focused measures like services and wages. Faster growth in unit labor cost as a result of the gap between accelerating wages and stagnant productivity. Structurally higher inflation expectations. Lower real interest rates in the U.K. than in other advanced economies. Prolonged weakness in the exchange rate. Again, all of this has come to fruition in the U.K. (Chart 19): Services CPI inflation is now at 2.2%, compared to only 1.7% for overall CPI inflation. Unit labor costs growth has accelerated from below zero before the Brexit referendum to a 2%-3% range since the end of 2016. The real 10-year gilt yield (deflated by the 10-year CPI swap rate) is now -3.1%, compared to a 0% real yield on 10-year U.S. Treasurys. The trade-weighted British pound remains close to its post-Brexit referendum lows. It is clear that the Brexit uncertainty has resulted in a structurally weaker, and more inflationary, U.K. economy – an outcome that may not be quickly reversed in the event a no-deal Brexit is avoided. This has important implications for the future monetary policy decisions of the BoE and the investment outlook for the pound and U.K. gilts. Bottom Line: Even before the actual withdrawal of the U.K. from the E.U. has occurred, Brexit has left a lasting mark on the U.K. economy through elevated uncertainty, severe weakness in business investment spending and anemic productivity. The net result is an economy with lower trend growth, a structurally weak exchange rate, and relatively high domestic inflation. Political Uncertainty Prevails Chart 20Public Opposes No-Deal Brexit United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Even after considering the cyclical and structural state of the U.K. economy, as we have done in this report, the near-term outlook is still entirely dependent on the Brexit outcome. The state of Brexit is more uncertain than ever due to the Supreme Court case against the government’s suspension of Parliament and Prime Minister Boris Johnson’s refusal to obey an order by Parliament to seek an extension to the October 31 exit deadline. What is not in doubt is that parliament opposes a disorderly, no-deal Brexit. And the best polling suggests that public opinion opposes a no-deal Brexit as well (Chart 20). Members soundly rejected Prime Minister Boris Johnson’s negotiation strategy in September – they prohibited both a no-deal Brexit and voted against holding an early election on two separate occasions (Chart 21). Johnson lost his coalition majority and yet cannot go to new elections, leaving him hamstrung until Parliament returns. What is likely regardless of the outcome is a substantial increase in fiscal spending, The United Kingdom is not a seventeenth-century Stuart monarchy – Parliament is the supreme political body in the constitution and its decrees cannot be permanently ignored or disobeyed. Whenever Parliament reconvenes, likely October 14, it will have the ability to ensure that the Brexit deadline is extended. The E.U. is likely to grant an extension because it is in the E.U.’s interest to delay or cancel Brexit and demonstrate to all members that leaving the bloc is neither desirable nor practical. The result will then be an election. Chart 21Boris Johnson’s Negotiation Strategy Failed United Kingdom: Cyclical Slowdown Or Structural Malaise? United Kingdom: Cyclical Slowdown Or Structural Malaise? Chart 22A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome A Hung Parliament Is The Likely Outcome Election polls show the Conservative Party breaking out, the Liberal Democrats overtaking Labour, and the Brexit Party maintaining an edge (Chart 22). Translating these polls to parliamentary seats is not straightforward because the first-past-the-post electoral system means that a smaller party can steal crucial votes from the most popular party leaving the second- or third-most popular party to win the seat. The key point is that the Brexit Party is a single-issue party and the Tories under Johnson are now monopolizing that same issue. If this dynamic persists, the Lib Dems pose a greater threat of splitting Labour’s votes than the Brexit Party does of splitting Conservative votes. The result is that it is still possible for the Conservatives to gain a majority, even though it seems unlikely given that they need 325-plus seats and have fallen to 288 seats after purging unruly members and losing leadership in Scotland. A hung Parliament is a more likely outcome. A hung Parliament will prolong the indecision and uncertainty – but will also be likely to remain united against a no-deal Brexit. An opposition coalition government will prevent a no-deal Brexit. Even a single-party Tory majority is not a disastrous outcome, as it would increase Johnson’s leverage with the E.U. and increase the likelihood that the E.U. would offer some concessions to get a withdrawal agreement passed, resulting in a Brexit deal and an orderly exit (Specifically, a Northern Irish limitation to the backstop, or a sunset clause or withdrawal mechanism for the same). Such a deal is in Johnson’s best interests so that he does not preside over a recession from the moment he returns to office. All of these outcomes point toward either an exit deal or a new chapter in which parliament seeks a new referendum. Chart 23Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending Expect An Increase In Fiscal Spending The worst outcome for the markets would be a weak Tory coalition majority that cannot agree on Ireland or pass an exit deal, as this could lead to paralysis, as it did with Theresa May, at a time when the prime minister is committed to delivering an exit come hell or high water. This is the scenario in which no-deal once again becomes a genuine risk. Subjectively we have estimated that the risk of no-deal is around 30%, but this is currently falling, not rising, as a result of parliament’s strong majorities against that outcome in September – and only an election can change that. It is fruitless trying to predict the U.K.’s future political landscape without knowing the conclusion of the Brexit saga. What is likely regardless of the outcome is a substantial increase in fiscal spending, reversing the “austerity” of the aftermath of the Great Recession. This trend is already apparent from Johnson’s current attempt to present a generous social spending package at the Tory party conference this fall – which would, if vindicated by a new election, represent a turnaround in Conservative fiscal policy (Chart 23). More fiscal spending will be needed to counteract the negative impact of a disorderly Brexit, or to placate the middle class once it becomes clear that leaving the E.U. is not a panacea for the UK’s problems, or to fulfill the agenda of an opposition government when it comes to power. In the event that a no-deal Brexit occurs, the U.K. will not only face a tumultuous economic aftermath, but the constitutional struggles among the three kingdoms will reignite due to the negative impact in Northern Ireland and the likely revival of Scottish independence efforts. Bottom Line: The U.K. is not a dictatorship and the prime minister cannot refuse to obey Parliament’s will. Parliament has voted clearly to delay a no-deal Brexit and will continue to do so. A disorderly exit remains a risk because an eventual election could return the Tories to power. But in this case, the E.U. will be more likely to offer a concession that enables Parliament to pass a withdrawal bill. The odds of no deal are no higher than 30%. The structural takeaway, regardless of the outcome, is that fiscal spending will rise. Investment Conclusions The episodes surrounding the collapse of the pound in 1992 carry important lessons for today.4  Crucially, most of the adjustment in the pound happened quickly, but a key difference from today is that an exit from the European Exchange Rate Mechanism was unanticipated, unlike Brexit. Foreign exchange markets are extremely fluid and adjust to expectations quite quickly. Peak to trough, cable has already fallen by circa 30% suggesting the bulk of the downward adjustment is done. Chart 24A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts A Binary Brexit Outcome for Gilts The British currency is free floating, meaning there are less “hidden sins” compared to the fixed exchange rate period. That said, the fair value of the pound has structurally weakened. 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. In the case of a soft Brexit (or no Brexit), the pound should converge toward the mid-point of its historical real effective exchange rate range, which would pin it 15%-20% higher, or at around 1.50. From a risk-reward perspective, this looks attractive. For U.K. gilts, the direction of yields is also dependent on the Brexit outcome, as there is essentially no change in policy rates discounted in the U.K. Overnight Index Swap (OIS) curve (Chart 24).  A “smooth” Brexit would allow the BoE to return its focus to fighting elevated U.K. inflation expectations. That would likely result in both higher gilt yields and a flattening of the gilt yield curve, as the market prices in future BoE rate hikes, and lower longer-term inflation expectations. A rising cable will also temper inflation expectations. Neither gilts nor U.K. inflation-linked bonds would perform well in this scenario.. A “no deal” Brexit, on the other hand, would prompt the BoE to cut interest rates in order to offset the potential hit to business and consumer confidence. This could occur even if inflation expectations remain high or rise further on pound weakness. That would mean lower gilt yields and a steepening of the gilt curve. Going overweight gilts but also long inflation-linked bonds would be the best way to position for this outcome. The scenarios for fiscal easing outlined earlier would also influence the shape of the gilt curve, resulting in some degree of bearish steepening as the gilt curve prices in both larger deficits and higher future inflation, all else equal. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Matt Gertken, Geopolitical Strategist mattg@bcaresearch.com Ray Park, CFA, Research Analyst ray@bcaresearch.com Footnotes 1 Andrew G Haldane, “Climbing the Jobs Ladder,” Bank of England, July 23, 2019 2 Bank of England External MPC Unit Discussion Paper No. 51, “The Brexit vote, productivity growth and macroeconomic adjustments in the United Kingdom”, August 2019 3  London’s role as a major global financial center makes the U.K. financial services industry a “tradeable” sector, in that a significant share of its output is “traded” to non-U.K. users. 4 Mathias Zurlinden, “The Vulnerability of Pegged Exchange Rates: The British Pound in the ERM,” Economic Research, Vol. 75, No. 5 (September/October 1993). Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

What Is The ISM's Message For Employment Prospects? What Is The ISM's Message For Employment Prospects? Following up from last week’s ISM-related analysis, we turn our attention to the labor market that is beginning to reveal some minor cracks. While the ISM debate has centered around the steep divergences between services and manufacturing on the headline number and the new orders subcomponents, the labor components have gone nearly unnoticed. Worrisomely on the employment front, the surveys are in agreement (bottom panel), warning that the labor market will have trouble standing on its own two feet. Tack on the latest NFIB survey, and the news gets grimmer. The top panel shows that an equally-weighted index of small business job openings and hiring plans is quickly losing momentum. Given that roughly 2/3 of job creation originates in small and medium businesses, non-farm payroll growth will likely continue to lose steam in the coming months, which is a bearish sign for the broad equity market (second & third panels). Bottom Line: Remain cautious on the prospects of the overall equity market. Please see the most recent Weekly Report for more details.    

