Manufacturing

Highlights Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion A Brief Inversion A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Low Yields Support Risk Assets I Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Low Yields Support Risk Assets II Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year.  The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary.  On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Global Growth Indicators Global Growth Indicators Chart 5Catalysts For Economic Recovery Catalysts For Economic Recovery Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong Inflation Could Complicate The Fed's Message Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta Global Yield Beta Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth High Beta Countries Are Most Sensitive To Economic Growth High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years.   Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Chart 9 Chart 9 Chart 9 Chart 9 Chart 9 Chart 9 Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt  (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Where's The Positive Carry In Bond Markets? Where's The Positive Carry In Bond Markets? Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports  3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The current global trade downtrend has primarily been due to a contraction in Chinese imports. The latter reflects weakness in China's domestic demand in general and capital spending in particular. The current global manufacturing and trade downturns will prove to be drawn out. Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. EM domestic bonds and EM credit markets could be the last shoe to drop in this EM selloff. Steel, iron ore and coal prices, will all deflate further due to supply outpacing demand in China. Feature In our report last week, we argued that the odds of a liquidation phase in EM are growing. This week’s report continues exploring this theme, offering additional rationale and evidence of a pending breakdown in EM. Trade Tariffs: The Wrong Focus? The media and many investors seem to be solely focused on the impact of U.S. tariffs against imports from China. Yet these tariffs have not been the primary cause of the ongoing global manufacturing and trade recessions. It appears that the headlines and many investors are looking at individual trees and ignoring the forest. Chart I-1Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Global trade contraction and China’s growth slump are not solely due to the trade tariffs imposed by the U.S. but rather stem from weakening domestic demand in China. Chart I-1 illustrates that Chinese aggregate exports are faring much better than imports. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. However, they have not yet done so. This entails that U.S. tariffs have so far not had a substantial impact on Chinese and global manufacturing. The key point we would like to emphasize is that the current global trade downtrend has primarily been due to a contraction in Chinese imports. In turn, the accelerating decline in mainland imports is a reflection of relapsing domestic demand in China. The latter has been instigated by lethargic money/credit impulses owing to the government’s 2017-2018 deleveraging campaign and its reluctance to undertake an economy-wide irrigation type stimulus. What’s more, the recent RMB depreciation will likely intensify the Chinese import contraction already underway, as the same amount of yuan will buy less goods priced in U.S. dollars than before (Chart I-2). Given the majority of goods and commodities procured by mainland companies are priced in dollars, suppliers will receive fewer dollars, and their revenue derived from sales to and in China will continue to shrink (Chart I-3). Chart I-2RMB Depreciation Will Depress China's Purchases From Rest Of The World RMB Depreciation Will Depress China's Purchases From Rest Of The World RMB Depreciation Will Depress China's Purchases From Rest Of The World Chart I-3China Is In A Recession From Perspective Of Its Suppliers China Is In A Recession From Perspective Of Its Suppliers China Is In A Recession From Perspective Of Its Suppliers   We do not deny that the trade war has prompted a deterioration in sentiment among Chinese businesses and consumers as well as multinational companies, which in turn has dented both their spending and global trade. We do not see these issues reversing anytime soon. If the imposed tariffs were the main culprit behind both weakness in Chinese growth and global trade, mainland exports would have registered a far-greater hit by now than imports. Chart I-4EM EPS Are Contracting EM EPS Are Contracting EM EPS Are Contracting Even though U.S. President Donald Trump is flip-flopping