Manufacturing

Dear clients, Over the next couple of weeks, we will be further analyzing China’s coronavirus outbreak, its economic impact, and the likely policy response, as well as the attendant investment recommendations. We will also examine any sector-related or regional themes that stem from the outbreak. Stay tuned. Jing Sima, China Strategist Highlights The peak in the number of new cases outside of the crisis epicenter will be more market-relevant than the total number of infections. New cases outside of the epicenter continue to rise, but a peak may be in sight. Our sense is that financial markets are likely to bottom earlier than the consensus expects. The economic impact on China from the outbreak will be large, but manufacturing activities in the majority of Chinese cities should resume by the end of February. It will take longer for the service sector to recover, implying a larger hit to the economy compared with the SARS episode given that services have grown in importance. This will force Chinese policymakers to set their financial deleveraging agenda aside for the rest of the calendar year. We maintain an overweight stance on Chinese stocks both tactically and cyclically, based on our view that the outbreak will soon be contained outside of Hubei province and that China’s budding economic recovery will be delayed, but not prevented, by the crisis. Feature The coronavirus (2019-nCoV) outbreak in China has sparked a selloff in risk assets around the globe. China’s A-share equity market, after an extended Chinese New Year market closure, was in a free fall when it reopened on February 3. In the offshore market, the MSCI China Index has declined by 9% from its most recent high on January 13, 2020 (Chart 1).  When attempting to forecast a turning point in bearish investor sentiment stemming from the outbreak, it is important to note that during the 2003 SARS epidemic, both global and Chinese equity markets rebounded when the number of new cases peaked in Hong Kong SAR and globally (Chart 2).  Chart 1Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chinese Stocks Have Been Hit Hard By The Virus Outbreak Chart 2Markets Bottomed As Total SARS Infections Peaked Markets Bottomed As Total SARS Infections Peaked Markets Bottomed As Total SARS Infections Peaked We maintain our long stance both tactically and cyclically on Chinese stocks, based on the following assessments: In the next three months, the panic brought on by 2019-nCoV will abate before the total number of new cases peaks, as investors focus on the turning point in the outbreak outside of the epicenter (Hubei province). Beyond the next three months, the outbreak will likely delay China’s economic recovery. However, this means that Chinese policymakers will not likely reduce the scale of their stimulative efforts this year. The Market Correction May Be Short-Lived Since the onset of the 2019-nCoV outbreak, many studies have attempted to predict the speed and magnitude of the spread of the virus. Using a mathematical model called Susceptible-Exposed-Infected-Recovered (SEIR), The Lancet,1 The University of Hong Kong,2 and Johns Hopkins CSSE3 all drew a conclusion that a peak in the current episode is likely to occur between late April and early May. The number of cases outside of the crisis epicenter will likely drive financial market sentiment. While we think this conclusion may be true for the total number of new cases, the total count will be less relevant to investors during this episode than during the 2003 SARS outbreak. Instead, it will be more useful to break down the total infection count into two sets of data: the number of new cases within the city of Wuhan and Hubei Province (the epicenter of the outbreak), and the number of new cases outside of Hubei. The latter is more likely to be the primary driver of short-term outbreak-related market sentiment. While Hubei is experiencing an acceleration in the daily rate of new cases, the number of new cases across the rest of China seems to be flattening off of late (Chart 3). We think that the number of cases outside of Hubei will peak earlier than within the epicenter. This is in contrast to the 2003 SARS outbreak when the peak of new cases in the rest of China and globally lagged the epicenter Hong Kong SAR by a month (Chart 4). Chart 3Number Of 2019-nCoV New Cases Flattening Outside The Epicenter Recovery, Temporarily Interrupted Recovery, Temporarily Interrupted Chart 4SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter SARS Outbreak Peaked Globally A Month After Peaking In The Crisis Epicenter There are two reasons for the difference between the 2003 SARS peak and projections for the 2019-nCoV outbreak: Timely cutoff of virus mobility outside of epicenter: The world responded quickly to contain the virus. During the 2003 SARS episode, Chinese authorities responded with protective measures only after the outbreak had already peaked in the epicenter. This time the Chinese government intervened at an early stage of the outbreak with forceful and in some cases extreme actions, including a near-complete lockdown of Wuhan (the crisis epicenter) and restrictions on inter- and intra-city traffic in other major metropolitan areas. Foreign governments in North America, Europe, and Southeast Asia took unprecedented measures to ban or limit air traffic to/from China. Furthermore, with timely and sufficient medical care, the fatality rate outside of the epicenter has been much lower4 – a significantly underreported fact. Mishandling of the crisis within the epicenter: Within Hubei province, particularly the city of Wuhan where the virus originated, the number of infections will likely continue climbing in the next two to even three months. The abovementioned studies suggest the number of cases in the epicenter is five to seven times higher than the official count. Local hospitals are experiencing severe shortages of medical supplies, meaning that people with mild-to-medium symptoms have reportedly been turned away. These patients are not included in the official statistics as confirmed or suspect cases. The discrepancy in reporting means these cases will be confirmed and recorded at a much later date. Without quarantine and treatment, these patients may continue to transmit the virus to others within the epicenter. This will have a tragic human cost, but it will hold few consequences for financial markets. The corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Bottom Line: Market sentiment will rebound following the peak in new 2019-nCoV cases outside the epicenter of Wuhan/Hubei. We think the peak may come as early as mid to late-February, which suggests the corrections in Chinese onshore and offshore stocks, while severe, will be fleeting. Economic Recovery In Sight Beyond the near-term, our view on China’s likely policy response and the economy’s fundamentals support a positive outlook for Chinese stocks over the next 6 to 12 months. In absolute dollar terms, the scale of the economic impact from the 2019-nCoV outbreak will likely be larger than the SARS episode in 2003. Unlike with SARS, when disruptions were mild and limited to the travel and retail sectors, the extreme measures China took in response to the coronavirus outbreak have essentially placed Chinese economic activity on hold. Chart 5Service Sector Now A Larger Part Of China's Economy Compared With 2003 Service Sector Now A Larger Part Of China's Economy Compared With 2003 Service Sector Now A Larger Part Of China's Economy Compared With 2003 China’s service sector is also likely to be more affected than manufacturing, because the outbreak coincided with the Chinese New Year holiday when services are normally in high demand. In addition, the service sector accounts for a much larger share of the Chinese economy than in 2003 (Chart 5). Therefore, the reduction in services output will have a comparatively bigger economic impact. However, as we think the 2019-nCoV outbreak outside of the epicenter will likely peak in February, the majority of nationwide manufacturing activity should resume no later than the last week of February. Chinese authorities have already signaled they will speed up government-led infrastructure investment as early as March. Chart 6Service Sector Took Longer To Recover After SARS Outbreak Service Sector Took Longer To Recover After SARS Outbreak Service Sector Took Longer To Recover After SARS Outbreak The service sector will take longer to recover. Following the 2003 SARS outbreak, the recovery in the service sector lagged the manufacturing and primary sectors by one quarter (Chart 6). This will likely delay the bottoming of the aggregate Chinese economy. We project a bottom in China’s economy towards the end of the second quarter of 2020. A delay in economic recovery will force Chinese policymakers to put aside their financial deleveraging agenda, and focus on economic growth for the year. 2020 marks the final year for policymakers to accomplish their goal to double GDP from 2010. This means policymakers will likely augment the amount of stimulus in order to stabilize the economy and avoid falling short of their growth target. Bottom Line: Business activities should resume in late February, with a bottoming in the economy towards the end of the second quarter of 2020. Monetary Support Already Lining Up The Chinese economy is on a structurally slowing trend, but is in an early stage of cyclically recovering from last year (Chart 7). This is in contrast with 2003 during the SARS outbreak when China’s economic growth was structurally accelerating, but the monetary environment was in a tightening cycle and industrial profit growth was downshifting (Chart 8). Chart 7Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chinese Economy Is On A Structurally Slowing Trend, But Is Cyclically Recovering... Chart 8...And Is In An Expansionary Monetary Cycle ...And Is In An Expansionary Monetary Cycle ...And Is In An Expansionary Monetary Cycle   As the performance of Chinese onshore stocks reflects domestic policy, Chinese A-shares, after briefly rebounded when the 2003 SARS outbreak peaked, underperformed the global benchmark during much of the 2004-2006 period when monetary policy tightened (Chart 9). Contrasting with 2003, we expect the PBoC to maintain a more accommodative monetary stance throughout 2020 (Chart 10): the PBoC cut the open market operation interest rates by 10bps on February 3. We expect this move to lead to a 5bps LPR and MLF rate cut in March. Moreover, the chance that the PBoC will cut the bank reserve requirement ratio (RRR) in Q2 is also increasing. Chart 9Chinese Onshore Equity Market Largely Driven By Domestic Policy Chinese Onshore Equity Market Largely Driven By Domestic Policy Chinese Onshore Equity Market Largely Driven By Domestic Policy Chart 10Easy Monetary Stance Is Here To Stay Easy Monetary Stance Is Here To Stay Easy Monetary Stance Is Here To Stay Bottom Line: Monetary policy will become more accommodative this year. Investment Conclusions Chinese stocks just went on sale, but the sale likely will not last long. Chart 11Chinese Stocks Are Priced At An Even Deeper Discount Chinese Stocks Are Priced At An Even Deeper Discount Chinese Stocks Are Priced At An Even Deeper Discount Over the next 0-3 months, Chinese equities will likely rebound as soon as the peak in the number of new cases outside of Wuhan/Hubei occurs. We believe the peak will happen within the next two weeks, and manufacturing activities in the majority of Chinese cities will resume following the peak in the outbreak. Depressed valuations in Chinese stocks compared with the global benchmark and the expectation of a rebound in Chinese economic activity should provide a good buying opportunity for global investors (Chart 11). In short, Chinese stocks just went on sale, but the sale likely won’t last long. Over a cyclical time horizon, we had previously predicted that China’s authorities may reduce the scale of the stimulus in the second half of this year as the economy starts to recover in Q1. The 2019-nCoV outbreak will alter the leadership’s policy trajectory and extend pro-growth support through 2020, and both the central and regional governments have announced a slew of policies in supporting businesses, particularly for the private sector. Our expectation that the viral outbreak will not derail China’s economic recovery suggests that corporate earnings will also rebound over a 6-12 month time horizon. One risk that we will be monitoring over the coming several months is the potential for firm- or sector-specific effects on earnings. The nationwide city lockdowns are certain to reduce or halt the flow of cash to businesses, and it is unclear whether this will have any disproportionate effects on corporate earnings relative to what we expect will occur for the economy beyond Q1. However, for now, our assumption is that the trend in earnings growth is likely to match that of the economy more generally unless evidence to the contrary presents itself. This supports an overweight position in Chinese stocks compared with their global peers over the coming 6-12 months.   Jing Sima China Strategist jings@bcaresearch.com Qingyun Xu, CFA Senior Analyst qingyunx@bcaresearch.com   Footnotes 1    “Nowcasting and forecasting the potential domestic and international spread of the 2019-nCoV outbreak originating in Wuhan, China: a modelling study”, The Lancet, January 31, 2020. 2   “Real-time nowcast on the likely extent of the Wuhan coronavirus outbreak, and forecasts domestic and international spread”, Hong Kong University, January 27, 2020 3   “Modeling the Spreading Risk of 2019-nCoV”, John Hopkins Center For Systems Science And Engineering, January 31, 2020. 4   As of February 3, 2020, the fatality rate of 2019-nCoV outside of Hubei stands at 0.2%, compared with a 3% fatality rate in Hubei province and 5.5% in Wuhan, according to the World Health Organization (WHO). Cyclical Investment Stance Equity Sector Recommendations