Highlights Portfolio Strategy Small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys, and if the Fed goes ahead and cuts interest rates in half in the coming year as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. The budding recovery in the 10-year UST yield, a rising Citi Economic Surprise Index (CESI) into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Healthy credit growth, still pristine credit quality and early signs of a recovery in the price of credit all signal that an overweight stance is warranted in the S&P banks index.  Recent Changes Last Wednesday we removed the S&P software index from the high-conviction overweight list for a 10% gain. Last Wednesday we removed the large cap size bias from the high-conviction list for a 9% gain. Table 1 The Great Rotation The Great Rotation Feature The SPX built on recent gains last week, but failed to surpass the July highs. Beneath the surface, some big sector shifts are taking place, but it is still early to declare a definitive change in trend. Dormant value stocks have awaken and are riding a high at the expense of growth and momentum names, on the back of a selloff in the bond market (Chart 1). Similarly, small cap stocks have a pulse, and started to outshine large caps. Even in a red SPX day, small cap indexes managed to close in the black (Chart 1). As a reminder with regard to our portfolio, last Wednesday we obeyed our S&P software stop and removed it from the high-conviction call list for a 10% gain, and simultaneously booked gains in the tactical large cap bias and removed it from the high-conviction call list (Chart 1). In both cases our shorter-term confidence was taken down a notch, and we intend to obey our cyclical trailing stops in both positions in order to protect gains for our portfolio (for additional details please refer to the Daily Sector Insights available here and here). Following up from last week’s ISM-related analysis, we turn our attention to the labor market that is beginning to reveal some minor cracks. While the ISM debate has centered around the steep divergences between services and manufacturing on the headline number and the new orders subcomponents, the labor components have gone nearly unnoticed. Chart 1Healthy Rotation Healthy Rotation Healthy Rotation Worrisomely on the employment front, the surveys are in agreement (second panel, Chart 2), warning that the labor market will have trouble standing on its own two feet. This is a bearish backdrop for the broad equity market (third panel, Chart 2). Tack on the latest NFIB survey, and the news gets grimmer. Chart 3 shows that an equally-weighted index of small business job openings and hiring plans is quickly losing momentum. Given that roughly 2/3 of job creation originates in small and medium businesses, non-farm payroll growth will likely continue to lose steam in the coming months (Chart 3). Chart 2Labor Market… Labor Market… Labor Market… Chart 3…Yellow Flags …Yellow Flags …Yellow Flags This week, we update an early cyclical sector and one of its key subcomponents. Finally, the still sinking stock-to-bond ratio corroborates the ISM and NFIB surveys’ messages. Crudely put, the longer that bonds outperform stocks, the higher the chances that employment will suffer a severe setback (Chart 4). Chart 4Last Man Standing Last Man Standing Last Man Standing Granted, the labor market is a lagging indicator and typically one of the last, if not the last, shoes to drop on the eve of recession. With regard to recession, a simple thought experiment is in order. If we assume the bond market’s forecast for another 100bps of fed funds rate (FFR) cuts in the coming year as accurate, then the FFR will fall to 1.25%. This Fed policy easing will represent a 44% fall in the FFR on a year-over-year basis. Since the late 1960s recession there have not been any mid-cycle slowdowns that the Fed has engineered by clipping the FFR in half (Chart 5). Put differently, when the Fed is compelled to cut interest rates so deeply in every iteration we examined a recession followed suit. Chart 5When The Fed Funds Rate Gets Halved, Recession Is The Reason When The Fed Funds Rate Gets Halved, Recession Is The Reason When The Fed Funds Rate Gets Halved, Recession Is The Reason In sum, small cracks are forming in the labor market according to the ISM manufacturing, ISM services and NFIB surveys and if the Fed goes ahead and cuts interest rates in half in the coming year, as the bond market currently forecasts, then a recession would be a foregone conclusion. Stay cautious on the prospects of the broad equity market. This week, we update an early cyclical sector and one of its key subcomponents. Stick With Financials… The 45bps rise in the 10-year U.S. Treasury (UST) yield over the past two weeks has breathed life back into the S&P financials sector, and for the time being we are sticking with an overweight recommendation. While it remains to be seen how sustainable the rise in yields will be, BCA's long-held view remains that the 10-year UST yield will sell off on a cyclical 9-12 time month horizon. If this is the case then financials stocks will lead the nascent sector rotation that commenced in late-August and outperform the SPX in the coming months (top panel, Chart 6). Foreign flows had put a solid bid under U.S. bonds and artificially suppressed yields and this is at the margin reversing. In addition, the market was hoping for a 50bps rate cut from the Fed in the September meeting further weighing on the UST yield, but now the odds of that happening are nil. Finally, the Citi Economic Surprise Index (CESI) has also come out of hibernation and spiked in positive territory, evidence that economic data estimates had hit rock bottom. This slingshot recovery in the CESI is tonic for financials stocks (bottom panel, Chart 6). On the earnings front, our profit growth model has kissed off the zero line. While financials sector EPS cannot grow indefinitely at a 30%/annum clip, the turn in our three-factor macro model is a positive development (second panel, Chart 7). Chart 6Moving In Lockstep With Rates Moving In Lockstep With Rates Moving In Lockstep With Rates Chart 7Unwarranted Extreme Bearishness Unwarranted Extreme Bearishness Unwarranted Extreme Bearishness Importantly, it stands in marked contrast to the sell side community. Analysts have been feverishly cutting EPS estimates for the sector, and now net earnings revisions have sunk to a level last hit during the great recession (middle panel, Chart 7). Similarly, relative 12-month and five-year forward profit growth forecasts are overly pessimistic. The upshot is that this lowered profit bar will be easy to surpass. With regard to shareholder friendly activities, while the overall share buyback frenzy has taken a breather, financials sector equity retirement is alive and kicking and on track to register the largest annual buyback since the short history of the data (second panel, Chart 8). If there is any sector with pent up buyback demand it is the financials sector that has been a net equity issuer until very recently still wrestling with equity dilution in the aftermath of the GFC. Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Dividend growth has been steady and in expansionary territory and the dividend payout ratio is far from waving any yellow flags. Moreover, financials yield 2.07% or 25bps higher than the 10-year UST yield and 17bps higher than the SPX, which is attractive for yield seeking investors (Chart 8). Moving on to relative valuations beyond the enticing relative dividend yield, relative price-to-book, relative forward P/E and our bombed out composite relative valuation indicator that collapsed to all-time lows suggest that financials are a screaming buy. Technicals remain oversold and also suggest that an overweight stance is warranted (Chart 9). Chart 8Pent-Up Demand For Shareholder Friendly Activities Pent-Up Demand For Shareholder Friendly Activities Pent-Up Demand For Shareholder Friendly Activities Chart 9Undervalued And Unloved Undervalued And Unloved Undervalued And Unloved Adding it all up, the budding recovery in the 10-year UST yield, a rising CESI into positive territory, improving profit prospects and alluring valuations suggest that the recent financials sector outperformance has more legs. Bottom Line: Stay overweight the S&P financials sector, that is compellingly valued, under-owned, and with promising profit prospects. … And Banks For A While Longer Banks stocks troughed in mid-August, sniffing out a sell-off in the bond market, and we continue to recommend an above benchmark allocation in the S&P banks index. This is a global phenomenon as even the ultimate global value group, Eurozone bank equities, bottomed out on August 15 alongside their U.S. peers. While the broad financials index is levered to interest rate movements, banks – that comprise roughly 42% of the S&P financials sector – are hyper-sensitive to changes in the risk-free asset. Thus, the recent jack up in interest rates represents a profit-augmenting opportunity for this early cyclical subgroup (Chart 10) Beyond the rising price of credit, credit growth is another key industry profit driver. Our bank loan models have crested, but are still expanding at a healthy clip (second and bottom panels, Chart 11). As long as they manage to remain above the zero line, they will prove a boon to bank earnings. Specifically on the consumer front, sky high consumer confidence coupled with rising wage inflation signal that consumer credit growth prospects remain upbeat (Chart 11). Chart 10Rising Rates=Buy Banks Rising Rates=Buy Banks Rising Rates=Buy Banks Importantly, the latest Fed Senior Loan Officer Survey painted a bright picture on both the demand and supply of credit. In more detail, bankers reported that a rising number of credit categories reversed course and demand for loans slingshot higher, likely as a delayed consequence of the dramatic fall in interest rates since last November (bottom panel, Chart 12). Chart 11Loan Growth… Loan Growth… Loan Growth… Chart 12…Prospects Are Firming …Prospects Are Firming …Prospects Are Firming Encouragingly, bank officers also reported that they were willing extenders of credit. Our in-house calculated overall gauge of loan tightening standards fell compared with last quarter, signaling that at the margin it is easier to get a loan (middle panel, Chart 12). Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index.  Finally, credit quality, the third key bank profit driver, is also emitting a positive signal. While a few loan categories have deteriorated recently in absolute terms, as percentage of loans outstanding, credit quality remains pristine (Chart 13). The upshot is that this credit quality backdrop combined with a jump in bank return-on-equity to low double digits, should serve as catalysts to unlock excellent value (third & bottom panel, Chart 13). Nevertheless, there are two risks worth close monitoring. First, parts of the yield curve inverted last December and more recently the 10/2 yield curve slope inverted warning that the path of least resistance is lower for bank net interest margins (NIMs, middle panel, Chart 14). Chart 13Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Pristine Credit Quality Is A Catalyst To Unlock Excellent Value Chart 14Two Risks To monitor Two Risks To monitor Two Risks To monitor Second, the ISM manufacturing survey fell below the boom/bust line in August for the first time since the late-2015/early-2016 manufacturing recession (bottom panel, Chart 14). Given that C&I loans are the largest loan category on the asset side of bank balance sheets, the current manufacturing recession may hurt bank profitability in two distinct ways. Not only C&I credit quality will worsen as the risk of defaults rises, but also C&I loan growth may take the back seat and weigh on bank profit growth prospects. Netting it all out, early signs of a recovery in the price of credit, healthy credit growth and still pristine credit quality signal that an overweight stance is warranted in the S&P banks index.  Bottom Line: Continue to overweight the S&P banks index, but keep it on the downgrade watch list, acknowledging the yield curve-related potential decline in NIMs and manufacturing recession-related C&I loan growth risks. The ticker symbols for the stocks in this index are: BLBG: S5BANKX – WFC, JPM, BAC, C, USB, PNC, BBT, STI, MTB, FITB, CFG, RF, KEY, HBAN, CMA, ZION, PBCT, SIVB, FRC.