on tariffs and their implementation, barring a major deal between the U.S. and China, business sentiment worldwide will not improve on a dime. In brief, delaying some import tariffs from September to December is unlikely to promote an imminent global trade recovery. The confrontation between the U.S. and China is profoundly not about trade: it is a geopolitical confrontation for global hegemony that will last years if not decades. Businesses in China and CEOs of multinational companies realize this, and they will not change their investment plans on Trump’s latest tweet delaying some tariffs. For now, we do not detect signs of an impending growth turnaround in China’s domestic demand and global trade. Therefore, China-related risk assets, commodities and global cyclicals are at risk of breaking down. Economic Rationale The global trade and manufacturing recession will linger for a while longer, and a recovery is not in the offing: The business cycle in EM/China continues to downshift. Consistently, corporate earnings are already or soon will be contracting in EM, China and the rest of emerging Asia (Chart I-4). EM corporate EPS contraction is broad-based (Chart I-5A and I-5B). The recent declines in oil and base metals prices entail earnings shrinkage for energy and materials companies (Chart I-5B, bottom two panels). Chart I-5AEM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based Chart I-5BEM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based EM EPS Contraction Is Broad Based   China’s monetary and fiscal stimulus has not yet been sufficient to revive capital spending in general and construction activity in particular (Chart I-6). Chinese household spending is also exhibiting little signs of recovery (Chart I-7). Chart I-6China: Building Construction Is Dwindling China: Building Construction Is Dwindling China: Building Construction Is Dwindling Chart I-7China: Consumer Spending Has Not Yet Recovered China: Consumer Spending Has Not Yet Recovered China: Consumer Spending Has Not Yet Recovered   Domestic demand continues to deteriorate, not only in China but also in other emerging economies, as we documented in our July 25 report. In EM ex-China, imports of capital goods and auto sales are contracting (Chart I-8). High-frequency freight data point to ongoing weakness in shipments in both the U.S. and China (Chart I-9). Chart I-8EM Ex-China: Domestic Demand Is Depressed EM Ex-China: Domestic Demand Is Depressed EM Ex-China: Domestic Demand Is Depressed Bottom Line: The current global manufacturing and trade downturns will prove to be drawn out, and investors should be wary of betting on an impending recovery. This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view which is anticipating an imminent global business cycle recovery. Chart I-9Global Freight Does Not Signal Recovery Global Freight Does Not Signal Recovery Global Freight Does Not Signal Recovery   Breakdown Watch Financial market segments sensitive to the global business cycle have been splintering at the edges. These cracks appear to be proliferating to the center and will render considerable damage to aggregate equity indexes. EM corporate EPS contraction is broad-based. We explained our rationale behind using long-term moving averages to identify significant breakouts and breakdowns in last week’s report. We also highlighted the numerous breakdowns that have already transpired. Today, we supplement the list: EM equity relative performance versus DM has fallen below its previous lows (Chart I-10, top panel). Crucially, emerging Asian stocks’ relative performance versus DM has clearly breached its 2015-2016 lows (Chart I-10, bottom panel). The KOSPI and Chinese H-share indexes have broken below their three-year moving averages (Chart I-11, top two panels). Chart I-10EM Equities Relative Performance Has Broken Down EM Equities Relative Performance Has Broken Down EM Equities Relative Performance Has Broken Down Chinese bank stocks in particular have been responsible for dragging China’s H-share index lower (Chart I-11, bottom panel). In addition, Chinese small-cap stocks dropped below their December low, as have copper prices and our Risk-On versus Safe-Haven currency ratio1 (Chart I-12). Finally, German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down (Chart I-13). Chart I-11Breakdowns In Korea And China... Breakdowns In Korea And China... Breakdowns In Korea And China...   