Highlights Duration: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. TIPS: We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. High-Yield: Investors should add (or increase) exposure to the high-yield energy sector, within an overweight allocation to junk bonds. Junk energy spreads are attractive, and exposure to the sector will mitigate the impact of a potential oil supply shock. Feature Only a month ago, investors were becoming more optimistic about a global growth rebound and the US/China phase 1 trade deal was pushing political risk into the background. Both of those factors caused the 10-year Treasury yield to rise throughout December, hitting an intra-day Christmas Eve peak of 1.95% (Chart 1). But since then, softer global PMI data and the US/Iranian military conflict brought global growth concerns and political risk back to the fore, breaking the uptrend in yields. Chart 1Bond Bear On Pause Bond Bear On Pause Bond Bear On Pause Global growth and political uncertainty are two of the five macro factors that we identify as important for US bond yields.1 And despite the recent setback, we think both factors will push yields higher in the coming months. Global Growth We have found that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index are the three global growth indicators that correlate most strongly with US bond yields. One reason for the recent pullback in yields is the disappointing December data from the Global and US Manufacturing PMIs. The ISM Manufacturing PMI moved deeper into recessionary territory. The Global Manufacturing PMI had been in a clear uptrend since mid-2019, but fell back to 50.1 in December, from 50.3 the month before (Chart 2). The US and Chinese PMIs also declined in December, though they remain well above the 50 boom/bust line (Chart 2, panels 3 & 4). The Eurozone and Japanese PMIs, meanwhile, are still in the doldrums (Chart 2, panels 2 & 5). More worrying than the small tick down in Global PMI is the US ISM Manufacturing PMI moving deeper into recessionary territory, from 48.1 to 47.2. However, we have good reason to think that stronger data are just around the corner (Chart 3). Chart 2Global PMI Ticks Down Global PMI Ticks Down Global PMI Ticks Down Chart 3ISM Manufacturing Index Will Rebound ISM Manufacturing Index Will Rebound ISM Manufacturing Index Will Rebound First, the difference between the new orders and inventories components of the ISM index often leads the overall index at turning points, 2016 being a prime example (Chart 3, top panel). Much like in 2016, a gap is opening up between new orders-less-inventories and the overall ISM. Second, the non-manufacturing ISM index remains strong despite the weakness in manufacturing (Chart 3, panel 2). With no contagion to the service sector of the economy, we’d expect manufacturing to pick back up. Third, the ISM Manufacturing index has diverged sharply from the Markit Manufacturing PMI, with the Markit index printing well above the ISM (Chart 3, panel 3).2 The ISM index has been more volatile than the Markit index in recent years, and should trend toward the Markit index over time. Fourth, regional Fed manufacturing surveys have generally been stronger than the ISM during the past few months. A simple regression model of the ISM index based on data from regional Fed surveys suggests that the ISM index should be at 49.7 today, instead of 47.2 (Chart 3, bottom panel). Finally, unlike the PMI surveys, the CRB Raw Industrials index has increased quite sharply in recent weeks (Chart 4). We should note that it is not the CRB index itself but rather the ratio between the CRB index and gold that tracks bond yields most closely, and this ratio has actually declined lately due to the strength in gold. Nonetheless, a sustained turnaround in the CRB index would mark a big change from 2019 and would send a strong bond-bearish signal. Chart 4CRB Sends A Bond-Bearish Signal CRB Sends A Bond-Bearish Signal CRB Sends A Bond-Bearish Signal Political Uncertainty The second factor that sent bond yields lower during the past few weeks was the military conflict between the US and Iran. Tensions appear to have de-escalated for now, and we would expect any flight-to-quality flows to unwind during the next few weeks.3 But while we see policy uncertainty easing in the near-term, sending bond yields higher, we reiterate our view that US political uncertainty is the number one risk factor that could derail the 2020 bear market in bonds.4 Specifically, we see two looming US political risks. The first relates to President Trump’s re-election odds. For now, Trump’s approval rating is in line with past incumbent presidents that have won re-election (Chart 5). But if his approval doesn’t keep pace in the coming months, he will try to do something to change his fortunes. That could mean re-igniting the trade war with China, or once again ramping up tensions with Iran. A Bernie Sanders or Elizabeth Warren victory would send a flight-to-quality into bonds. The second risk is that one of the progressive candidates – Bernie Sanders or Elizabeth Warren – secures the Democratic nomination for president. Right now, both trail Joe Biden in the polls and betting markets (Chart 6), but things could change rapidly as the primary results come in during the next few months. The stock market would certainly sell off if an Elizabeth Warren or Bernie Sanders presidency seems likely, sending a flight to quality into bonds.5 Chart 5Trump’s Approval Rating Must Rise Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Chart 6Democratic Nomination Betting Odds Democratic Nomination Betting Odds Democratic Nomination Betting Odds Bottom Line: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. Playing An Oil Supply Shock In US Bond Markets US/Iranian military tensions are easing for now, but could flare again in the future. For that reason, it’s worth considering how US bond markets would respond in the event of a conflict between the US and Iran that removed a significant amount of the world’s oil supply from the market, causing the oil price to spike. The first implication is that US bond yields would fall. Even though it’s tempting to say that the inflationary impact of higher oil prices would push yields up, this effect would not dominate the flight-to-quality into US bonds that would result from the increase in political uncertainty. Case in point, Chart 1 shows that, while the inflation component of yields was stable as tensions flared during the past few weeks, it didn’t come close to offsetting the drop in the 10-year real yield. Beyond the impact on Treasury yields, there are two other segments of the US bond market that would be materially impacted by an oil supply shock: the TIPS breakeven inflation curve and corporate bond spreads. Buy TIPS Breakeven Curve Flatteners Table 1CPI Swap Curve Sensitivity To Oil Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock When considering the impact of an oil supply shock on TIPS breakeven inflation rates, we first look at how the cost of inflation protection is influenced by changes in the oil price. Table 1 shows the sensitivity of weekly changes in different CPI swap rates to a $1 increase in the price of Brent crude oil. We use CPI swap rates instead of TIPS breakeven inflation rates because data are available for a wider maturity spectrum. Our analysis applies equally to the TIPS breakeven inflation curve. Two conclusions are apparent from Table 1. First, the entire CPI swap curve is positively correlated with the oil price, a higher oil price moves CPI swap rates higher and vice-versa. Second, the sensitivity of CPI swap rates to the oil price is greater at the short-end of the curve than at the long-end. This is fairly intuitive given that higher oil prices are inflationary in the short-term but could be deflationary in the long-run if they hamper economic growth. Chart 7Coefficients Stable Over Time Coefficients Stable Over Time Coefficients Stable Over Time Chart 7 shows that our two main conclusions are not dependent on the chosen time horizon. The 2-year CPI swap rate is positively correlated with the oil price for our entire sample period, as is the 10-year rate except for a brief window in 2014. The 2-year rate’s sensitivity is also consistently higher than the 10-year’s. Based on this analysis, we can suggest two good ways to hedge against the risk of an oil supply shock that sends prices higher: Buy inflation protection, either in the CPI swaps market or by going long TIPS versus duration-equivalent nominal Treasuries. Buy CPI swap curve (or TIPS breakeven inflation curve) flatteners.6 But we can introduce one more wrinkle to our analysis. Oil prices can rise because of stronger demand or because a shock suddenly removes supply from the market. It’s possible that the cost of inflation protection behaves differently in each case. Fortunately, the New York Fed has made an attempt to distinguish between those two scenarios. In its weekly Oil Price Dynamics Report, the Fed decomposes Brent oil price changes into demand-driven changes and supply-driven changes.7 It does this by looking at how other financial assets respond to oil price changes each week. Chart 8 shows the cumulative change in the Brent oil price since 2010, along with the New York Fed’s supply and demand factors. According to the Fed, demand has pressured the oil price higher since 2010, but this has been more than offset by greater supply. Chart 8Supply & Demand Oil Price Decomposition Supply & Demand Oil Price Decomposition Supply & Demand Oil Price Decomposition Using the New York Fed’s supply and demand series, we look at how CPI swap rates respond to higher oil prices in three different scenarios. First, we identify 252 weeks when demand and supply both contributed to higher oil prices. Second, we identify 95 weeks when higher oil prices were driven solely by demand. Finally, and most pertinently, we identify 92 weeks when higher oil prices were driven only by supply (Table 2). Table 2Weekly Change In CPI Swap Rate When Brent Oil Price Increases Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios are consistent with our results from Table 1. CPI swap rates across the entire curve move higher more than half the time, with greater increases at the short-end of the curve. However, the scenario we are most interested in is the ‘Supply Driven’ scenario. Presumably, a military conflict with Iran that took oil supply off the market would lead to less supply and also a decrease in global demand. Results for this scenario are more mixed. The 1-year CPI swap rate still rises 60% of the time, but rates further out the curve are somewhat more likely to fall. With this in mind, CPI swap curve or TIPS breakeven curve flatteners look like the best way to hedge against an oil supply shock, better than an outright long position in inflation protection. This is good news, since we have previously argued that owning TIPS breakeven curve flatteners is a good idea even without an oil supply shock.8 Corporate bond excess returns respond positively to changes in the oil price. We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. Buy