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Highlights The ECB loaded a bazooka, and core Eurozone yields rose: The ECB surprised dovishly last Thursday, and European bond yields duly fell … for an hour. Then they began to back up as fast as they fell, and when Friday’s trading ended, only Greek and Italian yields were lower than where they started. The market action supports our contention that things are not so bad, assuming the worst-case trade scenarios do not materialize: Underpinned by a robust labor market, the U.S. should have little trouble growing at a trend pace over the next twelve months. Meanwhile, the global economy may be in the process of turning. Reversals within the U.S. equity market have gotten a lot of attention so far this month, but it’s too early to claim that a broad factor inflection is underway: If global growth prospects have bottomed, defensive sectors’ outperformance is due to reverse, which will cause havoc for momentum strategies. It is premature to call for a value revival, however. Feature Maybe long Treasury yields aren’t going to zero after all. After bottoming just below 1.43% the day after Labor Day, the 10-year Treasury yield surged 45 basis points across eight sessions as of Friday’s lunchtime peak (Chart 1). The move has been enough to retrace better than three-fifths of its steep slide from mid-July to the beginning of September, but relative to the extended plunge from 3.24% that began last November, the bounce barely registers. Chart 1Up, Up And Away Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) Chart 2Pulled Lower By Expected Rate Cuts... Pulled Lower By Expected Rate Cuts... Pulled Lower By Expected Rate Cuts... The takeaway is that it’s important to keep the moves in context. Just as the collapse in Treasury yields didn’t indicate that the U.S. economy was headed for an imminent recession, their modest, if rapid, recovery doesn’t indicate that all the dark clouds are gone from the horizon. From a purely domestic perspective, the 180-basis-point (“bps”) peak-to-trough decline in the 10-year Treasury yield unfolded nearly step-for-step with an equivalent decline in the expected fed funds rate twelve months out (Chart 2). Since a 1.25% target fed funds rate this time next year is incompatible with our view of the economy, we expect rates will move higher. The ECB committed itself to accommodation for longer than markets had expected; … Chart 3...And Other Sovereign Yields ...And Other Sovereign Yields ...And Other Sovereign Yields Chart 4Better Times Ahead? Better Times Ahead? Better Times Ahead? The Treasury market doesn’t exist in a vacuum, however. Yield moves in similarly-rated sovereign bonds have an effect on Treasuries, and declines in European sovereign yields have exerted a gravitational pull all year long (Chart 3). The backup in yields that followed the ECB’s dovish surprise on Thursday suggests that Eurozone sovereign bond markets may have bought the rumor and sold the news. If global growth is in the process of bottoming, as global leading indicators suggest, falling yields would run counter to the fundamental backdrop (Chart 4). You May Fire When Ready, Draghi To judge by the spate of columns urging helicopter-style accommodation measures, the expectations bar for the European Central Bank’s long-awaited September meeting had been set pretty high. The cut in the ECB’s deposit facility rate to -0.5% from -0.4%, with provisions to mitigate the pressure negative rates exert on banks, was in line with the market consensus, as was a resumption of quantitative easing. Investors did not foresee that the ECB would embark on open-ended bond purchases, however, a plan quickly labeled “QE Infinity.” The ECB also dumped its no-hikes-before-mid-2020 guidance – now it won’t move until the inflation outlook “robustly” moves toward its 2% target – and lengthened the maturities on TLTRO loans while lowering their rates.1 The surprise indicated that the ECB is taking the slowdown seriously, at home (most evident in Germany, which is flirting with recession after a quarter-over-quarter GDP contraction) and abroad. It is premature to declare the action a flop, as headline writers were quick to do, citing the evanescent decline in core bond yields and the euro, because QE impacts are subject to several factors. Sovereign yields can rise on QE announcements if markets judge the impact of relaxed inflation vigilance will outweigh the impact of the entry of a new, price-insensitive buyer to the marketplace. As long as real yields fall, the central bank will have achieved its goal. … if it develops that the incremental accommodation wasn’t necessary, equities and spread product should reap the benefits. U.S. investors are mostly concerned with the impact on global markets and the global economy. Even if nominal sovereign yields have bottomed and competitive devaluation has neutered the currency channel, incremental easing should boost risk assets’ prospects, via pushing incumbent sovereign holders into spread product (the portfolio balance effect), promoting business and consumer confidence, incentivizing bank lending, and nudging other central banks (like Denmark’s, which immediately cut its policy rate in response) to ease monetary conditions themselves (Figure 1). On those counts, we view the ECB’s surprise as modestly improving the prospects for risk assets. TINA is alive and well. Figure 1Monetary Policy And The Economy Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) The Employment Situation We have repeatedly cited the robustness of the labor market as a reason for not giving up on the U.S. economy, or equities and spread product. If expanding payrolls and increasing compensation can keep consumption growing at just a 2% clip, the probability of a U.S. recession, and of an equity bear market and a new default cycle, is fairly slim. If the labor market isn’t as strong as we’ve judged, more defensive portfolio positioning may be in order. Since the beginning of the second quarter, the monthly employment situation reports have revealed a slowing in hiring activity, halting the quickening that stretched from last year through the end of the first quarter (Chart 5). The slowing trend is less concerning than it might appear to be on its face. The current expansion, 122 months old and counting, is the longest on record, and now that it has already drawn considerable numbers of people back into the labor force and back to work, it has become increasingly difficult to find and attract new workers. Even the current monthly pace of job gains, 156,000 over the last three months, still puts downward pressure on the unemployment rate, as it takes less than 110,000 new jobs to maintain the status quo. With net job gains outpacing new entrants into the labor force, wages should rise. Average hourly earnings rose 3.2% in August on a year-over-year basis, though the 0.4% month-over-month gain suggests they may be about to challenge the top end of the tight 3.1-3.2% range that’s prevailed all year. Investors’ and economists’ patience with the Phillips Curve is increasingly wearing thin, as they wait for the decline in the unemployment rate to show up in wage gains, but we consider the underlying supply-demand relationship to be immutable. The prime-age employment-to-population ratio hit an 11-year high in August, and is solidly back in the middle of the range that has prevailed over the 30 years that female participation gains have stabilized (Chart 6). Chart 5Slower Payroll Gains... Slower Payroll Gains... Slower Payroll Gains... Chart 6...Will Still Tighten The Labor Market ...Will Still Tighten The Labor Market ...Will Still Tighten The Labor Market Chart 7The Unkinked Phillips Curve Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) The prime-age employment-to-population ratio is an important measure for the Phillips Curve because it exhibits a consistent linear relationship with wage gains. The fit between the non-employment-to-population ratio (1 minus the employment-to-population ratio) and the employment cost index (Chart 7, top panel) is a little tighter than the fit with average hourly earnings (Chart 7, bottom panel), but both regression equations project an annual increase in wages of 3.3% at the current 20% (1-80%) level, and a 7-bps gain for every 20-bps decline in the prime-age non-employment-to-population ratio. Given that our payrolls model projects a pickup in the pace of hiring (Chart 8, top panel), and the quits rate just moved off of its extended plateau (Chart 9), upward pressure on wages will continue to build.   Chart 8Demand For Workers Is Still Solid Demand For Workers Is Still Solid Demand For Workers Is Still Solid Chart 9Movin' On Up Movin' On Up Movin' On Up Bottom Line: Payroll gains are slowing, but they remain robust enough to push the key prime-age employment-to-population ratio higher, and exert upward pressure on wages.   Factor Rotation Chart 10Momentum Hits The Wall,... Momentum Hits The Wall,... Momentum Hits The Wall,... Reversals within the U.S. equity market have been drawing increasing amounts of attention, as momentum stocks have hit a wall while long-suffering value stocks have begun to peel themselves off the canvas (Chart 10). We can easily see a scenario in which the momentum factor has a very difficult time, if relative performance shifts from defensive sectors to cyclical sectors as investors begin to perceive that they have been overly pessimistic about the domestic and global business cycle, and cease to hide in bond proxies like Utilities and REITs. Given the defensives’ run of outperformance over the last year, momentum indexes disproportionately favor them over cyclicals. The S&P 500, MidCap 400 and SmallCap 600 Momentum Indexes all show a pronounced defensives bias, with Health Care, Utilities and Real Estate all commanding double their baseline weight in at least one index (Table 1), making S&P’s momentum indexes vulnerable to a defensives-to-cyclicals rotation. Table 1The Dullest Stocks Have Been The Hottest Here Comes The Cavalry (Again) Here Comes The Cavalry (Again) Over the last three years, we have thought a lot about the value factor, asking how it should be defined, which financial statement metrics indicate its presence, and the business and monetary policy cycle backdrops that are most conducive to its outperformance. Low-priced stocks have been in a punishing extended slump versus high-priced stocks since early 2007 (Chart 11), and we think they have yet to bottom. The recent value stock rally has been a function of higher 10-year Treasury yields, and banks’ (which account for an outsized share of popular value benchmarks) recent tendency to trade in lockstep with them. We do not think a two-week backup in yields is the stuff that a genuine value factor inflection point is made of. Chart 11...But The Value Factor Has Yet To Turn ...But The Value Factor Has Yet To Turn ...But The Value Factor Has Yet To Turn A detailed explanation of our rationale is beyond the scope of this report,2 but the following points summarize our take: The value factor has gotten killed since the crisis, but we doubt that it’s dead. Value has historically treaded water during bull markets, and shined in bear markets. The fed funds rate cycle is the best predictor of value’s relative performance. Value has historically crushed the overall market when monetary policy is restrictive. The most popular style indexes have barely any factor merit. The S&P 500’s Growth and Value indexes are little more than Tech and Financials proxies. Value will shine again, but not until monetary policy is restrictive. If the Fed doesn’t hike the fed funds rate above the equilibrium fed funds rate until 2021, value investors will have to gut out another year-plus of underperformance. Bottom Line: The momentum factor could suffer in the near term if cyclicals reassert primacy over formerly hot defensives. The value factor’s fortunes will not turn for at least another year. Investment Implications We understand the discomfort of investors who feel like ZIRP, NIRP and QE have obliterated normal investing relationships. Disorienting as it has been to see nominal Treasury returns shrivel, the rising tide of negative-yielding bonds is like a surreal detail from a David Lynch movie. The investment world has indeed turned upside-down when investors buy bonds for capital gains to offset the interest they have to pay for the privilege of lending. Austrian School advocates are surely not the only dearly departed investing veterans rolling in their graves. It’s not the environment we wanted, but it’s the environment we got, so we’re going to buck up and do our best to squeeze excess returns out of it. We have to invest in the markets we have, however, not the markets we want. It does neither ourselves nor our clients any good to throw up our hands, bitterly lament our fate and wish ill upon the exponents of the activist, ultra-accommodative approach to central banking that is now in fashion. Some old relationships still apply, and the combination of a quietly improving global economic backdrop with incremental monetary accommodation everywhere one turns is good for risk assets. We continue to recommend that investors resist the urge to get defensive before the excess-return window closes for this cycle. We are not advocating that investors let their guard down, and assume that central banks will be able to keep the plates spinning indefinitely. They will not – monetary interventions are a poor substitute for organic growth in productivity or the size of the working-age population, and so are inefficiently directed fiscal spending programs – but we bet they can through the next quarterly or annual period over which an institutional manager is going to be evaluated. The upshot is that investors should remain especially vigilant for signs of trouble, and be prepared to act more tactically than normal to adjust their portfolios, but shouldn’t de-risk them yet, lest they miss the last of the fat-year returns they’ll need to tide themselves over during the coming lean years.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Targeted longer-term refinancing operations (TLTROs) are ECB loans to banks intended to encourage lending to households and non-financial corporations. 2 Interested readers should see the May 16, 2018 Global ETF Strategy/Equity Trading Strategy Special Report, “Smart-Beta ETF Selection Update – Is Value Still Worth It?,” the October 2018 Bank Credit Analyst Special Report, “Is It Time To Buy Value Stocks?,” and the October 2, 2018 U.S. Investment Strategy Special Report, “When Will Value Work Again?,” available at etf.bcaresearch.com, www.bcaresearch.com and usis.bcaresearch.com, respectively.