Chart I-12...In Commodities Space As Well bca.ems_wr_2019_08_15_s1_c12 bca.ems_wr_2019_08_15_s1_c12 Chart I-13German Manufacturing Stocks Are In Free Fall German Manufacturing Stocks Are In Free Fall German Manufacturing Stocks Are In Free Fall   This implies that Germany’s manufacturing slowdown is not limited to the auto sector but rather is pervasive. Besides, these companies are greatly exposed to China/EM demand, and their share prices simply reflect the ongoing slump in China/EM capital spending. There are several other market signals that are at a critical technical juncture, and their move lower will confirm our downbeat view on global growth and cyclical markets. In particular: The global stocks-to-U.S. Treasurys ratio has dropped to a critical technical line (Chart I-14, top panel). Failure to hold this defense line would signal considerable downside in global cyclical assets. Similarly, the Chinese stock-to-bond ratio – calculated using total returns of both the MSCI China All-Share index and domestic government bonds – has plunged. The path of least resistance for this ratio might be to the downside (Chart I-14, bottom panel). Given China is the epicenter of the global slowdown, this ratio is of vital importance. The lack of recovery in this ratio signifies lingering downside growth risks. Finally, global cyclical sectors’ relative performance versus defensive ones is sitting on its three-year moving average (Chart I-15). A move lower will qualify as a major breakdown and confirm the absence of a global manufacturing and trade recovery. Chart I-14Global Stocks-To-Bonds Ratio: Sitting On Edge Global Stocks-To-Bonds Ratio: Sitting On Edge Global Stocks-To-Bonds Ratio: Sitting On Edge Chart I-15Global Cyclicals Versus Defensives: At A Critical Juncture Global Cyclicals Versus Defensives: At A Critical Juncture Global Cyclicals Versus Defensives: At A Critical Juncture   Bottom Line: Several important markets have already experienced technical breakdowns, and a few others are at risk of doing so. All in all, these provide us with confidence in maintaining our downbeat stance on EM risk assets and currencies. EM Bonds: The Last Shoe To Drop? Although EM share prices are back to their December lows, EM local currency and U.S. dollar bonds have done well this year, benefiting from the indiscriminate global bond market rally. However, there are limits to how far and for how long the performance of EM domestic and U.S. dollar bonds can diverge from EM stocks, currencies and commodities prices (Chart I-16). EM domestic bond yields have plunged close to the 2013 lows they touched prior to the Federal Reserve’s ‘Taper Tantrum’ selloff (Chart I-17, top panel). That said, on a total return basis in common currency terms, the GBI EM domestic bond index has not outperformed U.S. Treasurys, as shown in the bottom panel of Chart I-17. Chart I-16Which Way These Gaps Will Close? Which Way These Gaps Will Close? Which Way These Gaps Will Close? Chart I-17EM Domestic Bonds: Poor Risk-Reward Profile EM Domestic Bonds: Poor Risk-Reward Profile EM Domestic Bonds: Poor Risk-Reward Profile   Looking forward, EM exchange rates remain critical to the returns of this asset class. With the GBI EM local currency bond index’s yield spread over five-year U.S. Treasurys at about 400 basis points, EM currencies have very little room to depreciate before foreign investors begin experiencing losses. We believe that further RMB depreciation, commodities prices deflation and EM exports contraction all bode ill for EM exchange rates. Consequently, we expect EM local bonds to underperform U.S. Treasurys of similar duration over the next several months. German chemical and industrial share prices such as BASF, Siemens and ThyssenKrupp have decisively broken down. Finally, the euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Within this asset class, our overweights are Mexico, Russia, Central Europe, Chile, Korea and Thailand, while we continue to recommend underweight positions in the Philippines, Indonesia, Turkey, South Africa, Brazil, Argentina and Peru within an EM local currency bond portfolio. As to EM credit space (hard currency bonds), these markets are overbought, and investors positioning is heavy. EM currency depreciation and lower commodities prices typically herald widening spreads. Argentina has a large weight in the EM credit indexes, and the crash in Argentine markets could be a trigger for outflows from this asset class. Technically speaking, there are already several negative signposts. The excess returns on EM sovereign and corporate bonds seem to have rolled over, having failed to surpass their early 2018 highs (Chart I-18). Besides, EM sovereign CDS spreads are breaking out (Chart I-19, top panel). Chart I-18EM Credit Markets Is Toppy EM Credit Markets Is Toppy EM Credit Markets Is Toppy Chart I-19EM Credit Space Is Entering Selloff EM Credit Space Is Entering Selloff EM Credit Space Is Entering Selloff   Finally, there are noticeable cracks in the emerging Asian corporate credit market. The price index of China’s high-yield property bonds – that account for a very large portion not only of the Chinese but also