Energy Junk Bonds Table 3Corporate Bond Sensitivity To Oil Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Corporate bonds are the second segment of the US fixed income market that could be materially impacted by an oil supply shock, particularly bonds in the energy sector. To assess the potential value of corporate bonds as a hedge, we repeat the above analysis but use weekly corporate bond excess returns versus duration-matched Treasuries instead of CPI swap rates. Table 3 shows that investment grade and high-yield corporate bond returns both respond positively to changes in the oil price. Further, we see that energy bonds are more sensitive to the oil price, outperforming the overall index when the oil price rises, and vice-versa. Chart 9 shows that, while oil price sensitivities vary considerably over time, they are almost always positive. Also, energy sector sensitivity has been consistently above that of the benchmark index since 2014. Chart 9Betas Mostly Positive Betas Mostly Positive Betas Mostly Positive Going one step further, we once again use the New York Fed’s supply and demand decomposition to identify weeks when supply and/or demand was responsible for higher oil prices. Because we have more historical data for corporate bonds than for CPI swaps, this time we identify 340 weeks when both supply and demand drove the oil price higher, 123 weeks when only demand drove it higher and 142 weeks when only supply was responsible for the higher oil price (Table 4). Table 4Weekly Corporate Bond Excess Returns (BPs) When Brent Oil Price Increases Bond Market Implications Of An Oil Supply Shock Bond Market Implications Of An Oil Supply Shock Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios show that higher oil prices boost excess returns to both investment grade and high-yield corporate bonds more than half the time. Energy bonds also tend to outperform their respective benchmark indexes in the ‘Demand & Supply Driven’ scenario, but perform roughly in-line with the benchmark in the ‘Demand Driven’ scenario. But once again, it is the ‘Supply Driven’ scenario that we are most interested in. Here, we see that an oil supply disruption that leads to higher oil prices also leads to lower corporate bond excess returns. This is true for both the investment grade and high-yield indexes and for energy bonds in both rating categories. However, we also note that high-yield energy debt significantly outperforms the overall junk index during these “risk off” periods. In contrast, investment grade energy debt is not a clear outperformer. Chart 10HY Energy Spreads Are Very Attractive HY Energy Spreads Are Very Attractive HY Energy Spreads Are Very Attractive These results line up with our intuition. When oil prices are driven higher by demand it could simply be a sign of strong economic growth and not any specific trend related to the energy sector. As such, we’d expect all corporate bonds to perform well in those scenarios, but wouldn’t necessarily expect energy debt to outperform. However, supply disruptions in the Middle East directly benefit US shale oil players, whose debt is principally found in the high-yield energy sector. The investment grade energy sector is less exposed to the US shale space, and its documented outperformance in the ‘Supply Driven’ scenario is weaker as a result. We already recommend an overweight allocation to high-yield bonds and a neutral allocation to investment grade corporates. Within that overweight allocation to high-yield bonds, we recommend shifting some exposure toward the energy sector for two reasons. First, high-yield energy was severely beaten-down last year and is ripe for a rebound if global economic growth recovers, as we expect (Chart 10). Second, our analysis suggests that an allocation to energy will help mitigate losses in the event of a renewed flaring of US/Iranian tensions that removes oil supply from the market. Bottom Line: We recommend that investors initiate TIPS breakeven curve flatteners (or CPI swap curve flatteners) and add exposure to the high-yield energy sector. Both positions look attractive on their own terms, but will also help hedge the risk of an oil supply disruption if US/Iranian tensions flare back up in the months ahead.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The others are: the output gap, the US dollar and sentiment. For more details please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 The Markit index is used in the construction of the Global PMI shown in Chart 2, 3 For more details on the politics behind the US/Iran conflict please see Geopolitical Strategy Special Alert, “A Reprieve Amid The Bull Market In Iran Tensions”, dated January 8, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets”, dated September 13, 2019, available at gis.bcaresearch.com 6 In the TIPS market, an example of a breakeven curve flattener would be to buy 2-year TIPS and short the 2-year nominal Treasury note, while also buying the 10-year nominal Treasury note and shorting the 10-year TIPS. 7 https://www.newyorkfed.org/research/policy/oil_price_dynamics_report 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Global Investment Strategy View Matrix Time For A Breather Time For A Breather Receding trade tensions; diminished risks of a hard Brexit; reduced odds of a victory for Elizabeth Warren in the US presidential elections; liquidity injections by most major central banks; and improved sentiment about the state of the global economy all helped push stocks higher late last year. Some clouds have formed over the outlook since the start of the year, however. The December US ISM manufacturing index fell to the lowest level since 2009, while the PMIs in the euro area, UK, and Japan gave up some of their November gains. The conflict between the US and Iran also flared up. Although tensions have abated in recent days, BCA’s geopolitical strategists worry that the détente may not last. The US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. They argue that this could create a dangerous power vacuum in the Middle East. Stock market sentiment is quite bullish at the moment, which makes equities more vulnerable to any disappointing news. While we are maintaining our positive 12-month view on global equities and high-yield credit in anticipation that global growth will rebound convincingly later this year, we are downgrading our tactical 3-month view to neutral. Ho Ho Ho After handing investors a sack of coal last Christmas, Santa was back to his true self this past holiday season. Global equities rose 3.4% in December, finishing the year off with a stellar fourth quarter which saw the MSCI All-Country World index surge by 8.6%. Five forces helped push stocks higher: 1) Receding trade tensions; 2) Diminished risks of a hard Brexit; 3) Reduced odds of a victory for Elizabeth Warren in the US presidential elections; 4) Liquidity injections by the Fed, ECB, and the People’s Bank of China; and arguably most importantly 5) Improved sentiment about the state of the global economy. Tarrified No More Trade tensions subsided sharply after China and the US reached a “Phase One” agreement. The deal prevented tariffs from rising on December 15th on $160 billion of Chinese imports. It also rolls back the tariff rate from 15% to 7.5% on about $120 billion in imports that have been subject to levies since September (Chart 1). Chart 1The Evolution Of The US-China Trade War The Evolution Of The US-China Trade War The Evolution Of The US-China Trade War In addition, the Trump Administration allowed the November 13th deadline on European auto tariffs to lapse. This suggests that the US is unlikely to impose tariffs under the Section 232 investigation of auto imports. The auto sector has been at the forefront of the global manufacturing slowdown, so any good news for that industry is welcome. To top it all off, the US House of Representatives ratified the USMCA, the successor to NAFTA, on December 19th. We expect it to be signed into law in the first quarter of this year. Brexit Risks Fading... Chart 2The Majority Of British Voters Aren't Keen On Brexit The Majority Of British Voters Aren't Keen On Brexit The Majority Of British Voters Aren't Keen On Brexit Boris Johnson’s commanding victory in the UK elections has given him the votes necessary to push a withdrawal bill through parliament by the end of the month. The British government will then seek to negotiate a free trade agreement by the end of the year. A “no-deal” Brexit is unacceptable to the majority of British voters (Chart 2). As such, the Johnson government will have no choice but to strike a deal with the EU. ... While Trump Gains On the other side of the Atlantic, President Trump’s re-election prospects improved late last year despite (and perhaps because of) the ongoing impeachment process. There is an uncanny correlation between the probability that betting markets assign to a Trump victory and the value of the S&P 500 (Chart 3). Chart 3An Uncanny Correlation An Uncanny Correlation An Uncanny Correlation Chart 4Who Will Win The 2020 Democratic Nomination? Time For A Breather Time For A Breather It certainly has not hurt market sentiment that Elizabeth Warren’s poll numbers have been dropping recently (Chart 4). Warren’s best hope was to squeeze out Bernie Sanders as soon as possible, thereby leaving the far-left populist lane all to herself. That dream appears to have been dashed, which suggests that even if Trump loses, a centrist like Joe Biden could emerge as president. An Uneasy Truce It remains to be seen how President Trump’s decision to assassinate General Qassem Soleimani, a top Iranian commander, will affect the election outcome. A YouGov/HuffPost poll taken over the weekend revealed that 43% of Americans approved of the airstrike against Soleimani compared to 38% that disapproved.1 History suggests that the public’s patience for war will quickly wear thin if it results in American casualties or significantly higher gasoline prices. Neither side has an incentive to allow the conflict to spiral out of control. Foreign minister Mohammad Javad Zarif tweeted on Tuesday shortly after Iran lobbed missiles at two US military bases that Iran had “concluded” its retaliatory strike, adding that “We do not seek escalation or war.” Despite claims on Iranian public television that 80 “American terrorists” were killed in the attacks, no US troops were harmed. This suggests that the Iranians may be putting on a show for domestic consumption. The US economy is less vulnerable to spikes in oil prices than in the past. Nevertheless, plenty of things could still go wrong. BCA’s geopolitical team, led by Matt Gertken, has argued that the US is seeking to shift its military focus towards East Asia in order to counter China’s ascendency. This could create a dangerous power vacuum in the Middle East. There is also a risk that President Trump overplays his hand. Contrary to the President’s claims, Soleimani was quite popular in Iran (Chart 5). If Trump begins to mock the Iranian leadership’s feeble response, Iran will have no choice but to take more aggressive action. Chart 5Soleimani Was More Popular In Iran Than Trump Claims Time For A Breather Time For A Breather Chart 6US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past US Economy Is Less Vulnerable To Spikes In Oil Prices Than In The Past One thing that could embolden Trump is that the US economy is less vulnerable to spikes in oil prices than in the past. US oil output reached as high as 12.9 mm b/d in 2019, allowing the country to become a net exporter of oil for the first time in history (Chart 6). Any increase in oil prices would incentivize further domestic production, which would help bring prices back down. The US economy has also become less energy intensive – it takes less than half as much oil to produce a unit of GDP today than it did in the early 1980s. Finally, unlike in the past, the Fed will not need to raise rates in response to higher oil prices due to the fact that inflation expectations are currently well anchored. In fact, as we discuss below, we expect the Fed and other central banks to continue to provide a tailwind for growth over the course of 2020. The Fed’s “It’s Not QE” QE Program The jump in overnight lending rates in mid-September torpedoed the Federal Reserve’s efforts to shrink its balance sheet. Thanks to a steady stream of Treasury bill purchases since then, the Fed’s asset holdings have swelled by over $400 billion, reversing more than half of the decline observed since early 2018 (Chart 7). Chart 