Highlights Our cyclical view is unchanged, … : Despite the evident risks from escalating trade tensions, soft global economic data, and widespread recession concerns, we expect the expansion and the bull markets in spread product and equities will remain intact. … as fiscal largesse has provided the U.S. economy with ample cushion: Per the IMF’s estimates, the fiscal stimulus package centered on the Tax Cuts and Jobs Act of 2017 amounted to about 70 basis points (“bps”) of fiscal thrust in 2018 and another 40 bps in 2019. But how is Congress’ unprecedented experiment shaping up beyond 2019?: The first-order impact of the tax cuts on government revenues is straightforward. The ultimate net effect turns on how lower taxes alter the course of corporate investment and work force participation. The CBO’s latest projections have the federal deficit widening by an additional $1 trillion over the next decade: Supply-side benefits from the 2017 Act have underwhelmed so far, and the fate of the federal budget depends on lawmakers’ restraint. We are long-run bearish on Treasuries and the dollar. Feature The fundamental backdrop remains mixed in the United States and the rest of the world. Global trade has slowed, and the world is experiencing a sharp manufacturing slowdown. The consensus of BCA researchers expects that manufacturing will soon find a footing, and the global economy will revive, helped along by easier monetary policy. A fiscal pick-me-up is long overdue, and would be especially welcome, but we are not holding our breath, especially when Japan finally seems prepared to impose its repeatedly-postponed VAT increase. Opinion within BCA is notably split, and the glass-half-full and glass-half-empty camps remain far apart. The mixed tone of the macro data offers something for bulls and bears, and contributed to the sharp single-day moves that characterized August’s equity action. Although the S&P 500 moved at least 1% in half of its sessions, however, it was down less than 2% for the month through Thursday. After slipping from its 3,000 perch amidst a 5% decline across August’s first three sessions on renewed trade hostilities, it traded in a narrow range between 2,825 and 2,945 the rest of the way (Chart 1). Chart 1Big Daily Swings, But A Tight Monthly Range The Longer Run The Longer Run The Fed is caught in a loop of responding to inorganic shocks. It tightened policy in 2018 while nervously looking over its shoulder at a sizable injection of procyclical fiscal stimulus that wound up exerting less overheating pressure than it had feared. Now it finds itself uncomfortably drawn into the vortex of the trade war, cutting rates to keep the expansion from being snuffed out prematurely by self-inflicted wounds. Various Fed officials seem to be chafing under the burden of serving as a bulwark against the drag from the tariff fights. As Chair Powell admonished in his Jackson Hole address, “[M]onetary policy … cannot provide a settled rulebook for international trade.” Like it or not, the Fed is stuck cleaning up other policymakers’ messes. Jackson Hole would normally have brought down the curtain on any meaningful market news until after Labor Day. But Bill Dudley, the head of the New York Fed from 2009 to 2018, had other ideas. He argued in a Bloomberg opinion column that the Fed should refuse to abet foolhardy trade policy with rate cuts that offset its ill effects. He went on to posit that it is within the Fed’s remit to set policy with an eye toward influencing the outcome of the 2020 presidential election. Dudley’s grenade enlivened a slow news day and had the effect of unifying the economics community in condemnation of his polemic. The Fed swiftly distanced itself from the comments, reiterating that its “decisions are guided solely by its congressional mandate,” and that “political considerations play absolutely no role.” It is hard to know what Dr. Dudley intended to accomplish, but he ensured that we will be at BCA’s 40th Annual Investment Conference bright and early on Friday, September 27th when he kicks off its second day. Initial Estimates Soon after the 2017 Tax Cuts and Jobs Act was passed, the Congressional Budget Office (“CBO”) assessed how its provisions would affect the U.S. economy. Although calculating the components involves myriad complex estimates, the budget equation is quite simple: Budget Surplus/(Deficit) = Revenues – Outlays. Cutting taxes clearly reduces revenues, and the reductions in individual tax rates, partially offset by limits on deductions, were estimated to cost the federal government roughly $300 billion over the next decade. The 10-year tab for lower corporate rates, and immediate expensing of business investments through 2022, was estimated to run about $1 trillion. Relief from some spending constraints brought the total estimated cost to $1.7 trillion. A trillion here, and a trillion there, and pretty soon you’re talking real money. Though the Act was sure to worsen the deficit, it contained provisions meant to encourage investment and labor supply. Corporate tax cuts and the full immediate expensing of investments in software and eligible equipment were expected to permanently increase the nation’s capital stock, thereby boosting the trend pace of productivity growth. A reduced individual income tax burden was expected to encourage more people to enter the workforce and incumbents to work longer hours. Ultimately, the CBO projected that the Act would boost the level of real potential GDP by 0.7%, on average, through 2029.  Six Quarters On It follows that people might work more if they are able to keep more of what they earn, but the data since individual income tax rates were reduced at the beginning of 2018 are inconclusive. The labor force participation rate has been treading water for several years (Chart 2, solid line), as it battles against the drag from baby boomer aging (Chart 2, dashed line). Prime-age labor force participation has risen very slowly off of its 2015 bottom, and has spent 2019 unwinding its gains from late last year (Chart 3). Average weekly hours worked remain locked in the narrow range that has prevailed since 2012 (Chart 4). Though it is difficult to isolate the drivers of participation gains, the part rate’s erratic 2018-9 course suggests that the Act has not yet had a discernible work force impact. Chart 2The Baby Boomers Have Become A Demographic Headwind The Baby Boomers Have Become A Demographic Headwind The Baby Boomers Have Become A Demographic Headwind Chart 3Labor Supply ##br##Gains ... Labor Supply Gains ... Labor Supply Gains ... Chart 4... Have Yet To Materialize ... Have Yet To Materialize ... Have Yet To Materialize Residential investment, which lost some tax subsidies via the Act’s limits on mortgage interest and state and local tax deductions, has declined in every quarter since it was passed, and we back it out of fixed investment to assess the Act’s impact on corporate investment. As with labor supply, the record so far is mixed. Fixed investment (ex-residential investment) built on its 4Q17 acceleration over the first three quarters of 2018 only to slide in the three subsequent quarters (Chart 5). Publicly traded corporations have proven more eager to share their cash windfall with shareholders than they have been to invest it. Chart 5Investment Stimulus? What Investment Stimulus? Investment Stimulus? What Investment Stimulus? Investment Stimulus? What Investment Stimulus? Looking Ahead – Activity Effects We accept that lower individual income tax rates make work more attractive. People respond to incentives, and more after-tax pay, all else equal, should encourage some discouraged workers to rejoin the labor market and push some of the currently employed to want to work more. The changes are modest, though, with take-home pay increasing $324, or 2%, for someone earning $20,000, and $1,299, or 3%, for someone earning $50,000 (Table 1). We see the Act as having no more than a modest marginal effect on labor supply, though it should help boost consumption until households begin to factor in seemingly inevitable future tax hikes. Table 1Take-Home Pay Is Up, But Not By Much The Longer Run The Longer Run If the 2017 Act really is going to boost the potential trend rate of growth, it will have to do so by pushing the rate of productivity growth higher.1 Workers are able to produce more in a given block of time when they’re endowed with more and better tools, and new tools require investment. If fixed investment doesn’t accelerate, there’s no reason to expect that productivity will (Chart 6). The capex outlook from the NFIB survey and the various Fed regional manufacturing surveys is iffy, and BCA has previously noted how an aging population and a shift to more capital-light businesses may restrain investment. Chart 6Investment Drives Productivity Investment Drives Productivity Investment Drives Productivity It will not be an easy matter to boost productivity by boosting capex, though some of businesses’ after-tax cash will likely find its way to investment. To help the process along, Congress incorporated a familiar provision: accelerated depreciation. Accelerated depreciation’s empirical record as an investment catalyst is hardly clear (Box), and we don’t find its theoretical basis terribly compelling. We think the Act’s trend growth impacts are more likely to disappoint the CBO’s expectations than exceed them. Investment confronts demographic headwinds, too. Pushing trend growth higher will not be easy. Box - An Anodyne Prescription A celebrated provision of the Act allows for the immediate expensing of qualified investments until 2022. Accelerated depreciation programs, which allow for more rapid expensing of investments in property, equipment and other depreciable assets in an attempt to stimulate investment, are a stock measure in lawmakers’ stimulus toolkit, but their effectiveness is hardly assured. For one thing, they’re not new, and businesses may have built up an immunity to them, as they have been a continuous feature of the tax code since 1981. The immediate expensing allowed under the 2017 Act is a form of bonus depreciation, which was initially introduced in the wake of the September 11th attacks. It has remained in place for all but one subsequent year, and though investment peaked during the other stretch that provided for immediate write-offs (September 2010 - December 2011), we are skeptical that it will materially increase the size of the capital stock going forward. Accelerated depreciation schemes encourage investment via the time value of money. They do not increase the depreciation benefit provided by a particular investment, they simply speed up its recognition. Savvy businesses may adjust the timing of their investments to take advantage of temporary bonus periods, but they will not necessarily invest more.2 With rock-bottom interest rates squeezing the time value of money, it’s possible that bonus depreciation’s impact may be especially muted this time. Looking Ahead – The Budget Deficit The CBO’s updated projections through 2029, released two weeks ago, call for the budget shortfall to widen by $800 billion more than previously estimated in January. Despite a downward revision of over $1 trillion in projected interest expense, additional spending has weakened the deficit outlook. It appears that elected officials simply can’t help themselves. In a climate in which neither Congress nor voters evince any desire to rein in the deficit, it seems foolishly naïve to assume that future sessions of Congress will abide by built-in expenditure limits like sunset provisions and spending caps. Although the CBO projects that federal revenues will rise across its 10-year forecasting horizon, they will not do so fast enough to keep up with outlays swollen by interest payments on the growing pile of Treasuries (Chart 7). The CBO sees debt as a share of GDP rising to 95% by 2029, within reach of the all-time high recorded after World War II (Chart 8). Financial markets don’t care now, and we don’t think they will any time in the near future, but the CBO’s baseline projections, which assume future Congresses abide by their stated commitments, probably represent an optimistic scenario. We are more inclined to expect the alternative scenarios, in which sunset provisions are ignored, and pre-set spending caps are set aside, to come to pass. Chart 7A Widening Budget Gap ... A Widening Budget Gap ... A Widening Budget Gap ... Chart 8... Leads To An Increased Debt Burden ... Leads To An Increased Debt Burden ... Leads To An Increased Debt Burden Investment Implications Chart 9The Dollar's Long-Run Direction Is Down The Dollar's Long-Run Direction Is Down The Dollar's Long-Run Direction Is Down Treasury yields are currently within sight of their July 2016 Brexit-inspired lows, and may well revisit them. Negative yields are a common feature well out the maturity curve in core Europe and Japan. A sustained move higher is not in the cards in the near term, and though we do expect yields to rise as the global economy gains some traction later this year, we do not foresee a disruptive move higher even over the next couple of years. The very long-term outlook for Treasuries is lousy, however, and the dollar also faces secular pressures (Chart 9). The U.S. is not likely to turn into Japan, but the next decade’s returns will likely pale beside those earned since 1982. We are congenitally optimistic about humanity, and Americans seem to have a particular knack for pulling rabbits out of hats. We do not see the U.S. turning into Argentina, Greece or even Japan. The debt burden will weigh on potential growth down the road, however, as debt service will limit Congress’ ability to deploy countercyclical adjustments and longer-term investments, and debt issuance will eventually crimp private entities’ access to capital. All of these factors will limit potential economic growth and contribute to softening returns on equity and credit. We continue to foresee tepid returns over the next ten years relative to the returns investors have grown accustomed to over the last four decades, and we would much rather borrow at current rates for the next 20 or 30 years than lend at them.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Economic growth is the sum of growth in productivity and growth in the size of the labor force. Since the Act does not bear on immigration or birthrates, productivity represents its best shot at moving the growth needle. 2 Congressional Research Service Report RL31852, The Section 179 and Section 168(k) Expensing Allowances: Current Law and Economic Effects, by Gary Guenther, May 1, 2018.  