the emerging Asian corporate bond universes – has petered out at an important technical resistance level (Chart I-19, bottom panel). Further, the relative total return of emerging Asia’s investment-grade corporate bonds against their high-yield peers is correlated with Asia corporate spreads, and presently points to wider spreads (Chart I-20). The rationale is that periods when safer parts of the credit universe outperform the riskier ones are usually associated with widening credit spreads. China’s property market remains vulnerable as the central authorities in Beijing have not provided much housing-related stimulus in the current downtrend. Furthermore, companies in this space are overleveraged, generate poor cash flow and have limited access to credit. The euro has begun rapid appreciation versus EM currencies. This will erode EM local bonds’ returns to European investors and trigger a period of outflows. Overall, Chinese property developers will affect the EM credit space in two ways. First, their credit spreads will likely continue to shoot up, generating investor anxiety and outflows from this asset class. Second, reduced investment by debt-laden and cash-strapped property developers will inflict pain on industrial and materials companies in Asia and beyond. We discuss the outlook for steel, iron ore and coal, which are very exposed to Chinese construction, in the section below. Bottom Line: For asset allocators, we recommend underweighting EM sovereign and corporate credit versus U.S. investment grade, a strategy we have been advocating since August 16, 2017 (Chart I-21). For dedicated portfolios, the list of our overweights and underweights, as always, is presented at the end of the report (page 21). Chart I-20Emerging Asian Corporate Spreads Will Widen Emerging Asian Corporate Spreads Will Widen Emerging Asian Corporate Spreads Will Widen Chart I-21Favor U.S. Investment Grade Versus EM Overall Credit Favor U.S. Investment Grade Versus EM Overall Credit Favor U.S. Investment Grade Versus EM Overall Credit   As for EM domestic bonds, we continue to recommend betting on yield declines in select countries without taking on currency risk. These include Korea, Chile, Mexico and Russia. We will warm up to this asset class in general when we alter our negative EM currency view. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Chinese Steel, Iron Ore And Coal Markets: Renewed Deflation Chart II-1Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Is Deflation In Steel And Coal Back? Unlike 2015 when steel, iron ore and coal prices collapsed, in the current downturn they have so far held up reasonably well. They have begun falling only recently (Chart II-1). Even though we do not anticipate a 2015-type Armageddon in steel, iron ore and coal prices, they will deflate further due to supply outpacing demand in China. For both steel and coal, the pace of “de-capacity” reforms in China has diminished considerably, with declining shutdowns of inefficient capacity and rising advanced capacity, as we argued in a couple of reports last year.  This has led to a faster growth in supply, while demand has been dwindling with weak economic growth. Lower steel, iron ore and coal prices will harm Chinese and global producers along with their respective countries.2 Steel And Iron Ore First, both crude steel and steel products output will likely grow at a pace of 5-7% (Chart II-2). As the 2016-2020 steel de-capacity target (150 million tons capacity reduction) was already achieved by the end of 2018, the scale of further shutdowns will be limited. In addition, collapsing graphite electrode prices reflect an increased supply of this material. This along with more availability of scrap steel will facilitate the continuing expansion of cleaner technology (electric furnace (EF)) steel capacity and their output in China. The newly added EF steel capacity is planned at about 21 million tons in 2019 (representing 1.8% of official aggregate steel production capacity), slightly lower than the 25 million tons in 2018. Second, we expect steel products demand to grow at 3-5%, slightly weaker than output. Construction accounts for about 55% of Chinese final steel demand, with about 35% stemming from the property market and 20% from infrastructure. The automotive sector contributes about 10% of final Chinese steel demand. All of these end markets are weak and do not yet show signs of revival (Chart II-3). Chart II-2Steel Production In China Steel Production In China Steel Production In China Chart II-3No Recovery In Chinese Demand No Recovery In Chinese Demand No Recovery In Chinese Demand   Concerning iron ore price, we expect more downside than in steel. Supply disruptions among Brazilian and Australian producers were the main cause for the significant rally in iron ore prices this year. Evidence is that these producers have already resumed their output recovery. Current iron ore prices are still well above marginal production costs of major global iron ore producers. Besides, ongoing large currency depreciation in commodity producing countries will push down their marginal production costs in U.S. dollars terms. This will encourage further supply.  