7Fed's Asset Holdings Are Growing Anew Fed's Asset Holdings Are Growing Anew Fed's Asset Holdings Are Growing Anew Chart 8The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed's Balance-Sheet Expansion Helped Fuel The Dot-Com Bubble The Fed has insisted that its latest intervention does not amount to a new QE program, stressing that it is buying short-term securities rather than long-dated bonds. In so doing, it is simply creating bank reserves, rather than seeking to suppress the term premium by altering the maturity structure of the private sector’s holdings of government debt. Nevertheless, even such straightforward interventions have proven to be powerful signaling tools. By growing its balance sheet, a central bank is implicitly promising to keep monetary policy very accommodative. It is worth remembering that the run-up in the NASDAQ in 1999 coincided with a significant balance-sheet expansion by the Fed in response to Y2K fears, which came on the heels of three “insurance cuts” in 1998 (Chart 8). Gentle Jay Paves The Way Chart 9Inflation Expectations Remain Muted Inflation Expectations Remain Muted Inflation Expectations Remain Muted In 2000, the Fed moved quickly to reverse the liquidity injection it had orchestrated the prior year. We do not expect such a reversal anytime soon. Moreover, unlike in 2000, when the Federal Reserve kept raising rates – ultimately bringing the Fed funds rate up to 6.5% in May 2000 – the Fed is likely to stay on hold this year. The Fed’s ongoing strategic policy review is poised to move the central bank even closer towards explicitly adopting an average inflation target of 2% over the course of a business cycle. Since inflation tends to fall during recessions, this implies that the Fed will seek to target an inflation rate somewhat higher than 2% during expansions. Realized core PCE inflation has averaged only 1.6% since the recession ended. Both market-based and survey-based measures of long-term inflation expectations remain downbeat (Chart 9). This suggests that the bar for raising rates this year is quite high. More Monetary Easing In The Euro Area And China Chart 10Chinese Monetary Easing Should Help Global Growth Bottom Out Chinese Monetary Easing Should Help Global Growth Bottom Out Chinese Monetary Easing Should Help Global Growth Bottom Out The ECB resumed its QE program in November after a 10-month hiatus. While the current pace of €20 billion in monthly asset purchases is well below the prior pace of €80 billion, the central bank did say it would continue buying assets for “as long as necessary” to bring inflation up to its target. The language harkens back to Mario Draghi’s 2012 “whatever it takes” pledge, this time applied to the ECB’s inflation mandate. Not to be outdone, the People’s Bank of China cut the reserve requirement ratio by 50 basis points last week, a move that will release RMB 800 billion ($US 115 billion) of fresh liquidity into the banking system. Historically, cuts in reserve requirements have led to faster credit growth and ultimately, to stronger economic growth both in China and abroad (Chart 10). The PBOC has also instructed lenders to adopt the Loan Prime Rate (LPR) as the new benchmark lending rate. The LPR currently sits 20bps below the old benchmark rate (Chart 11). Hence, the PBOC’s order amounts to a stealth rate cut. Our China strategists expect further reductions in the LPR over the next six months. In addition, the crackdown on shadow bank lending seems to be subsiding, which bodes well for overall credit growth later this year (Chart 12). Chart 11China: Stealth Monetary Easing China: Stealth Monetary Easing China: Stealth Monetary Easing Chart 12Crackdown On Shadow Banking In China Is Easing Crackdown On Shadow Banking In China Is Easing Crackdown On Shadow Banking In China Is Easing   Rising Economic Confidence Chart 13Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Recession Fears Amongst Economists Began To Gather Steam At The Start Of Last Year Chart 14The Wider Public Was Also Worried About A Downturn The Wider Public Was Also Worried About A Downturn The Wider Public Was Also Worried About A Downturn   At the start of 2019, nearly half of US CFOs thought the economy would be in a recession by the end of the year. Similarly, two-thirds of European CFOs and four-fifths of Canadian CFOs expected their respective economies to succumb to recession. Professional economists were equally dire (Chart 13). Households also became increasingly worried about a downturn. Google searches for “recession” spiked to near 2009-highs last summer (Chart 14). The mood has certainly improved since then. According to the latest Duke CFO survey, optimism about the economic outlook has increased. More importantly, CFO optimism about the prospects for their own firms has risen to the highest level in the 18-year history of the survey (Chart 15). Chart 15CFOs Have Become More Optimistic Of Late CFOs Have Become More Optimistic Of Late CFOs Have Become More Optimistic Of Late Show Me The Money Going forward, global growth needs to accelerate in order to validate the improved confidence of CFOs and investors alike. We think that it will, thanks to the lagged effects from the easing in financial conditions in 2019, a turn in the global inventory cycle, a de-escalation in the trade war, easier fiscal policy in the UK and euro area, and re-upped fiscal/credit stimulus in China. For now, however, the economic data remains mixed. On the positive side, household spending is still robust across most of the world, a fact that has been reflected in the resilience of service-sector PMIs (Chart 16). Chart 16AThe Service Sector Has Remained Resilient (I) The Service Sector Has Remained Resilient (I) The Service Sector Has Remained Resilient (I) Chart 16BThe Service Sector Has Remained Resilient (II) The Service Sector Has Remained Resilient (II) The Service Sector Has Remained Resilient (II) Chart 17US Wage Growth Has Picked Up, Especially At The Bottom Of The Income Distribution Time For A Breather Time For A Breather Chart 18US Housing Backdrop Is Solid US Housing Backdrop Is Solid US Housing Backdrop Is Solid The US consumer, in particular, is showing little signs of fatigue. The Atlanta Fed GDPNow estimates that real personal consumption grew by 2.4% in the fourth quarter, having increased at an average annualized pace of 3% in the first three quarters of 2019. Both a strong labor market and housing market have buoyed US consumption. Payrolls have risen by an average of 200K per month for the past six months, double what is necessary to keep up with labor force growth. This week’s strong ADP release – which featured a 29K jump in jobs in goods-producing industries in December, the best since April – suggests that today’s jobs report will remain healthy. In addition, wage growth has picked up, particularly at the bottom of the income distribution (Chart 17). Residential construction has also been strong. Homebuilder sentiment reached the best level since June 1999 (Chart 18). Global Manufacturing: Too Early To Call The All-Clear The outlook for manufacturing remains the biggest question mark in the global economy. The US ISM manufacturing index dropped to 47.2 in December, its lowest level since June 2009. The composition of the report was poor, with the new orders-to-inventory ratio dropping close to recent lows. Chart 19Other US Manufacturing Gauges Are Not As Weak As The ISM Other US Manufacturing Gauges Are Not As Weak As The ISM Other US Manufacturing Gauges Are Not As Weak As The ISM We would discount the ISM report to some extent. The regional Fed manufacturing indices have not been nearly as disappointing as the ISM (Chart 19). The Markit PMI, which tracks US manufacturing activity better than the ISM, clocked in at a respectable 52.4 in December, down only slightly from November’s reading of 52.6. Nevertheless, it is hard to be excited about the near-term outlook for US manufacturing, especially in light of Boeing’s decision to suspend production of the 737 Max temporarily. Most estimates suggest that the production halt will reduce real US GDP growth by 0.3%-to-0.5% in the first quarter. The euro area manufacturing PMI gave up some of its November gains, falling to 46.3 in December. While the index is still above its September low of 45.7, it has been under 50 for 11 straight months now. The UK and Japanese PMI also retreated. Chinese manufacturing has shown clearer signs of bottoming out. Despite dipping in December, the private sector Caixin manufacturing PMI remains near its 2017 highs. The official PMI published by the National Bureau of Statistics is less upbeat, but still managed to come in slightly above 50 in December. The production subcomponent reached the highest level since August 2018. Reflecting the positive trend in the Chinese economy, Korean exports to China rose by 3.3% in December, the first positive growth rate in 14 months (Chart 20). Taiwan’s exports have also rebounded. The manufacturing PMI rose above 50 in both economies in December. In Taiwan’s case, this was the first time the PMI moved into expansionary territory since September 2018. On balance, we continue to expect global manufacturing to recover in 2020. This is in line with our observation that global manufacturing cycles typically last three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 21). That said, the weakness in European and US manufacturing (at least judged by the ISM) is likely to give investors pause. Chart 20Some Positive Signs Emerging From Korea And Taiwan Time For A Breather Time For A Breather Chart 21A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle   Investment Conclusions We turned bullish on stocks in late 2018, having temporarily moved to the sidelines during the summer of that year. Global equities have gained 25% since our upgrade. We see another 10% of upside for 2020, led by European and EM bourses. Despite its recent gains, the real value of the MSCI All-Country World Index is only 3% above its prior peak in January 2018. The 12-month forward PE ratio of 16.3 is still somewhat lower than it was back then. The valuation picture is even more enticing if we compare equity earnings yields with bond yields, which is tantamount to computing a rough equity risk premium (ERP). The global ERP remains quite high by historic standards, especially outside the US where earnings yields are higher and bond yields are generally lower (Chart 22). Chart 22The Equity Risk Premium Is Fairly High, Especially Outside The US The Equity Risk Premium Is Fairly High, Especially Outside The US The Equity Risk Premium Is Fairly High, Especially Outside The US Chart 23Stock Market Sentiment Is Quite Bullish Stock Market Sentiment Is Quite Bullish Stock Market Sentiment Is Quite Bullish   Nevertheless, sentiment is quite positive towards stocks at the moment (Chart 23). Elevated bullish sentiment, against the backdrop of ongoing uncertainty about the outlook for global manufacturing and an uneasy truce between the US and Iran, poses a near-term headwind to risk assets. As such, while we are maintaining our positive 12-month view on global equities and high-yield credit, we are downgrading our tactical 3-month view to neutral for the time being. We do not regard this as a major realignment of our views; we will turn tactically bullish again if stocks dip about 5% from current levels.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Footnotes 1 Ariel Edwards-Levy, “Here's What Americans Think About Trump's Iran Policy,” TheHuffingtonPost.com (January 6, 2020).   MacroQuant Model And Current Subjective Scores   Time For A Breather Time For A Breather Strategic Recommendations Closed Trades