Feature Introduction Chart 1Japanese Equities: ##br##Buying Opportunity Or Value Trap? Japanese Equities: Buying Opportunity Or Value Trap? Japanese Equities: Buying Opportunity Or Value Trap? Clients have recently been asking us a lot about Japan. The reason seems clear. With the consistent outperformance of U.S. equities over the past decade, and their rather high valuations now, asset allocators are looking for an alternative. Emerging Markets and the euro zone have major structural concerns which suggest they are unlikely to outperform over any prolonged period (even if they might have a short-lived cyclical pop). Maybe Japan – whose own structural problems are well known and so surely priced in by now – could be a candidate for outperformance and a structural rerating over the next three to five years. Indeed, since the Global Financial Crisis (GFC), Japanese equities have not performed as badly as you might have imagined: they have performed in line with all their global peers – except for the U.S. (Chart 1). In this Special Report, we answer the most common questions that clients have asked us about the long-term (three to five year) outlook for Japan, and try to address the key issue: Are Japanese equities now a buying opportunity, or still a value trap? Our conclusions are as follows: The Japanese economy is still weighed down by structural problems – stubborn disinflation, and a shrinking and aging population – which means consumption growth will remain weak over the coming years. Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. We think it is unlikely, therefore, that Japanese equities will outperform in the long run. In that sense, Japan probably is a value trap, not a buying opportunity. In the past, Japanese equities benefited from bouts of Chinese reflationary stimulus – which we expect will be ramped up in the coming months – but the effect was usually short-lived and muted. The clash between accommodative monetary policy and contractionary fiscal policy, particularly October’s tax hike, is likely to dampen any revival in the Japanese economy. Global Asset Allocation downgraded Japanese equities to underweight over a six-to-12 month investment horizon in our most recent Quarterly Outlook.1 We find it hard to make a strong “rerating” case for Japan, and so, do not expect Japanese equities to outperform other major developed markets in the long run. Why Isn’t Inflation Rising? Chart 2Domestic Drivers Muted Japanese Inflation Domestic Drivers Muted Japanese Inflation Domestic Drivers Muted Japanese Inflation The market clearly does not believe that Bank of Japan (BoJ) Governor Haruhiko Kuroda can raise inflation to the BoJ’s target of 2%, despite negative interest rates and massive quantitative easing. The 5-year/5-year forward CPI swap rate, a proxy for inflation expectations, is currently at 0.1% (Chart 2, panel 1). Japan’s ultra-accommodative monetary policy has failed to push recorded inflation higher, with the core and core core measures2 both at 0.6% as of June (Chart 2, panel 2). In its recent outlook, the BoJ revised down its inflation forecasts in fiscal years 2019, 2020, and 2021 to 1.0%, 1.3%, and 1.6% respectively, implying that it does not expect to get even close to 2% over the forecast horizon.3  Prior to the bursting of Japan’s bubble in 1990, a big percentage of Japanese inflation came from domestic factors: housing, culture and recreation, and health care. By contrast, prices of items manufactured overseas, mainly in China, and imported goods – especially furniture and clothing – did not rise much. The same was true for other developed economies such as the U.S. and the euro area. However, since the 1990s, domestically-produced items in Japan have failed to rise in price, unlike the situation in the U.S. This kept a lid on Japanese inflation. Housing in particular, which represents about 20% of the inflation basket, now contributes only 0.02% to Japanese core core inflation (Chart 2, panels 3 & 4). Chart 3Deregulation = Low Inflation Deregulation = Low Inflation Deregulation = Low Inflation There are three main reasons for this difference: Stagnant wages Unfavorable demographics Deregulation The first two causes are discussed in detail below. Gradual deregulation of various industries has also been disinflationary. In the 1980s, Japan remained a highly regulated economy, with the government fixing many prices and limiting entry into many sectors. Although change has been slow, deregulation and the introduction of competition have caused structural downward pressure on prices in a number of industries, notably telecommunications and utilities. For example, deregulation of electric power companies in 2016 allowed increased competition and new entrants into the market.4 As a result, electricity prices in Japan dropped from an average of 11.4 JPY/Kwh prior to full deregulation to 9.3 JPY/Kwh (Chart 3). But there are still many industries which are more tightly regulated in Japan than in other advanced economies (the near-ban on car-sharing services such as Uber, and tight restrictions on AirBnB are just the most newsworthy examples). This suggests that structural disinflationary pressures are likely to persist on any further deregulation. Why Is Wage Growth Stagnant, Despite A Tight Labor Market? Chart 4Wages Have Been Beaten Down... bca.gaa_sr_2019_08_09_c4 bca.gaa_sr_2019_08_09_c4 Japan’s labor market appears very tight. The unemployment rate is 2.3%, the lowest since the early 1990s, and the jobs-to-applications ratio is 1.61, the highest since the 1970s. And yet wage growth has remained stagnant, averaging only 0.5% over the past five years. (Chart 4).5  There are a number of structural reasons why wages have failed to respond to the tight labor market situation. One major contributory factor is the social norm of “lifetime employment,” whereby many employees, especially at large companies, tend to stay with their initial employer through their careers, being rotated from one department to another, without becoming specialists in any particular field. This means they have little pricing power – and few transferable skills – when it comes to seeking a mid-career change. This social norm is also reflected in Japan’s typical salary schemes, which are based on employment length (Chart 5, panel 1). Wages tend to rise with age, while in other developed economies they peak around the age of 50. Another factor is the big increase in recent years in part-time and temporary positions, which typically pay lower wages than full-time positions. Because employment law makes it hard (if not impossible) to fire workers, companies have tended to prefer hiring non-permanent staff, who are easier to replace. Part-time workers have increased by 11 million over the past three decades, compared to an increase of two million in full-time workers (Chart 5, panel 2). A substantial part of this increase in part-time employment came from both the elderly and women joining the labor market – groups that have little wage bargaining power (Chart 5, panel 3). Part-time wage growth has also turned negative this year (Chart 5, panel 4). Bonuses are a significant portion of wages, and tend to be rather volatile, moving in line with corporate profits, which have weakened this year (Chart 5, panel 5). Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. Nonetheless, there are some tentative signs of a change in this social norm. The number of employees changing jobs has been rising over the past few years. This is mostly evident among employees aged over 45, signaling the need for experienced personnel (Chart 6, panel 1). The percentage of unemployed who had voluntarily quit their jobs, rather than being let go, has also reached an all-time high (Chart 6, panel 2). This evidence suggests that employees are increasingly willing to leave their jobs in search of a more interesting or a better-paid one. Given such a tight labor market, it seems only a matter of time before there is some pressure on employers to increase salaries in order to attract talent. Chart 5...Mainy Due To Part-Time Employment ...Mainy Due To Part-Time Employment ...Mainy Due To Part-Time Employment Chart 6Changing The Norm Changing The Norm Changing The Norm   Is There An Answer To Japan’s Demographic Problem? Chart 7Japanese Population: Shrinking And Aging Japanese Population: Shrinking And Aging Japanese Population: Shrinking And Aging Deteriorating demographics is a key reason why inflation has remained subdued. The Japanese population peaked in 2009 and, over the past eight years, has shrunk on average by 0.2%, or 220,000 people, a year. Furthermore, the working-age population (25-64) has shrunk by 6 million, or 10%, since its peak in 2005. With marital rates continuing to fall, and fertility rates doing no more than stabilizing, there is no sign of a quick turnaround in this situation (Chart 7, panels 1 & 2). Prime Minister Abe has eased immigration laws to try to put a stop to the population decline. Late last year, the Diet passed a law that will allow more foreign workers into the country. The law will provide long-term work visas for immigrants in various blue-collar sectors, whereas the previous regulation allowed in only highly skilled workers. It will also enable foreign workers to upgrade to a higher-tier visa category, giving them a path to permanent residency, and allowing them to bring their families along.6  However, Japan’s closed culture raises the question of how successful Prime Minister Abe’s immigration reforms will be. The number of foreign residents has risen over the past few years, reaching a cumulative 2.73 million people, but this has been insufficient to reverse the decline in the population. In addition, without implementing effective measures to integrate new immigrants and support their efforts to become long-term residents, these reforms are likely to be minor in their impact (Chart 7, panel 3). Chart 8Aging Population = Slowing Productivity Aging Population = Slowing Productivity Aging Population = Slowing Productivity Japan’s population is not just shrinking but also aging. People aged 65 and older comprise 28% of the total population (Chart 7, panel 4). That figure is projected to reach 40% within the next 40 years. The dependency ratio – those younger than 15 years and older than 64, as a ratio of the working-age population – continues to rise rapidly (Chart 7, panel 5). Moreover, older people tend to be less productive. Because of this, Japan’s productivity may continue to decline from its current level, which is already low compared to other developed countries (Chart 8). The combination of a shrinking working-age population and poor productivity growth means that Japan’s trend real GDP growth over the next decade – absent an increase in capital expenditure or improvement in technology – is unlikely to be above zero.7   Some argue that Japan’s aging population could be the trigger to overcoming its disinflation problem. They argue that, as the share of the elderly-to-total-population increases, public expenditure on health care will balloon. The United Nations projects the median age in Japan to be 53 years, 10 and 5 years older than in the U.S. and China, respectively, by 2060 (Chart 9). This implies that the Japanese government, which currently pays about 80% of total health care expenditure, will face an increasing burden from medical spending, elderly care, and public pension payments. These expenditures are projected to increase from 19% to 25% of GDP (Chart 9, panel 2). The government, therefore, may have no alternative but to resort to monetizing its debt to pay these bills, which would ultimately prove to be inflationary. Chart 9Aging Population = Higher Fiscal Burden Aging Population = Higher Fiscal Burden Aging Population = Higher Fiscal Burden Chart 10 In some countries, BCA has argued, an aging population is inflationary because retirees’ incomes fall almost to zero after retirement, but expenditure rises, particularly towards at the end of life as they spend more on health care.8 The resulting dissaving, and disparity between the demand and supply of goods, should have inflationary effects. But this rationale does not hold for Japanese households. Older people in Japan tend to maintain their level of savings (Chart 10). This phenomenon might change as a new generation, keener on leisure activities and less culturally attuned to maximizing savings, retires. But to date, at least, Japan’s aging process has been disinflationary. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Moreover, to reduce the burden on its budget, the government will continue its efforts to keep down health care costs, which have a 5% weight in the core core inflation measure. We find it unlikely, therefore, that the BoJ will achieve its 2% inflation target over the next few years. So, What Else Could The BoJ Do? Chart 11The BoJ's Ammunition Is Running Out The BoJ's Ammunition Is Running Out The BoJ's Ammunition Is Running Out Over the past six years, since Kuroda became governor in 2013, the Bank of Japan has rolled out aggressive monetary easing. It has cut rates to -0.1% and introduced a policy of “yield curve control,” which aims to keep the yield on 10-year JGBs at 0%, plus or minus 20 basis points. As a result, it now holds JPY479 trillion of JGBs, or 46% of the total outstanding amount (and equivalent to 89% of Japan’s GDP). It has also bought an average of JPY6 trillion of equity ETFs a year over the past three years (Chart 11, panels 1 & 2), to bring its total equity ETF holdings to JPY28 trillion, almost 5% of Japan's equity market cap. However, as noted above, these policies have had little impact on inflation, or on inflation expectations. BCA’s Central Bank Monitor indicates that Japan needs to ease monetary conditions further (Chart 11, panel 3). What alternative tools could the BoJ use to spur inflation? The BoJ could cut rates further, and indeed the futures market is discounting a 10 basis points cut over the next 12 months (Chart 11, panel 4). In its July Monetary Policy Committee meeting, the bank committed to keeping policy easy “at least through around spring 2020.” But it seems reluctant to cut rates, given that this would further damage the profitability of Japan’s banks, particularly the rather fragile regional banks. Indeed, one can argue that a small rate cut would be unlikely to have much effect, given the impotence of previous such moves. The BoJ might be inclined to emulate the ECB and extend its asset purchase program. It owns only JPY3 trillion of corporate bonds, and has bought almost no new ones since 2013 (Chart 11, panel 5), although the small size of the Japanese corporate bond market would give it limited scope to increase these purchases. It could also increase its purchases of REITs, of which it currently owns JPY26 trillion. It could even consider buying foreign assets (as does the Swiss National Bank), though this would annoy the U.S. authorities, who would consider it currency manipulation. Some economists argue in favor of a Japanese equivalent of the ECB’s Targeted Long-Term Refinancing Operations (TLTRO). In other words, the BoJ should provide funds to banks at rates significantly below zero, provided they use the proceeds to give out loans to households and corporations.9 This would not only increase credit in the economy, but also bolster banks’ declining profitability. Some academics consider Japan, which appears stuck in a liquidity trap, as the perfect setting to try out Modern Monetary Theory (MMT).10,11 However, the Ministry of Finance remains fixated on reducing Japan’s excessive pile of outstanding government debt, which is currently 238% of GDP. When MMT was debated in the Japanese Diet this June, Finance Minister Taro Aso dismissed it, saying “I’m not sure I should even call it a theory, it’s a line of argument,” and insisted that tax hikes are necessary to secure Japan’s welfare system. The Ministry’s current plan is to close the primary budget deficit by 2027.  