As China has increased its use of scrap steel in its crude steel production, the country’s iron ore demand has not grown much. In fact, imports of this raw material have contracted (Chart II-4) As scrap steel prices are currently very low relative to the price of imported iron ore (Chart II-5), steel producers in China will continue to use scrap steel instead of iron ore. Chart II-4China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking China's Imports Of Iron Ore Have Been Shrinking Chart II-5Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore Scrap Steel Is A Cheap Substitute For Iron Ore   Coal Chart II-6Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Coal Output Is Rising, But Beijing's Goal To Reduce Its Usage Chinese coal prices will also be under downward pressure. First, coal output growth will likely slow but will still stand at 2-4% down from a current 6% level (Chart II-6, top panel). The government has set a production goal of 3900 million tons for 2020. Given last year’s output of 3680 million tons, this implies only a 2.9% annual growth rate this year and the next. Second, the demand for both thermal coal and coking coal will likely weaken. They account for 80% and 20% of total coal demand, respectively. About 60% of Chinese coal is used to generate thermal power. As the country continues to promote the use of clean energy, thermal power output growth will likely slow further. Increasing the nation’s reliance on clean energy is an imperative strategic objective for Beijing. Given that thermal coal still accounts for a whopping 70% of electricity production, China will maintain its effort on reducing coal in its energy mix (Chart II-6, bottom panel). In the same vein, the government will continue to replace coal with natural gas in home heating. Finally, Chinese coal import volumes are likely to decline as the nation is increasingly relying on its domestic sources. In particular, the strategic Menghua railway construction will be completed in October. It will be used to transport the commodity from large producers in the north to the coal-deficit provinces in the south. This will reduce the nation’s coal imports, as the transportation cost of shipping domestic coal to the southern power plants will become more competitive than imported coal. Macro And Investment Implications First, companies and economies producing these commodities will face deflationary pressures. These include - but are not limited to - Indonesia, Australia, Brazil and South Africa, as well as steel producers around the world. Second, the RMB depreciation will allow China to gain further market share in the global steel market. In fact, China’s share of global steel output has been rising (Chart II-7, top panel). The bottom panel of Chart II-7 shows that steel production in the world excluding China have actually come to a grinding halt at a time when mainland producers have enjoyed high output growth. Global steel stocks have broken down and global mining equities are heading into a breakdown (Chart II-8). Chart II-7China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market China Has Been Gaining A Share In Global Steel Market Chart II-8Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks Breakdown In Steel And Mining Stocks   Finally, we remain bearish on commodities and other global growth sensitive currencies. In particular, we continue shorting the following basket of EM currencies against the U.S. dollar: ZAR, CLP, COP, IDR, MYR and KRW. Ellen JingYuan He, Associate Vice President ellenj@bcaresearch.com   Footnotes 1          Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      This is BCA’s Emerging Markets Strategy view and is different from BCA’s house view. Equities Recommendations Currencies, Fixed-Income And Credit Recommendations