Highlights Economy & Inflation: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. BoJ Options: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. 2020 Japan Bond Strategy: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve. Feature Chart 1The Role Of Japan In Global Bond Investing Is Complex The Role Of Japan In Global Bond Investing Is Complex The Role Of Japan In Global Bond Investing Is Complex In a year where the majority of global bond markets have delivered stellar returns, Japanese fixed income performance has predictably languished in 2019 compared to the other developed economies. Despite a cyclically weak economy with very low inflation, Japanese government bond (JGB) yields have been locked in narrow ranges at or below 0% throughout the year. Monetary policy is a big reason for that, as the Bank of Japan (BoJ) has run of out of fresh stimulus options to try and push JGB yields even lower. In this Special Report, we make the case for owning JGBs as a low-beta, defensive asset in global fixed income portfolios over the next 6-12 months – a period when improving growth is expected to exert upward pressure on global bond yields, but where JGB yields are expected to remain anchored with Japan likely to lag the global upturn (Chart 1). The Japanese Growth & Inflation Backdrop Is No Threat To JGBs Japan’s economy has suffered alongside the global industrial downturn in 2019, with the Japanese manufacturing PMI struggling below 50 for seven consecutive months. Both business investment and exports have been contracting, in response to the slump in global and trade and increase in uncertainty related to the US-China tariff war. The underlying trend in consumer spending – the largest component of Japan’s economy – is more difficult to interpret, however, because of the volatility surrounding the October hike in the consumption tax. On October 1st, Japanese Prime Minister Abe’s government finally passed its long-desired hike in the consumption tax rate from 8% to 10%, in a bid to begin chipping away at Japan’s massive fiscal debt burden. The timing of the move, which had been twice delayed previously, appears ill-advised given the overall weakness in the economy. That can be seen in the response of consumer demand to the tax increase. Japanese consumers, quite rationally, front-loaded purchases in September in advance of the tax hike, but that surge was followed by a collapse in nominal retail sales in October of -14% on a month-over-month basis (Chart 2). This was much larger than the decreases seen after the previous consumption tax increases in 1997 and 2014. This may seem surprising given that the Japanese unemployment rate is a stunningly low 2.4%, suggesting a tight labor market that should be boosting wage growth and consumer confidence. Quite the opposite is happening, however, as consumer confidence is depressed and wage growth is contracting in real terms (bottom panel). Even more unusual is that real disposable income growth for Japanese households is now up to 5% (year-over-year), after stagnating for much of the previous decade. The acceleration is due to more people, especially women and senior citizens, having joined the labor force and found work – on a “per worker” basis, income growth is much less impressive and is more in line with stagnant wage growth. Therefore, unless there is clear acceleration of wages, a sustainable improvement in aggregate consumption is not expected. In the absence of an unlikely consumer boom, a pickup in global trade and manufacturing activity is a necessary requirement to stabilize the Japanese economy where the manufacturing sector is relatively larger than that of other major developed countries (20% of GDP).1 On that front, the news is getting better with the recent improvement seen in the global manufacturing PMI, global ZEW and our own global leading economic indicator (LEI). Looking at the overall conditions in Japan's manufacturing sector, however, there are still mixed signals indicating that a true bottom has been reached (Chart 3): Chart 2Challenging Times For Japanese Consumers Challenging Times For Japanese Consumers Challenging Times For Japanese Consumers Chart 3A Trough In Japanese Manufacturing A Trough In Japanese Manufacturing A Trough In Japanese Manufacturing the Markit manufacturing PMI did rise modestly in November, but remains at only 48.9 (top panel); the most recent Tankan survey from the BoJ showed that both large and small firms in the manufacturing sector expect business conditions to worsen (second panel); real capital spending growth did perk up in the third quarter in the GDP accounts, but additional gains are unlikely given the still moderate reading on manufacturing business confidence (third panel); machine tool orders continue to contract on a year-over-year basis, although the growth in domestic orders may be stabilizing; foreign orders remain depressed due to weakening Chinese demand for automotive and electronic equipment (bottom panel). Chart 4Japan"s Non-Manufacturing Sector Is Struggling Japan"s Non-Manufacturing Sector Is Struggling Japan"s Non-Manufacturing Sector Is Struggling Turning to the services sector, which accounts for around 80% of the Japanese economy, the data also show only moderate growth. This is mainly because demand for services is less influenced by global economic conditions, and more related to the tight labor market and rising household income growth. Even given that better fundamental backdrop, however, it is still not clear that services can drive growth in the Japanese economy in 2020 (Chart 4): Chart 5Past The Worst For Japanese Exports Past The Worst For Japanese Exports Past The Worst For Japanese Exports while the Tankan survey of large non-manufacturing firms has stayed at the same high level seen since 2014, the data for smaller firms has weakened steadily throughout 2019; the Markit services PMI index has remain solidly above the 50 boom/bust line all year long, yet overall sales for non-manufacturers contracted by -3.1% on a year-over-year basis in the third quarter of the year according to Japan’s Ministry of Finance. One potential ray of hope for Japanese growth comes from exports. While growth in total nominal exports is still contracting by –9.2% on a year-over-year basis, the recent pickup in our global LEI is heralding a potential bottoming in export momentum (Chart 5). In particular, the emerging market sub-component of our global LEI is signaling a potentially sharp pickup in demand for Japanese exports to Asia (middle panel). A similar optimistic message is given regarding Chinese demand, based on the modest improvement in the OECD China LEI (bottom panel). Yet these developments are still in the early stages and could be derailed by a breakdown of the US-China trade negotiations (not the base case scenario of BCA’s geopolitical strategists). Summing it all up, the Japanese economy remains in a fragile state after absorbing multiple blows from trade uncertainty, contracting global manufacturing activity and, more recently, an ill-timed hike in the consumption tax. While some data is showing signs of bottoming, the momentum is unlikely to be strong enough in 2020 to generate much upward pressure on Japanese bond yields. Japanese Inflation Remains A No-Show Japan remains the poster child for the global low inflation backdrop of the post-crisis decade. Even an economy with an unemployment rate near record lows can still not generate inflation sustainably above 0%. Headline CPI inflation is now at only 0.2%, while and core CPI inflation is slightly higher at 0.7% (Chart 6). The former is being dragged down by the lagged impact of lower oil prices and the stubbornly firm Japanese yen. More worrisome, however, is that services CPI inflation dipped slightly below 0% in November (middle panel), in line with the contraction seen in the domestic corporate goods prices and import prices indices (bottom panel). Chart 6Inflation Remains WELL Below The BoJ"s Target Inflation Remains WELL Below The BoJ"s Target Inflation Remains WELL Below The BoJ"s Target Chart 7Not A Consistent Story From Japanese Inflation Expectations Not A Consistent Story From Japanese Inflation Expectations Not A Consistent Story From Japanese Inflation Expectations Market-based inflation expectations, measured using either CPI swap rates or breakevens from inflation-linked bonds, are also hovering close to 0% (Chart 7). In a bit of a surprise, survey-based measures of inflation expectations produced by the BoJ are closer to the 2-3% range, even though realized inflation only reached that range once, on an annual calendar year basis, since 1991 – in 2014, unsurprisingly another year with a consumption tax increase. The market-based inflation indicators are more important for bond investors, however. It will take a sustained increase in realized inflation before the JGB market begins to worry about inflation again. Perhaps that can begin to happen in 2020 if Japanese and global growth improves, coming alongside some yen weakness. More likely, next year will be another year of mushy inflation readings from Japan as the economy tries to emerge from the slowdown seen in 2019 and the unnecessary tightening of fiscal policy coming from the consumption tax hike (which is likely to cause a temporary, but not sustained, blip in realized inflation rates in 2020). Bottom Line: The macro backdrop in Japan remains bond friendly for JGBs; growth momentum is only starting to bottom out, but will lag the recovery heralded by improving global leading economic indicators, while inflation remains closer to 0% than the BoJ's 2% target. There’s Not Much New The BoJ Can Do The BoJ remains in a bind with regards to future monetary policy decisions. Inflation remains far below its target, while the economy is struggling to generate above-potential growth. Yet unemployment remains exceptionally low and, by the BoJ’s own estimates, Japan’s economy is operating with no spare capacity (i.e. the output gap is a positive number). For a traditional central bank that believes in the tradeoff between spare capacity/unemployment and inflation, like the BoJ, the data is sending a very confusing message about the next policy move. Can A Weaker Yen Solve Japan’s Low Inflation Problem? Chart 8The Balance Of Payments Remains Yen-Supportive The Balance Of Payments Remains Yen-Supportive The Balance Of Payments Remains Yen-Supportive The BoJ’s job in setting the right policy to get Japanese inflation higher would be made a lot easier if the yen were not so stubbornly firm. On a trade-weighted basis, the yen is 10.1% above the low seen in 2018 and 22.9% above the 2015 low (Chart 8). This has happened despite the disappointing performance of the Japanese economy and the negative interest rates that have typically made the yen a good funding currency for global carry trades. While there has been likely been some safe-haven demand for the yen given the global growth uncertainties and sharp decline in non-Japanese bond yields in 2019, the root cause for the yen strength is more fundamental. Our colleagues at BCA Research Foreign Exchange Strategy published a Special Report last week, reviewing the balance of payments of the major global currencies.2 Going through the components for Japan, the current account balance remains firmly positive at 3.4% of GDP, despite the fact that the trade balance is now negative. The main reason for that is the steady 4% of GDP in the investment income balance – an inevitable result given Japan’s massive net foreign asset position. On the capital account side, there has been a steady increase in net foreign direct investment (FDI) outflows over the past several years, as more Japanese companies have moved productive capacity offshore (and fewer foreign companies invest in Japan). In addition, portfolio outflows have been gaining momentum with Japanese investors ramping up their purchases of foreign long term assets. Add it all up and Japan's basic balance (the current account plus net FDI) is now negative for the first time since 2015 (bottom panel). Thus, Japan’s balance of payments may now finally be in a position to generate some yen weakness that can help boost domestic inflation – if some of the uncertainties over global growth and the US-China trade negotiations begin to dissipate, as we expect in 2020. So what can the BoJ do? The BoJ has maintained a negative policy interest rate for 45 months since cutting rates below zero in February 2016. Yet according to our BoJ Monitor, there is still a need for additional monetary policy easing to combat weak growth and inflation (Chart 9). Chart 9The BoJ"s Policy Options Are Limited The BoJ"s Policy Options Are Limited The BoJ"s Policy Options Are Limited Interest rate markets do not expect the BoJ to do much with short-term interest rates in 2020, with only -5bps of cuts discounted in the Japanese overnight index swap (OIS) curve. BoJ officials have not outright dismissed the possibility that another rate cut could happen, but policymakers have learned that negative rates are lethal for the profits of the banking system. That can be seen in Japan, where bank profits have contracted -19.4% over the past year as negative borrowing rates have become more deeply entrenched. Other parts of the Japanese financial system, like insurance companies and pension funds that need income to meet payouts and liabilities, also suffer from