Moreover, the Bank of Japan Law bans the central bank from underwriting government debt, due to the abuses of this in the 1930s, when it funded Japan’s militarist expansion12 – though there are no limits on how much the BoJ can buy in the secondary market.  Our conclusion is that negative rates and quantitative easing have reached the limit of their effectiveness. Even if the BoJ ramps up the measures it has taken up until now, this will have little impact on inflation. It will be only when the government finally understands that a combination of easy fiscal and monetary policy is single effective tool left that the situation can change. There is little sign of this happening soon. It will probably take a crisis before this mindset shifts. Are There Any Signs Of Improvement In Japan’s Banking Sector? Japan’s financial sector is also one of its longstanding problems. After Japan’s 1980s bubble burst, the BoJ aggressively cut rates from 6% to 0.5% over the span of eight years. Long-term rates also fell. Falling interest rates reduced Japanese banks’ net interest margins. The banks spent the 1990s cleaning up their balance sheets and recapitalizing themselves. In the end, the banks’ cumulative losses (including write-offs and increased provisioning) during the 1992-2004 period reached the equivalent of 20% of Japanese GDP.13 Japanese bank stocks have consistently underperformed the aggregate index since the late 1980s (with the exception of a short period in the mid-2000s) – and by 75% since 1995 (Chart 12, panel 1). It now seems like banks' relative performance is bound by the policy rate. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Bank loan growth throughout the period of 1995-2006 was weak or negative, as banks became more risk averse and borrowers focused on repairing their balance sheets (Chart 12, panel 2). It has picked up a little over the past decade, but remains low at around 2%-4%. This has been a drag on economic activity since both Japan’s corporate and household sectors rely much more heavily on banks for funding compared to the U.S. or the euro area (Chart 12, panels 3 & 4). As a result of stagnant loan growth at home, Japanese banks have in recent years expanded their activities overseas, particularly in south-east Asia. Foreign lending for Japan’s three largest banks comprises 29.7% of total loans, 33% of which is to Asia.14 This represents a risk for future stability since these assets could easily become non-performing in the event of an Emerging Markets crisis in the next recession. Chart 12Bank Stocks Have Consistently Underperformed... Bank Stocks Have Consistently Underperformed... Bank Stocks Have Consistently Underperformed... Chart 13...Because Of Weak Loan Growth ##br##And Poor Profits ...Because Of Weak Loan Growth And Poor Profits ...Because Of Weak Loan Growth And Poor Profits By the mid-2000s, Japanese banks had finished cleaning up from the 1980s bubble and the non-performing loan ratio is now low. But measures of profitability such as return on assets and net interest margin remain poor by international standards (Chart 13). Japanese financial institutions’ capital adequacy ratios have also deteriorated moderately over the past five years, according to the BoJ’s Financial System Report, as risk-weighted assets have increased more quickly than profits. The core capital adequacy ratio of just above 10% is significantly lower than in other major developed economies.15 How Should Investors Be Positioned In The Short-Term? There are two factors that will determine how Japanese equities perform over the next 12 months: Chinese stimulus, and the impact of the consumption tax hike in October. Can Chinese Reflation Help Boost Japanese Economic Activity? Chart 14Chinese Stimulus Boosts Japan's Activity... Chinese Stimulus Boosts Japan's Activity... Chinese Stimulus Boosts Japan's Activity... Chart 15...Yet Its Impact Is Short-Lived And Muted ...Yet Its Impact Is Short-Lived And Muted ...Yet Its Impact Is Short-Lived And Muted While Japan is not a particularly open economy – exports represent only 15% of GDP – its manufacturing sector is very exposed to global trade, and the swings in this sector (which is a lofty 20% of GDP) have a disproportionately large marginal impact on the overall economy. China accounts for 20% of Japan’s exports, roughly 3% of Japan’s GDP (Chart 14). China’s economic slowdown since 2017 has clearly weighed heavily on Japanese exports and the manufacturing sector. Japanese machine tool orders have contracted for nine months, in June reaching the lowest growth since the GFC, -38% year-on-year. Vehicle production growth has also been weak, rising only 1.8% year-to-date compared to 2018, and overall industrial production growth has turned negative, falling by 4.1% YoY in June. It seems that global growth data has not yet bottomed. The German manufacturing PMI remains well below the boom/bust line at 43.2. Korean export growth is also contracting at a double-digit rate. Nevertheless, we expect the global manufacturing downturn – which typically lasts about 18 months from peak-to-trough – to bottom towards the end of this year.16 This will be supported by the Chinese authorities accelerating their monetary and fiscal stimulus, although the magnitude of this might not be as big as it was in 2012 and 2015.17 Japanese economic activity has historically been closely correlated with Chinese credit growth, with a lag of six-to-nine months (Chart 15). What Will Be The Impact Of The Consumption Tax Hike? Japanese consumer demand has been sluggish for some time, mainly as a result of low wage growth. The planned rise in the consumption tax from 8% to 10% in October is likely to dampen consumption further. With the economy currently so weak, there seems little justification for a tax rise. But, having postponed it twice, it seems highly unlikely that Prime Minister Abe will do so again, particularly after his victory in last month’s Upper House election, which was a de facto referendum on the tax hike. Chart 16Previous Tax Hikes Hurt Sales Badly Previous Tax Hikes Hurt Sales Badly Previous Tax Hikes Hurt Sales Badly The OECD, based on Japanese government data, estimates the impact on households of the tax hike will be 5.7 trillion yen (about 1% of GDP).18 Consumers did not take previous tax rate hikes well. Spending was brought forward to the two to three months immediately before the hike. However, following the hike, not only did sales fall back, they also trended down for some time (Chart 16). The risk to the economy is that the same happens again.  The government, however, is planning several measures to mitigate the tax burden (Table 1). It will not apply the tax increase to food and beverages, which will stay at 8%. The government will implement a fiscal package including free early childhood education, support for low-income earners, and tax breaks on certain consumer durable goods, such as automobiles and housing. It will also introduce a rebate program, to encourage consumer spending at small retailers using non-cash payments (partly to reduce tax avoidance by these businesses).19 Based on the government’s estimates, these measures will be enough to fully offset the impact of the tax hike. However, the IMF’s Fiscal Monitor sees fiscal policy tightening due to the tax rate hike, although by less than in 2014. Its estimate is a drag of 0.6% of potential GDP in 2020 (Chart 17). Table 1Easing The Tax Hike Burden Japan: Frequently Asked Questions Japan: Frequently Asked Questions Chart 17Clash Of Policies: Fiscal Vs. Monetary Clash Of Policies: Fiscal Vs. Monetary Clash Of Policies: Fiscal Vs. Monetary   Previous sales tax hikes caused a short-lived jump in inflation, which trended lower afterwards. Assuming a full pass-through rate of price increases to consumers, the BoJ expects the hike to raise core inflation by +0.2% and +0.1% in fiscal years 2019 and 2020 respectively.20 Consumers did not take previous tax rate hikes well. As such, over the next 12 months, Global Asset Allocation recommends an underweight on Japanese equities. While a bottoming of the global manufacturing cycle and the impact of Chinese stimulus are positive factors, there are better markets in which to play this, given the risks surrounding Japanese consumption caused by the consumption tax rise. Are Improvements In Corporate Governance Enough To Make Japanese Equities A Long-Term Buy? Chart 18Corporate Governance Not Improving Enough Corporate Governance Not Improving Enough Corporate Governance Not Improving Enough Many investors believe that improved corporate governance could be the catalyst the stock market needs to outperform. It is true that there have been some improvements in recent years. Japanese companies have increased the share of independent directors on their boards, although this remains low by international standards (Chart 18, panel 1). Share buybacks have increased, and are on track to hit all-time high this year (Chart 18, panel 2). However, the improvements are still somewhat superficial. Cash holdings of Japanese companies are about 50% of GDP and 100% of market capitalization. The dividend payout ratio, at 30%, is significantly lower than in other developed markets, for example 40% in the U.S. and 50% in the euro area (Chart 18, panels 3 & 4). Why haven’t Japanese corporations returned their excess cash to shareholders? The answer is that many companies simply do not believe that they hold excess cash (Chart 19). The lack of a vibrant market for corporate control, and the general failure of activist foreign investment funds in Japan, means there is also less pressure on companies to use cash efficiently, and to raise leverage to improve their return on equity. The growing presence of the BoJ in the stock market is also a concern. The BoJ now holds over 70% of outstanding ETF equity assets, and is on track to become the single largest owner of Japanese stocks within a couple of years. With the BoJ not taking an active role as a shareholder, this risks undermining corporate governance reforms.21 It also suggests that, without the BoJ’s equity purchases over the past few years, Japanese equities might have performed even worse. Foreign investors have been the main buyers of Japanese equities over the past two decades, offsetting net selling by domestic households and most types of financial institutions. But foreign purchases have recently started to roll over, a trend that could be another catalyst for downward pressures on the stock market, if it were to continue (Chart 20). Chart 19 Chart 20Who Will Buy If Foreigners Don't? Who Will Buy If Foreigners Don't? Who Will Buy If Foreigners Don't?   We conclude, therefore, that signs of improvement in corporate governance are still sporadic and not sufficient to justify a major rerating of the Japanese corporate sector.   Bottom Line GAA recommends an underweight on Japan over a 12-month time horizon, since the drag on consumption from the tax hike will override any positive impact from a rebound in global growth caused by Chinese stimulus. In the longer term, a stubborn refusal to use fiscal policy as well as monetary easing, the limited improvement in corporate governance, and Japan’s intractable structural problems such as demographics, mean it is hard to make a strong rerating case for Japanese equities.   Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Quarterly Portfolio Outlook, “Precautionary Dovishness – Or Looming Recession?” dated July 1, 2019, available on gaa.bcaresearch.com. 2      The BoJ calculates core inflation as headline inflation less fresh food, and core core inflation as headline inflation less fresh food and energy. 3      Please see “Outlook for Economic Activity and Prices (July 2019),” Bank Of Japan, July 2019. 4      Please see “Energy transition Japan: 'We have to disrupt ourselves,' says TEPCO,” Engerati, April 24, 2017.   5      Wage growth is total cash earnings, which includes regular/scheduled earnings plus overtime pay plus special earnings/bonuses. 6      Menju Toshihiro, “Japan’s Historic Immigration Reform: A Work in Progress,” nippon.com, February 6,2019. 7      Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019, available at gaa.bcaresearch.com. 8      Please see Global Asset Allocation Special Report, “Investor’s Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com. 9      Takuji Okubo, “Japan’s dormant central bank may have to rouse itself once more,” Financial Times, May 27, 2019. 10     The core idea of MMT is that, since governments can print as much of their own currency as they require, they do not need to raise money in order to spend money. Japan could increase its fiscal spending and, as long as the BoJ bought the increased bond issuance, this would not raise interest rates. 11     Please see Global Investment Strategy Special Report, “MMT And Me,” dated May 31 2019, available at gis.bcaresearch.com. 12     Please see Global Asset Allocation Special Report, “The Emperor’s Act Of Grace,” dated 8 June 2016, available at gaa.bcaresearch.com. 13     Mariko Fujii and Masahiro Kawai, “Lessons from Japan’s Banking Crisis 1991-2005,” ADB Institute Working Paper, No. 222, June 2010. 14     Mizuho, Mitsubishi UFJ and Sumitomo Mitsui. Data from March 2019 annual reports. 15     Please see “Financial System Report,” Bank of Japan, April 2019. 16       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com. 17       Please see GAA’s latest Monthly Portfolio Update, “Manufacturing Recession, Consumer Resilience, Dovish Central Banks,” dated 1 August 2019, available at gaa.bcaresearch.com. 18     Please see “OECD Economic Surveys: Japan,” OECDiLibrary, April 15, 2019. 19     Please see “Government plans 5% rebates for some cashless payments after 2019 tax hike,”The Japan Times, November 22, 2018. 20     Please see “Outlook For Economic Activity And Price (July 2019),” Bank Of Japan, July 30, 2019. 21     Andrew Whiffin, “BoJ’s dominance over ETFs raises concern on distorting influence,” Financial Times, March 31, 2019.