Dear Client, Next week I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Amr answers some key questions that clients have been asking about Japan recently: Does the Bank of Japan have any monetary policy ammunition left? How hard will October’s tax hike hit consumption? Has Japan’s corporate governance improved meaningfully? Is there a case for a rerating of Japanese equities? I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Highlights Risk assets are likely to struggle over the next few weeks as investors digest both the decision by President Trump to further raise tariffs on Chinese imports, and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. Despite the bluster from the Trump Administration, a trade deal between the U.S. and China is still more likely than not. The failure to reach a deal would weaken the U.S. economy, hurting Trump’s reelection prospects. Reassuringly, there is scant evidence that the global manufacturing downturn has infected the service sector to any significant degree. This is true not just for the U.S., but for manufacturing-intensive economies such as Germany as well. The share of manufacturing in both GDP and employment has fallen steadily around the world. Manufacturing output has also become less volatile over time, and less correlated with service sector growth. As global manufacturing activity starts to recover later this year, earnings growth will pick up. Stay overweight global equities relative to bonds on a 12-month horizon, while preparing to increase exposure to EM and European stocks. Feature First The Fed, And Then Trump Risk assets got hit by a one-two punch this week. First, the Federal Reserve dashed investors’ hopes for an extended easing cycle. While the Fed did cut rates by 25 basis points and pledged to end its balance sheet runoff in August (two months earlier than previously indicated), Jay Powell’s characterization of the Fed’s current mantra as a “mid-cycle adjustment to policy” suggested that further cuts were far from guaranteed. To reinforce the point, Powell stated that the Fed was not at “the beginning of a lengthy cutting cycle.” “That’s not our perspective now, our outlook,” he added. Contributing to the hawkish backdrop, Esther George, the president of the Kansas City Fed, and Eric Rosengren, the once fairly dovish president of the Boston Fed, voted to keep rates unchanged. Equities initially plunged on Wednesday following Chair Powell’s press conference. Markets rallied back Thursday morning, only to tumble again in the wake of President Trump’s decision to further raise tariffs on Chinese imports. There is no shortage of theories purporting to explain the timing of Trump’s decision. Was he trying to send a message to the Fed that it had better keep easing? Was he annoyed that Elizabeth Warren, Bernie Sanders, and a number of other presidential contenders tried to outflank him on trade during the Democratic debate the prior evening by suggesting he was not protectionist enough? Regardless, risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. While a severe escalation of the trade war would tip the scales towards recession, the risk of such an outcome remains low. Negotiations with China are ongoing. The threat to further raise tariffs in September is consistent with the “maximum pressure” doctrine that has governed Trump’s policy decisions. Ultimately, the failure to reach a trade deal would weaken the U.S. economy, undermining Trump’s reelection prospects. The fact that the latest tranche of tariffs, unlike previous ones, will fall mainly on consumer goods could further hurt Trump in the polls. He does not want that. The Manufacturing Cycle: How Low Will It Go? Chart 1The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Trade tensions have undoubtedly exacerbated the global manufacturing downturn. However, trade policy hasn't been the only culprit, as evidenced by the fact that manufacturing activity began to decelerate even before the trade war heated up in earnest. As we explained in detail last week,1 manufacturing activity tends to follow a “natural cycle” lasting about three years, with output growth rising for the first 18 months, and falling for the next 18 months (Chart 1). The latest downleg began at the start of 2018. Thus, as long as the trade war does not spiral out of control, we should soon see a bottom in the manufacturing cycle based on this timing. For now, the evidence for such a bottom remains mixed. It is encouraging that data released this week showed an improvement in the Chinese Caixin Manufacturing PMI and a slight uptick in the new orders component of the U.S. ISM manufacturing survey. Nevertheless, both surveys remain weak in absolute terms. Meanwhile, the European PMIs have continued to deteriorate, taking the global manufacturing PMI down to 49.3 in July, the lowest level since October 2012.  