negative interest rates on domestic fixed income assets. Therefore, the BoJ cutting policy rates deeper into negative territory is a very unlikely outcome, even if the economy and inflation continue to struggle, as the risks to the financial system would be worsened. So what else can the BoJ do to provide further monetary stimulus, if necessary? The choices are limited. The BoJ could alter its forward guidance to signal to the market that rates will remain low for a very long time, but that would have a limited effect with rate levels already so low. The central bank could also ramp up its pace of asset purchases, but that will also prove difficult as it owns nearly 50% of outstanding JGBS and nearly 80% of outstanding ETFs. Buying more assets would likely not generate any easier financial conditions, and would simply further disrupt the liquidity of Japan’s financial markets. A March 2019 academic study found that the impact on Nikkei 225 stock returns from the BoJ ETF buying has grown smaller over time despite the increased purchase amounts.3 Chart 10More Room For The BoJ To Buy Shorter Maturity Bonds Japanese Government Bonds In 2020: Boring, But Useful Japanese Government Bonds In 2020: Boring, But Useful The BoJ could lower its “Yield Curve Control” target yield for 10-year JGBs to below 0%, but that would also prove difficult as the BoJ already owns a whopping 75% of all outstanding 10-year JGBs (Chart 10) – a figure that would likely need to increase if global bond yields continue to drift higher in 2020, as we expect, forcing the BoJ to buy more 10-year JGBs to ensure that yields do not rise. A unique option might be for the BoJ to purchase foreign bonds. This would potentially help further weaken the yen, which would help increase exports and inflation. Although given the current global backdrop of populism and trade protectionism, a policy specifically designed to weaken the yen would likely not be greeted warmly by other countries. In our view, there is only one plausible option that the BoJ could consider to ease policy further in 2020 to fight low inflation – choosing a different maturity point for its Yield Curve Target. For example, instead of targeting a 10-year JGB near 0%, the BoJ could target a 5-year JGB near 0%. The BoJ owns a lower share of outstanding bonds in that part of the curve (around 45%, by our calculations). The net result could be a steeper JGB curve, which could help ease the drag on profits of the Japanese banks from negative longer-term yields and a flat curve (Chart 11). One thing is for certain: none of the conditions that we have long believed would be necessary before the BoJ would consider abandoning its yield curve target and letting yields rise – a USD/JPY exchange rate between 115 and 120; core CPI inflation and nominal wage inflation both above 1.5%; and clear signs of JGB overvaluation - are currently in place (Chart 12). The BoJ has to continue to stay accommodative, even if other central banks turn less dovish as global growth improves in 2020. Chart 11Shifting BoJ Purchases Could Generate A Steeper JGB Curve Shifting BoJ Purchases Could Generate A Steeper JGB Curve Shifting BoJ Purchases Could Generate A Steeper JGB Curve Chart 12These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target These Must ALL Happen Before The BoJ Lifts Its JGB Yield Target   Bottom Line: The BoJ has limited policy choices available to provide more stimulus, with negative policy rates crushing Japanese bank profitability and the central bank already owning massive amounts of JGBs and ETFs. Overweight Low-Beta JGBs In Global Bond Portfolios In 2020 Chart 13Overweight Low-Beta JGBs In 2020 Overweight Low-Beta JGBs In 2020 Overweight Low-Beta JGBs In 2020 As we have discussed in previous reports, yield betas of developed market sovereign bonds to changes in the “global” bond yield are a good tool to use when considering fixed income country allocation decisions when yields are rising everywhere.4 We are currently recommending overweight allocations to government bonds in countries with more dovish central banks and/or where yields are low in relative terms – namely, Germany, Japan and Australia. Not by coincidence, those are also countries whose government bonds have the lowest yield betas among the major developed economies. The rolling 52-week yield betas for JGB yields to the “global” yield (defined as the yield-to-maturity of the Bloomberg Barclays Global Treasury index) is shown in Chart 13. We show the betas for different maturity “buckets” across the yield curve, and we also present the same betas for US Treasuries and German government bonds for comparison. The betas for JGBs are consistent but positive across the entire yield curve, around 0.5 or less. German yields have a similar beta at shorter maturities but a beta close to 1.0 at the longer-end of the curve. US Treasuries, to no surprise, are the highest beta market, with yield betas of 1.5 or more across the entire yield curve. The positive low beta for JGBs means that Japanese bond yields will still move in the same direction as global yields, but with far less volatility. Thus, during the period when global government bonds are rallying, low-beta markets like Japan underperform versus global benchmarks. That has been the story in 2019, when much of the world needed to ease monetary policy but Japan was already at very accommodative policy settings. When global yields are rising, however, lower beta markets should see smaller yield increases and better relative performance. That will be the story for JGBs in 2020, given the strong likelihood that Japan will lag the global economic rebound that we expect next year and the BoJ will be forced to, once again, be the most dovish central bank among the major economies. Bottom Line: Dedicated bond investors should overweight Japan in global government bond portfolios over the next year, as a complement to an overall below-benchmark duration exposure. Expect some mild yield curve steepening pressure if the BoJ attempts to use its limited remaining policy tools, like targeting shorter maturities for its asset purchases, to try and alleviate the pressure on banks from negative rates and a flat yield curve.   Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Ray Park, CFA Research Analyst ray@bcaresearch.com Footnotes 1 Based on the value added from manufacturing as % of GDP. Other countries, by comparison: China: 29%; Germany: 21%; World: 16%; US: 11%. Source: United Nations and World Bank. 2 Please see BCA Research Foreign Exchange Strategy Special Report, “Updating Our Balance Of Payments Monitor” dated November 29, 2019, available at fes.bcaresearch.com. 3 Kimie Harada and Tatsuyoshi Okimoto, "The BOJ’s ETF Purchases and Its Effects on Nikkei 225 Stocks", RIETI Discussion Paper Series 19-E-014, March 2019. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, " Cracks Are Forming In The Bond-Bullish Narrative", dated October 23, 2019, available at gfis.bcaresearch.com.

Highlights Investors should remain overweight global stocks relative to bonds over the next 12 months and begin shifting equity exposure towards non-US markets. Bond yields will rise next year as global growth picks up, while the dollar will sell off. The extent to which bond yields increase over the long term depends on whether inflation eventually stages a comeback. Today’s high debt levels could turn out to be deflationary if they curtail spending by overstretched households, firms, and governments. However, high debt levels could also prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. Which of these two effects will win out depends on whether central banks are able to gain traction over the economy. This ultimately boils down to whether the neutral rate of interest is positive or negative in nominal terms. While there is little that policymakers can do to alter certain drivers of the neutral rate such as the trend rate of economic growth, they do have control over other drivers such as the stance of fiscal policy. Ironically, a structural shift towards easier fiscal policy could lead to a decline in government debt-to-GDP ratios if higher inflation, together with central bankers' reluctance to raise nominal rates, pushes real rates down far enough. This suggests that the endgame for today’s high debt levels is likely to be overheated economies and rising inflation.   Stay Bullish On Stocks But Shift Towards Non-US Equities We returned to a cyclically bullish stance on global equities following the stock market selloff late last year, having temporarily moved to the sidelines in June 2018. We have remained overweight global equities throughout 2019. Two weeks ago, we increased our pro-cyclical bias by upgrading non-US stocks within our recommended equity allocation at the expense of their US peers. Our decision to upgrade non-US equities stems from the conviction that global growth has turned the corner. Manufacturing has been at the heart of the global slowdown. As we have often pointed out, manufacturing cycles tend to last about three years – 18 months of weaker growth followed by 18 months of stronger growth (Chart 1). The current slowdown began in the first half of 2018, and right on cue, the recent data has begun to improve. The global manufacturing PMI has moved off its lows, with significant gains seen in the new orders-to-inventories component. Global growth expectations in the ZEW survey have rebounded. US durable goods orders surprised on the upside in October. The regional Fed manufacturing surveys have also brightened, suggesting upside for the ISM next week (Chart 2). Chart 1A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Chart 2Some Manufacturing Green Shoots Some Manufacturing Green Shoots Some Manufacturing Green Shoots     Unlike in 2016, China has not allowed a major reacceleration in credit growth this year. Instead, fiscal policy has been loosened significantly. The official general government deficit has increased from around 3% of GDP in mid-2018 to 6.5% of GDP at present. The augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019. This is a bigger deficit than during the depths of the Great Recession (Chart 3). As a result of all this fiscal easing, the combined Chinese credit/fiscal impulse has continued to move up. It leads global growth by about nine months (Chart 4). Chart 3China Has Been Stimulating, Fiscally China Has Been Stimulating, Fiscally China Has Been Stimulating, Fiscally Chart 4Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth Chinese Stimulus Should Boost Global Growth The dollar tends to weaken when global growth strengthens (Chart 5). The combination of stronger global growth and a softer dollar will disproportionately benefit cyclical equity sectors. Financials will also gain thanks to steeper yield curves (Chart 6). The sector weights of non-US stock markets tend to be more tilted towards deep cyclicals and financials. As a consequence, non-US stocks typically outperform when global growth picks up (Chart 7). Chart 5The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 6Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials In addition, valuations favor stocks outside the US. Non-US equities currently trade at 13.8-times forward earnings, compared to 18.1-times for the US. The valuation gap is even greater if one looks at price-to-book, price-to-sales, and other measures (Chart 8). Chart 7Non-US Equities Usually Outperform When Global Growth Improves Non-US Equities Usually Outperform When Global Growth Improves Non-US Equities Usually Outperform When Global Growth Improves Chart 8US Stocks Are Relatively More Expensive US Stocks Are Relatively More Expensive US Stocks Are Relatively More Expensive Trade War Remains A Key Risk The US-China trade war remains a key risk to our bullish equity view. President Trump continues to send conflicting signals about the status of the talks. He complained last week that Beijing is not “stepping up” in finalizing a phase 1 agreement, adding that China wants a deal “much more than I do.” This Wednesday he struck a more optimistic tone, saying that negotiators were in the “final throes” of deal. However, he made this statement on the same day that he decided to sign the Hong Kong Human Rights and Democracy Act into law, a decision that was bound to antagonize China. According to our BCA geopolitical team, Trump had little choice but to sign the bill. The Senate approved it unanimously, while the House voted for it 417-1. Failure to sign it would have resulted in an embarrassing veto by