Highlights So What? Saudi Arabia’s geopolitical risks and still-elevated domestic risks reinforce our cyclically constructive view on oil prices. Why? Saudi Arabia is still in a “danger zone” of internal political risk due to the structural transformation of its economy and society. External risks arising from the Iran showdown threaten to cutoff oil production or transportation, adding to the oil risk premium. We expect oil price volatility to persist, but on a cyclical basis we are constructive on prices. We are maintaining our long EM oil producer equities trade versus the EM equity benchmark excluding China. This basket includes Saudi equities, although in the near term these equities face downside risks. Feature The pace of change in Saudi Arabia has been brisk. Women are driving, the IPO of Aramco is in the works, and the next monarch is likely to be a millennial. Changes to the global energy economy have raised the urgency for an economic transformation that will have political and social consequences, forcing a structural transformation. While the results thus far are attractive, the adjustment phase will be rocky. Saudi Arabia’s successful transition depends on its ability to navigate three main threats: Chart 1The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The Epic Shale Shake-Up Continues The growth of U.S. shale producers and the dilution of Saudi Arabia’s pricing power: Since the emergence of shale technology, Saudi Arabia faces a new reality in oil markets (Chart 1). Even in the current environment of supply disruptions from major producers such as Iran, Venezuela, and Libya, Brent prices have averaged just $66/bbl so far this year, weighed down by the global slowdown, and the macro context of rising U.S. production. Saudi Arabia has had to enlist the support of Russia in the production management agreement (OPEC 2.0) in effort to support oil prices. But continued oil production cuts come at the expense of the coalition’s market share, and crude exports are no longer a dependable source of revenue for Saudi Arabia. Domestic social and political uncertainties: The successful functioning of the political system has been dependent on the government’s ability to support the lifestyles of its citizens, who have grown accustomed to the generosity of their rulers. But economic challenges bring fiscal challenges. Moreover, shifting powers within the state raise the level of uncertainty and risks during the transition phase. Saber-rattling in the region: Heightened tensions with arch-enemy Iran are posing significant risks of instability and armed conflict that could affect oil production and transportation. And as the war in Yemen enters its fifth year, it poses risks to Saudi finances and oil infrastructure – as highlighted by the multiple drone attacks on Saudi oil facilities in May. These structural risks now dominate Saudi Arabia’s policy-making. OPEC 2.0’s decision at the beginning of this month to extend output cuts into 2020 aims to smooth the economic transition by maintaining a floor under oil prices. Meanwhile Crown Prince Mohammad bin Salman’s Vision 2030 is underway – it is a blueprint for a future Saudi Arabia less dependent on oil (Table 1). Table 1Vision 2030 Highlights Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts Saudi leadership will struggle to minimize near term instability without jeopardizing necessary structural change. In addition to an acute phase of tensions with Iran that could lead to destabilizing surprises this year or next, Saudi Arabia’s economy has just bottomed and is not yet out of the woods. Saudi Arabia’s Economy And Global Oil Markets: Adapting To The New Normal The trajectory of Saudi Arabia’s economic performance has improved since the U-turn in its oil-price management. From 2014-16 Riyadh attempted to drive U.S. shale producers out of business by cranking up production and running prices down. Since then it has supported prices through OPEC 2.0’s production cuts (Chart 2). Export earnings have rebounded over the past two years, reversing the current account deficit (Chart 3). Although net inflows from trade in real terms contribute a much smaller share of overall economic output compared to the mid-2000s, the good news is that the trade balance is back in surplus. Chart 2Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Return To Cartel Tactics Boosted Economy Nevertheless, the external balance remains hostage to oil prices and may weaken anew over a longer time horizon. Chart 3Current Account Balance Has Improved Current Account Balance Has Improved Current Account Balance Has Improved Chart 4Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Oil Revenues Easing Budget Strain ... For Now Greater government revenues are helping to improve the budget (Chart 4), but it remains in deficit. Moreover, we do not expect Saudi Arabia to flip the budget to a surplus over the coming two years. Despite our Commodity & Energy Strategy team’s expectation of higher oil prices in 2019 and 2020,1 Saudi Arabia will struggle to balance its budget in the coming 18 months (Chart 5). Their average Brent projection of $73-$75/bbl over the next 18 months still falls short of Saudi’s fiscal breakeven oil price. Most importantly, the kingdom’s black gold is no longer a reliable source of income. Chart 5 Weak oil revenues create a “do-or-die” incentive for Saudi policymakers to diversify the economy. As Chart 1 above illustrates, Saudi Arabia is losing global oil influence to U.S. shale producers. While OPEC 2.0 restrains production, the U.S. will continue dominating production growth, with shale output expected to grow ~1.2mm b/d this year and ~1 mm b/d in 2020.2 Saudi Aramco has been the driving force behind the production cuts (Chart 6), yielding more and more of its market share to American producers. Chart 6 The bad news for Saudi Arabia is that shale producers are here to stay. The kingdom is poorly positioned for this loss of control over oil markets (Chart 7) and is being forced to adapt by diversifying its economy at long last. Chart 7A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports A Long Way To Go In Diversifying Exports Little progress has been made on this front, despite the fanfare surrounding the Vision 2030 plan. 70% of government revenues were derived from the oil sector last year, an increase from the 64% share from two years prior, and Saudi Arabia’s dependence on oil trade has actually increased over the past year (Chart 8).3 This week’s announcement of Aramco’s plans to increase output capacity by 550k b/d does not support the diversification strategy. Nevertheless, the Saudis appear to be redoubling their efforts on Aramco’s delayed initial public offering. The IPO is an important aspect of the diversification process. It is also a driver of Saudi oil price management – other things equal, higher prices support the Saudis’ rosy assessments of the company’s total worth. While an excessively ambitious timeline and indecision over where to list the shares have been setbacks to the plan, last weekend’s meeting between King Salman and British finance minister Philip Hammond follows Crown Prince Mohammad bin Salman’s reassertion last month that the IPO would take place in late 2020 or early 2021.4 On the non-oil front, given that Saudi Arabia’s fiscal policy is procyclical, activity in that sector is dependent on the performance of the oil sector. Strong oil sales not only improve liquidity, but also allow for greater government expenditures – both of which stimulate non-oil activity (Chart 9). This means the improvement in the non-oil sector is more a consequence of the rebound in oil revenues than an indication of successful diversification. Chart 8Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Saudi Reliance On Oil Not Falling Yet Yet the reform vision is not dead. Weak oil revenues may be a blessing in disguise, presenting Saudi policymakers with a “do-or-die” incentive to intensify diversification efforts. Chart 9Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Non-Oil Activity Still Depends On Oil Sales Bottom Line: By enlisting the support of Russia, Saudi Arabia has managed to maintain a floor beneath oil prices. However, this comes at the expense of falling market share. This leaves authorities with no choice but to diversify the economy – a feat yet to be performed. Domestic Instability Is A Potential Threat Political and social instability in Saudi Arabia is the second derivative of the new normal in global oil markets. So far instability has been limited, but the transition phase is ongoing and the government may not always manage the rapid pace of structural change as effectively as it has over the past two years. Traditionally, Saudi decision-making has comprised the interests of three main social actors: (1) the ruling al Saud family and Saudi elites (2) religious rulers, and (3) Saudi citizens. In the past, the royal family has been able to mitigate social dissent and maintain stability by ensuring that the financial interests of its citizens are satisfied while granting extensive authority to religious groups. The government has transferred profits amassed from oil to Saudi citizens in the form of subsidies for housing, fuel, water, and electricity; public services; and employment opportunities in bloated and inefficient bureaucracies. Going forward, pressure on Riyadh to reduce expenditures and adapt its budget to the changing oil landscape will persist. The authorities will have to continue to shake down elites for funds, or make cuts to these entitlements, or both. Hence policymakers are attempting to walk a thin line between near-term stability and long-term structural change. Several instances of official backtracking show that authorities fear the potential backlash. Following mass discontent in 2017, the Saudi government rolled back most of a series of cuts to public sector wages and benefits that would have led to massive fiscal savings. Instead, the government raised revenue by increasing prices of subsidized goods and services, including fuel, while doling out support to low-income families. The government also introduced a 5% value-added tax in January 2018. Unemployment – especially youth unemployment – is elevated. This is frightening for the authorities. What about the guarantee of cushy government jobs? 45% of employed Saudis work in the public sector. The consequence is an unproductive labor force lacking the skills necessary to succeed in the private sector. Declining oil revenues remove the luxury of supporting a large, unproductive labor force. Chart 10Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Youth And Woman Unemployment A Structural Constraint Against this backdrop, unemployment – especially youth unemployment – is elevated (Chart 10). This is frightening for the authorities as over half of Saudi citizens are below 30 years of age and the fertility rate is above replacement level implying continued rapid population growth. It will be a challenge to find employment for the rising number of young people. All the while, jobs in the private sector – which will need to take in the growing labor force – are dominated by expatriate workers. Saudi citizens hold only 20% of jobs in the private sector – but this sector makes up 60% of the country’s employment. Fixing these distortions is challenging. Overall, monthly salaries of nationals are more than double those of expatriates (Chart 11). High wage gaps also exist among comparably skilled workers, reducing the incentive to hire nationals. Chart 11 With non-Saudis holding over 75% of the jobs, the incentive to employ low-wage expatriate workers has also weighed on the current account balance through large remittance outflows (Chart 12). And while the share of jobs held by Saudi citizens increased, this is not on the back of an increase in the number of employed Saudis. Rather, while the number of nationals with jobs contracted by nearly 10% in 