the Senate. The key point is that the new law does not force Trump to take any immediate actions against China. This suggests that the trade talks will continue. In fact, from China's point of view, Congress’ desire to pass a Hong Kong bill may provide a timely reminder that getting a deal done with Trump now may be preferable to waiting until after the election and potentially facing someone like Elizabeth Warren who is likely to make human rights a key element of any deal to roll back tariffs. Waiting For Inflation If global growth accelerates next year, history suggests that bond yields will rise (Chart 9). Looking further out, the extent to which bond yields will continue to increase depends on whether inflation ultimately stages a comeback. Right now, most of our forward-looking inflationary indicators remain well contained (Chart 10). However, this could change if falling unemployment eventually triggers a price-wage spiral. Chart 9Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Stronger Economic Growth Will Put Upward Pressure On Government Bond Yields Chart 10An Inflation Breakout Is Not Imminent An Inflation Breakout Is Not Imminent An Inflation Breakout Is Not Imminent     Many investors are skeptical that such a price-wage spiral could ever emerge. They argue that automation, globalization, weak trade unions, and demographic changes make an inflationary outburst rather implausible. We have addressed these arguments in the past1 and will not delve into them in this report. Instead, we will focus on one argument that also gets a fair bit of attention, which is that high debt levels will prove to be deflationary. Are High Debt Levels Inflationary Or Deflationary? Total debt levels in developed economies are no lower today than they were during the Great Recession. While private debt has fallen, public debt has risen by roughly the same magnitude, leaving the overall debt-to-GDP ratio unchanged (Chart 11). Meanwhile, debt levels in emerging markets have risen substantially. A common rebuttal to any suggestion that inflation might rise over the medium-to-longer term is that high debt levels around the world will cause households, firms, and governments to pare back spending. While this may be true, it could also be argued that high debt levels could prompt central banks to engineer higher inflation in order to reduce the real burden of debt obligations. So which effect will win out? Given the choice, it is likely that most policymakers would opt for higher inflation. This is partly because high unemployment and fiscal austerity are politically toxic. It is also because falling prices make it very difficult to reduce real debt burdens. The experience of the Great Depression bears this out: Private debt declined by 25% in absolute terms between 1929 and 1933. However, due to the collapse in nominal GDP, the ratio of debt-to-GDP actually increased more in the first half of the 1930s than during the Roaring Twenties (Chart 12). Chart 11Global Debt Levels Remain High Global Debt Levels Remain High Global Debt Levels Remain High Chart 12The Experience Of The Great Depression Shows Deleveraging Is Impossible Without Growth The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation?   Means, Motive And Opportunity Chart 13A Kinked Relationship: It Takes Time For Inflation To Break Out The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? There is a big difference between wanting to engineer higher inflation and being able to do so. The distinction between success and failure ultimately boils down to a seemingly technical question: Is the neutral rate of interest – the interest rate consistent with full employment and stable inflation – positive or negative in nominal terms? When the neutral rate is above zero, central banks can gain traction over the economy. Even if the neutral rate is only slightly positive, a zero rate would be enough to keep monetary policy in expansionary territory. When monetary policy is accommodative, the unemployment rate will tend to drop. Eventually the “kink” in the Phillips curve will be reached, resulting in higher inflation (Chart 13). In contrast, when the neutral rate is firmly below zero, monetary policy loses traction over the economy. Since there is a limit to how deeply negative policy rates can go before people decide to hold cash, the central bank could find itself out of ammunition. This could set off a vicious circle where high unemployment causes inflation to drift lower, leading to an increase in real rates. Rising real rates will then further curb spending, causing inflation to fall even more. Drivers Of The Neutral Rate Two of the more important determinants of the neutral rate of interest are the growth rate of the economy and the national savings rate. If either the savings rate rises or economic growth slows, the stock of fixed capital will tend to pile up in relation to GDP, leading to a higher capital-to-output ratio.2 As Chart 14 shows, this has already happened in Europe and Japan. An increase in the capital-to-GDP ratio will drag down the rate of return on capital. A lower interest rate will be necessary to ensure that the capital stock is fully utilized. Chart 14Capital Stock-To-Output Ratios Have Risen The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? Realistically, there is not much that policymakers can do to raise trend GDP growth. While looser immigration policy would allow for a faster expansion of labor force growth, this is politically contentious. Increasing productivity growth is also easier said than done. Fiscal Policy And The Neutral Rate In contrast, policymakers already have a ready-made mechanism for lowering the savings rate: fiscal policy. The fiscal balance is a component of national savings. If the government runs a larger budget deficit in order to finance tax cuts or higher transfer payments to households, national savings will decline and aggregate demand will rise. Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. Since one can think of the neutral rate as the interest rate that brings aggregate demand in line with the economy’s supply-side potential, anything that raises demand will also lift the neutral rate. Once the neutral rate has risen above the zero bound, monetary policy will gain traction again. This implies that central banks should never run out of ammunition in countries whose governments can issue debt in their own currencies. While higher inflation stemming from fiscal stimulus will erode the real value of private sector debt obligations, won’t the impact on total debt be offset by the increase in public debt? Not necessarily. True, larger budget deficits will raise the stock of government debt. However, nominal GDP will also rise on account of higher inflation. Standard debt sustainability equations state that the government debt-to-GDP ratio could actually fall if higher inflation pushes real policy rates down far enough. As discussed in Box 1, such an outcome is quite likely when inflation accelerates in response to an overheated economy, but the central bank nevertheless refrains from raising nominal rates. The Final Verdict We are finally ready to answer the question posed in the title of this report: Is the endgame for today’s high debt levels deflation or inflation? The answer is inflation. People with a 30-year fixed rate mortgage will always favor inflation over deflation. And there are more voters who owe mortgage debt than own mortgage debt. Chart 15Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Germany's Competitive Advantage Over The Rest Of The Euro Area Is Deteriorating Politics is moving in a more populist direction. Whether it is left-wing populism of the Elizabeth Warren/Jeremy Corbyn variety or right-wing populism of the Donald Trump/Matteo Salvini variety, the result is usually bigger budget deficits and higher inflation. Even in those countries where populism has been slow to take hold, there may be pragmatic reasons for loosening fiscal policy. For example, Germany’s trade surplus with the rest of the euro area has fallen in half since 2007, largely because German unit labor costs have increased more than elsewhere (Chart 15). As Germany loses its ability to ship excess production to the rest of the world, it may end up having to rely more on easier fiscal policy to bolster demand. Of course, the path to higher inflation is paved with interest rates that stay lower for much longer than the economy needs to reach full employment. This means we are entering a period where first the US economy, and then many other economies, will start to overheat, and yet central banks will still refrain from tightening monetary policy until inflation rises well above their comfort zones. Such an environment will be positive for stocks for as long as it lasts, even if it eventually produces a mighty hangover.   Peter Berezin Chief Global Strategist peterb@bcaresearch.com   Box 1 When Does A Large Budget Deficit Lead To A Lower Government Debt-to-GDP Ratio?   The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? Footnotes 1    Please see Global Investment Strategy Special Report, “1970s-Style Inflation: Could It Happen Again? (Part 2),” dated August 24, 2018. 2   This point can be seen through the lens of the widely used Solow growth model. In steady state, the desired level of investment in the model is given by the formula: I=(a/r)(n+g+d)Y where a denotes the output elasticity of capital, r is the real rate of interest, n is labor force growth, g is productivity growth, d is the depreciation rate, and Y is GDP. Savings is assumed to be a constant fraction of income, S=sY. Equating savings with investment yields: r=(a/s)(n+g+d). A decrease in the growth rate of the economy (n+g) shifts the investment schedule downward, leading to a lower equilibrium rate of interest. This initially makes investing in fixed capital more attractive than buying bonds. Over time, however, the marginal return on capital will fall as the capital stock expands in relation to GDP.    Strategy & Market Trends MacroQuant Model And Current Subjective Scores The Debt Supercycle Endgame: Deflation Or Inflation? The Debt Supercycle Endgame: Deflation Or Inflation? Strategic Recommendations Closed Trades

Highlights There is little risk that inflation will heat up over the next several months, … : Weak growth is more of a threat to the global economy than inflation. … which means the Fed won’t be in any hurry to take away this year’s rate cuts, … : We expect the Fed to leave the target fed funds rate alone for nearly all of 2020. … giving the economy plenty of opportunity to overheat: If trade tensions move to the back burner, and global manufacturing activity revives, the “insurance” rate cuts executed by the Fed and other central banks may turn out to have been unnecessary. The investment punch line is that accommodative monetary policy is likely to push asset prices and Treasury yields higher: Our revised Rates View Checklist supports going back to a below-benchmark duration stance over the tactical timeframe, in line with our cyclical view. Feature BCA researchers’ latest monthly view meeting opened with a discussion of whether inflation or deflation is the bigger risk to financial markets. Should investors be more concerned about signs of overheating or stalling growth? With inflation unable to get traction in any of the major economies, we all agreed that growth is the more critical unknown. An investor who gets the growth call right has the best chance of getting broad asset class positioning right, along with country, sector, duration, credit and currency tilts. While we continue to believe that there are more inflation pressures beneath the surface of the US economy than most investors realize, they are highly unlikely to manifest themselves any time soon. At today’s low-single-digit levels, inflation’s investment import is limited to its impact on monetary policy. Inflation expectations remain far below the levels that are consistent with the Fed’s inflation target (Chart 1), and the Fed is likely to keep policy easy until they adjust higher. Though it is uncertain just what levels of realized inflation, or inflation expectations, would trigger the Fed’s reaction function, we are confident that inflation will not be an issue in the coming year. Chart 1No Pressure To Remove Accommodation No Pressure To Remove Accommodation No Pressure To Remove Accommodation Chart 2Global Revival Ahead? Global Revival Ahead? Global Revival Ahead? We expect that global growth will surprise to the upside, pulling bond