2018, jobs held by non-Saudis declined at a faster pace. The absolute number of employed Saudis is down 37% since 2015. “Saudization” efforts are aimed at reducing the wage gap – such as a monthly levy per worker on firms where the majority of workers are non-Saudi; wage subsidies for Saudi nationals working in the private sector; and quotas for hiring nationals. But these have mixed results. While Saudi employment has improved, the associated reduced productivity and higher costs have been damaging. Thus, these labor market challenges pose risks to both domestic stability, and the economy. Moreover, even though improved liquidity conditions have softened interbank rates, loans to government and quasi-government entities still outpace loans to the private sector (Chart 13). This “crowding out” effect is not conducive to a private sector revival. It is conducive to central government control, which the leadership is tightening. Chart 12Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Jobs For Expatriate Workers Have Declined Chart 13Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Monetary Conditions Ease But Private Credit Lags Facing these structural factors, authorities are attempting to appease the population through social change. There has been a marked relaxation in the ultra-conservative rules governing Saudi society. Permission for women to drive cars has been granted and the first cinemas and music venues opened their doors last year. Critically, religious rulers are seeing their wide-ranging powers curtailed. The hai’a or religious police are now only permitted to work during office hours. They no longer have the authority to detain or make arrests, and may only submit reports to civil authorities. While these changes appeal to the new generation, they also run the risk of provoking a “Wahhabi backlash.” This risk is still alive despite the past two years of policy change. The recently approved “public decency law” – which requires residents to adhere to dress codes and bans taking photos or using phrases deemed offensive – reveals the authorities’ need to mitigate this risk. Popular social reforms are occurring against a backdrop of an unprecedented centralization of power. Mohammad bin Salman will be the first Saudi ruler of his millennial generation. The evolving balance of power between the 15,000 members of the royal family will hurl the kingdom into the unknown. The concentration of power into the Sudairi faction of the ruling family, through events such as the 2017 Ritz Carlton detentions, is still capable of provoking a destabilizing backlash. Discontent among royal family members and Saudi elites may give rise to a new, fourth faction, resentful of the social and political changes. At the moment, the state’s policies have generated some momentum. A number of major hardline religious scholars and clerics have apologized for past extremism and differences over state policy and have endorsed MBS’s vision of a modern Saudi state and “moderate” Islam – the crackdown on radicalism has moved the dial within the religious establishment.5 But structural change is not quick and the social pressures being unleashed are momentous. Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. The government is guiding the process, but the consensus is correct that internal political risk remains extremely high. There has been a structural increase in that risk, as outlined in this report – and it is best to remain cautious even regarding the cyclical increase in political risk over the past two years. Bottom Line: Saudi Arabia’s new economic reality is ushering in social and political change at an unprecedented pace. Unless the interests of the three main social actors – the royal family, religious elites, and Saudi citizens – are successfully managed, a new faction comprised of disaffected elites may arise. A Dangerous Neighborhood Putting aside the longer term threat from U.S. energy independence, Saudi Arabia’s oil production and transportation infrastructure are currently in danger from saber-rattling or conflict in the region. Saudi officials originally expected the war in Yemen to last only a few weeks, but the conflict is now in its fifth year and still raging. The claim by the Iran-backed Houthi insurgents that a recent drone attack on Saudi oil installations was assisted by supporters in Saudi Arabia’s Eastern province – home to the majority of the country’s 10%-15% Shia population and oil production – is also troubling as it shows that the above domestic risks can readily combine with external, geopolitical risks. The U.S. is also joining Israel and Saudi Arabia in applying increasing pressure on Iran, which risks sparking a war. Our Iran-U.S. Tensions Decision Tree illustrates that the probability of war between the U.S. and Iran – which would involve the Saudis – is as high as 40% (Diagram 1). Diagram 1Iran-U.S. Tensions Decision Tree Saudi Arabia: Changing In Fits And Starts Saudi Arabia: Changing In Fits And Starts We are not downgrading this risk in the wake of President Trump’s decision not to conduct strikes on Iranian radars and missile launchers on June 20. President Trump claims he wants negotiations instead of war, but his administration’s pressure tactics have pushed Iran into a corner. The Iranian regime is capable of pushing the limits further (both in terms of its nuclear program as well as regional oil production and transport), which could easily lead to provocations or miscalculation. The Saudi-Iranian rivalry is structurally unstable as a result of Iran’s capitalization on major strategic movements of the past two decades. The Saudis have lost a Sunni-dominated buffer in Iraq, they have lost influence in Syria and Yemen, and their aggressive military efforts to counter these trends have failed.6 The Israelis are equally alarmed by these developments and trying to persuade the Americans to take a much more aggressive posture to contain Iran. As a result, the Trump administration reneged on the 2015 U.S.-Iran nuclear agreement and broader détente – intensifying a cycle of distrust with Iran that will be difficult to reverse even if the Democratic Party takes the White House in 2020. Hence there is a real possibility of attacks on Saudi oil production facilities, domestic pipelines, and tankers in transit in the near term. Moreover, the majority of Saudi Arabia’s exports transit through two major chokepoints making these barrels vulnerable to sabotage: The Strait of Hormuz, which Iran has resumed threatening to block; The Bab-el-Mandeb Strait, located between Yemen and East Africa, which was the site of an attack on two Saudi Aramco tankers last year, forcing a temporarily halt in shipments. Chart 14 Saudi Arabia is acutely aware of these risks. It is the top buyer of U.S. arms and, as a result of the dramatic strategic shifts since the American invasion of Iraq, it is the world’s leading spender on military equipment as a share of GDP (Chart 14). One of our key “Black Swan” risks of the year is that the Saudis may be emboldened by the Trump administration’s writing them a blank check. Bottom Line: In addition to the structural risks associated with Saudi Arabia’s economic, social and political transition, geopolitical tensions in the region are elevated. Warning shots are still being fired by Iran and their proxies (such as the Houthis), and oil supplies are at the mercy of additional escalation. Investment Implications Saudi Arabia’s equity market is halfway through the process of joining the benchmark MSCI EM index. The process will finish on August 29, 2019 with Saudi taking up a total 2.9% weighting in the index. Research by our colleague Ellen JingYuan He at BCA’s Emerging Markets Strategy shows that in the case of the United Arab Emirates, Qatar, and Pakistan, inclusion into MSCI created a “buy the rumor, sell the news” phenomenon and suggested that a top of the market was at hand.7 Saudi equities have recently peaked in absolute terms and relative to the emerging market benchmark, supporting this thesis. Saudi equity volatility has especially spiked relative to the emerging market average, which is appropriate. We expect ongoing bouts of volatility due to the immediate, market-relevant political risks outlined above. The risk of a disruptive conflict stemming from the Saudi-Iran and U.S.-Iran confrontation is significant enough that investors should, at minimum, expect minor conflicts or incidents to disrupt oil markets in the immediate term. We expect oil price volatility to persist. Because Riyadh is maintaining OPEC 2.0 discipline in this environment, oil prices should experience underlying upward pressure. It is not that the Saudis are refusing to support the Trump administration’s maximum pressure against Iran but rather that they are calibrating their support in a way that hedges against the risk that Trump will change his mind, since that risk is quite high. This is the 55% chance of an uneasy status quo in U.S.-Iran relations in Diagram 1, which requires at least secret U.S. relaxation of oil sanction enforcement. Moreover, the Saudis want to reduce the downside risk of weak global growth and support their national interest in pushing Brent prices toward $80/bbl for fiscal and strategic purposes. Our pessimistic assessment of the Osaka G20 tariff truce between the U.S. and China is more than offset by our expectation since February that China’s economic policy has shifted toward stimulus rather than the deleveraging of 2017-18. We assign a 68% probability to additional trade war escalation in Q4 this year or at least before November 2020. But since a dramatic trade war escalation would lead to even greater stimulus, we still share our Commodity & Energy Strategy’s cyclical view that the underlying trend for oil prices is up. We are maintaining our recommendation of being long EM oil producers’ equities relative to EM-ex-China. This trade includes Saudi Arabian equities, but as a whole it has upside in the near-term as Brent prices are below our expected average and Chinese equities are still down 10% from their April highs.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Our Commodity & Energy Strategy team expects Brent prices to average $73/bbl this year and $75/bbl in 2020. For their latest monthly balances assessment, please see “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 2 Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “Supply-Demand Balances Consistent With Higher Oil Prices,” dated June 20, 2019, available at ces.bcaresearch.com. 3 The higher export dependence on oil reflects the rebound in oil prices in 2018, rather than a decline in non-oil exports. Given the strong relationship between activity in the oil and non-oil sectors, non-oil exports also increased in 2018. 4 Saudi Aramco’s purchase of a 70 percent stake in SABIC from the Saudi Public Investment Fund (PIF) earlier this year reportedly contributed to the IPO delay. The deal will capitalize the PIF, enabling it to diversify the economy. 5 See, for example, James M. Dorsey, “Clerics and Entertainers Seek to Bolster MBS’s Grip on Power,” BESA Center Perspectives Paper No. 1220, July 7, 2019, available at besacenter.org. 6 The U.S., Saudi Arabia, and their allies are trying to restore Iraq as a geopolitical buffer by cultivating an Iraq that is more independent of Iranian influence – and this is part of rising regional frictions. Iraqi Prime Minister Adel Abdul Mahdi’s recently issued decree to reduce the power of Iraq’s Iran-backed milita, the Popular Mobilization Forces (PMF) and integrate them into Iraq’s armed forces by forcing them to choose between either military or political activity. Just over a year ago, Iraq’s previous Prime Minister Haider al-Abadi issued a decree granting members of the PMF many of the same rights as members of the military. 7 Please see BCA Frontier Markets Strategy, “Pakistani Stocks: A Top Is At Hand,” March 13, 2017, available at fms.bcaresearch.com.