yields and risk asset prices higher. BCA’s global LEI bottomed earlier this year, and the diffusion index that leads directional moves in the LEI has turned sharply higher (Chart 2). The improvement is consistent with the easing in global financial conditions and the tentative détente in the trade war. Although we will not count on a completed “Phase I” agreement until it is signed, financial markets’ allergic reaction to trade tensions seems to have encouraged the White House to back off lest it undermine its re-election prospects. Interest Rates – Looking Back Figure 1Rates View Checklist Refreshing Our Rates View Refreshing Our Rates View We rolled out our Rates View Checklist a little over a year ago to systematize our interest rate analysis and to clarify the rationale underpinning our views1 (Figure 1). Detailing the key series we monitor to anticipate the future direction of rates helps clients think along with us while giving them the chance to adapt the framework for their own purposes. As we were starting from a position of recommending below-benchmark duration, the checklist was aimed at identifying and tracking the factors that could encourage us to become more constructive about Treasury bonds. We never did warm to duration on a cyclical basis, though we did turn tactically neutral in mid-August. Part of the reason was that we did not give enough weight to events outside of the US. Highly-rated, developed-market sovereign bonds are substitutes for one another, and there is a limit to how much currency-adjusted yields can deviate across countries. Very low to negative yields in the UK, France, Germany and Switzerland have exerted a magnetic pull on Treasury yields (Chart 3), and the different sovereigns should move in tandem going forward, with currency-hedged yields observing a tight range. Chart 3Birds Of A Feather Birds Of A Feather Birds Of A Feather The short end of the yield curve exerts considerable influence on rates across all maturities. Our US bond strategists’ golden rule of bond investing homes in on the deviation between actual and expected moves in the fed funds rate as the key determinant of duration positioning outcomes. Following their lead, our checklist is oriented around anticipating the Fed’s reaction to important incoming data. It seems to have done its job over the last year, highlighting the factors that drove the Fed to switch from dialing back accommodation to dialing it up. Although we never checked more than four of the eleven boxes in the checklist – Inverted Yield Curve, Sluggish Rise in Realized Inflation, Sluggish Rise in Inflation Breakevens and International Duress – those four boxes were enough to inspire the Fed’s dovish pivot. That pivot has so far encompassed three quarter-point rate cuts, pruning back the funds rate to 1.75% from 2.5%. It turns out that the key items in the checklist were the orientation of the yield curve; sluggish inflation expectations that the Fed worried could become “unanchored on the downside;” and the shadow of trade tensions that seem to have induced a global manufacturing recession, even if they have yet to infect the DM economies’ larger services sector. They tipped the scales for Fed policy and we will be especially alert to them going forward. Interest Rates – Looking Ahead Figure 2Revised Rates View Checklist Refreshing Our Rates View Refreshing Our Rates View While our interpretation of the checklist left something to be desired, we are convinced that the checklist approach is sound. We return to its framework for insight into the current rates outlook, after making a few tweaks to shore it up (Figure 2). Starting with Fed perceptions, there is still some daylight between our fed funds rate expectations and the market’s, as we think the Fed is done cutting, while the money market assigns a high probability to the possibility of one more cut (Chart 4). The combination of rate cuts and the rally in 10-year Treasury yields got the yield curve back to its typical upward-sloping orientation in October (Chart 5), so we can now uncheck the inverted curve box. We see the five-month inversion as a reason to be more vigilant, but given the unusually negative term premium, we are not treating it as a hard-and-fast sign of looming weakness. The money market has priced out all but one more rate cut, and the yield curve is no longer inverted, suggesting that recession fears are abating. Chart 4Looking For One More Cut Looking For One More Cut Looking For One More Cut Chart 5The Curve Is No Longer Inverted The Curve Is No Longer Inverted The Curve Is No Longer Inverted Chart 6Inflation Is Muted, ... Inflation Is Muted, ... Inflation Is Muted, ... We continue to check both of the sluggish inflation boxes. Realized inflation measures, headline and core, have slumped (Chart 6), and below-target inflation expectations remain a hot-button concern, judging by Fed speakers’ repeated references to them. The Fed has strapped itself to the mast with all its talk about inflation expectations, and it will not begin removing accommodation until inflation expectations revive. We cannot directly observe the output gap, but nearly 3% growth in 2018, and a rip-roaring labor market, offer solid evidence that it has closed and we leave its box unchecked. Labor market indicators unanimously point to the conclusion that monetary accommodation is not necessary. The unemployment rate is a full percentage point below the Fed’s and the CBO’s estimates of NAIRU. Ancillary indicators like the broader definition of unemployment including discouraged workers and involuntary part-time workers (Chart 7, top panel), and the openings (Chart 7, middle panel) and quits rates (Chart 7, bottom panel) from the JOLTS survey, testify to an extremely tight labor market. We expect that the pause in wage acceleration will prove temporary (Chart 8). Chart 7... Despite A Red-Hot Labor Market ... Despite A Red-Hot Labor Market ... Despite A Red-Hot Labor Market Chart 8Wage Gains Will Pick Up Again Wage Gains Will Pick Up Again Wage Gains Will Pick Up Again Chart 9No Overheating In The Real Economy No Overheating In The Real Economy No Overheating In The Real Economy With cyclical spending well short of past business cycle peaks (Chart 9), the real economy isn’t exerting any pressure on the Fed to intervene to choke off the expansion. (Although a modest pace of Fed hikes would support below-benchmark duration positioning, aggressive tightening to cut off overheating leads to recessions, and would favor long-maturity Treasuries.) We have removed the financial sector imbalances box because there has been no apparent follow through from Governor Brainard’s speech last September, which appeared to set the stage for tightening on the basis of frothy credit conditions. We maintain the international duress box, which is meant to alert us to an overseas crisis or near-crisis that could spark a flight to quality that depresses Treasury yields and/or inspires the Fed to pursue easier policy in an attempt to stave off contagion risks. Green shoots in manufact-uring, here and abroad, support the idea that growth outside the U.S. could be poised to accelerate. Chart 10Global Manufacturing Is Coming Back ... chart 10 Global Manufacturing Is Coming Back ... Global Manufacturing Is Coming Back ... Chart 11... And US Manufacturing May Have Bottomed ... And US Manufacturing May Have Bottomed ... And US Manufacturing May Have Bottomed We add “Flagging Global Growth” to address the global growth blind spot that undermined our call last year. Our US Bond Strategy colleagues find that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials Index are the global growth measures that exert the strongest influence on Treasury yields. The Global Manufacturing PMI has risen off its lows over the last three months and is within striking distance of getting back above the 50 contraction/expansion line, led by the US2 and China (Chart 10). The outlook for the US ISM Manufacturing PMI looks good on several counts. First, the comparatively modest manufacturing sector tends to move with the much larger services sector, and the sharp bounce in the Services PMI bodes well for the Manufacturing PMI (Chart 11, top panel). Within the manufacturing survey, New Export Orders’ leap back over 50 suggests that the global economy may have already seen the worst of the manufacturing weakness that has swept the rest of the world (Chart 11, bottom panel). The jury is still out on the CRB Raw Industrials-to-gold ratio (Chart 12, top panel), as industrial commodity prices have yet to show any spunk (Chart 12, bottom panel).   Chart 12Commodities Have Yet To Turn Commodities Have Yet To Turn Commodities Have Yet To Turn Chart 13A Weaker Dollar Would Support Higher Rates A Weaker Dollar Would Support Higher Rates A Weaker Dollar Would Support Higher Rates With our trio of indicators mixed-to-positive on balance, we leave the global growth box unchecked. We have also added a dollar box to monitor when Treasury yields are drifting out of alignment with other sovereign yields. If the dollar and Treasury yields rise together, we would view the rise in yields as suspect and at risk of being reversed.3 There doesn’t appear to be any decoupling pressure now, as Treasury yields have risen while the dollar has bumped around in a narrow range (Chart 13, top panel), and bullish sentiment toward the dollar has cooled off, pointing the way to a currency-approved path to higher yields (Chart 13, bottom panel). Bottom Line: We check only two of the boxes in our revised rates checklist (Figure 2), supporting a below-benchmark duration stance. Investment Implications Like all investors, we hate to get anything wrong. We were wrong on rates, though, failing to see the potential for the 10-year Treasury yield to fall to 1.5%. The duration miss undermined results within the fixed income sleeve of our recommendations, as we didn’t take it off until the 10-year Treasury yield had fallen to 1.74% .4 We have modified our rates checklist to force ourselves to be more aware of the world beyond the US, but the available data still support below-benchmark duration positioning, and we now recommend going back to it over the tactical (0-3-month) timeframe. The date when monetary policy turns restrictive has been pushed out, and so have the dates when the bull markets in risk assets will end. We note that our overall asset allocation calls have performed well. Since we upgraded equities in our first 2019 report,5 the S&P 500 Total Return Index has gained 24% while our Treasury underweight, as proxied by the Bloomberg Barclays US Treasury Total Return Index, is up 7% (Chart 14, top panel). Since we upgraded spread product in late January,6 the Bloomberg Barclays US Corporate Investment Grade and High Yield Total Return Indexes are up 12% and 8%, respectively, versus the Treasury Index’s 7% (Chart 14, bottom panel). Chart 14Underweighting Treasuries Has Been The Way To Go Underweighting Treasuries Has Been The Way To Go Underweighting Treasuries Has Been The Way To Go The run-up to the Fed’s series of mid-cycle rate cuts doomed our duration call, but it has fortified the case for overweighting equities and spread product. We still expect the expansion, the equity bull market, and spread product’s long period of generating excess returns to die at the hands of the Fed. Now that the date when monetary policy settings become restrictive has been indefinitely delayed, the end-dates of the equity and credit bull markets have as well. We continue to recommend overweighting equities and spread product, and underweighting Treasuries.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the September 17, 2018 US Investment Strategy Weekly Report, “What Would It Take To Change Our Bearish Rates View?” available at usis.bcaresearch.com. 2 The Global PMI is compiled from Markit’s individual country PMIs, so the chart shows the Markit US PMI instead of the more familiar ISM measure. 3 It the dollar were to rise significantly while Treasury yields rose faster than other DM sovereign yields, currency-adjusted Treasury yields would decouple from peer yields and arbitrage activity would likely bring them back down. 4 Please see the August 12, 2019 US Investment Strategy Weekly Report, “When The Facts Change,” available at usis.bcaresearch.com. 5 Please see the January 7, 2019 US Investment Strategy Weekly Report, “What Now?” available at usis.bcaresearch.com. 6 Please see the January 28, 2019 US Investment Strategy Weekly Report, “Double Breaker,” available at usis.bcaresearch.com.