What one can say more definitively is that at least so far, the manufacturing downturn has not infected the service sector to any significant degree (Chart 2). The U.S. non-manufacturing ISM will be released on Monday, but the June reading of 55.1, while below year-ago levels, was still in the middle of its historic range (Chart 3). Chart 2AThe Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) Chart 2BThe Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II)   Chart 3U.S. ISM Non-Manufacturing Still Close To Its Historic Average U.S. ISM Non-Manufacturing Still Close To Its Historic Average U.S. ISM Non-Manufacturing Still Close To Its Historic Average Strong demand for services has underpinned U.S. employment growth which, in turn, has supported consumption growth. Real PCE rose by 4.3% in Q2. The jump in the Conference Board’s index of consumer confidence in July suggests that U.S. consumers remain upbeat. Notably, the services PMI has increased in the euro area this year, even as the manufacturing sector has weakened there. In Germany, where the manufacturing PMI plunged to 43.2 in July, the non-manufacturing PMI still managed to clock in at 55.4, up from 51.8 in December 2018. Manufacturing: A Canary In The Coal Mine Or Just A Coal Mine? The fact that the overall German economy has not come crashing down despite its high reliance on manufacturing is reassuring. Nevertheless, many investors remain convinced that it is just a matter of time before manufacturing woes precipitate a broad-based economic downturn. Such concerns are well founded if protectionism causes the entire global trading system to come crashing down. However, provided that this does not occur, it is unlikely that slower manufacturing growth, in and of itself, will trigger a recession. Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. Contrary to conventional wisdom, there is little evidence that manufacturing leads the broader economy. Chart 4 clearly shows that manufacturing output tracks overall real GDP growth, with no clear lead-lag relationship. Chart 4Manufacturing Activity Moves In Sync With The Broad Economy Manufacturing Activity Moves In Sync With The Broad Economy Manufacturing Activity Moves In Sync With The Broad Economy Granted, manufacturing growth is more volatile than GDP growth, but that is simply because of the nature of manufacturing production. More than half of manufacturing output consists of durable goods. Purchases of durable goods tend to be lumpy over time. When unemployment starts to rise, households typically postpone purchases of, say, refrigerators and automobiles, while businesses postpone purchases of capital goods. As inventories pile up, manufacturers respond by cutting output. The opposite happens during expansions. The Declining Role Of Manufacturing In The Economy As a share of GDP, global manufacturing output currently stands at 16%. The manufacturing share has been trending lower in most countries (Chart 5). In the U.S., where the data goes back much further, manufacturing output has declined from over 25% of GDP in the 1950s to 11% of GDP at present. The share of manufacturing jobs in total employment has dropped in tandem (Chart 6). Chart 5The Declining Role Of Manufacturing Is A Global Phenomenon The Declining Role Of Manufacturing Is A Global Phenomenon The Declining Role Of Manufacturing Is A Global Phenomenon Chart 6The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling   The volatility of manufacturing growth rates has also fallen over time. This has occurred partly because of better inventory management techniques. Chart 7 shows that the ratio of real nonfarm inventories-to-domestic sales of goods and structures has been trending lower for the past 40 years. Diminished fears of oil embargos and price controls, which were rampant during the 1970s, have also allowed inventory levels to come down. Chart 7A Structural Decline In The Inventories-To-Sales Ratio Starting In The Early 1980s A Structural Decline In The Inventories-To-Sales Ratio Starting in The Early 1980s A Structural Decline In The Inventories-To-Sales Ratio Starting in The Early 1980s As manufacturing has become a smaller and less volatile part of the economy, its impact on the service sector has diminished. In fact, we estimate that all of the reduction in the variance of U.S. private sector GDP growth over the past 50 years can be attributed to a smaller contribution from the goods-producing sector, as well as a decline in the correlation between goods-producing and service-producing industries (Chart 8). Chart 8 Investment Conclusions Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. As long as the trade war does not boil over, global manufacturing activity should recover during the remainder of this year, boosting corporate earnings in the process. More cyclically-oriented stock markets and sectors will benefit the most. Non-U.S. stocks have the advantage of trading at a substantial discount to their U.S. peers. Chart 9 shows that U.S. stocks trade at 17.5-times forward earnings, while non-U.S. stocks trade at only 13.5-times forward earnings. We expect to upgrade European and EM equities over the coming months. Chart 9AEquities: Better Valuations Outside The U.S. (I) Equities: Better Valuations Outside The U.S. (I) Equities: Better Valuations Outside The U.S. (I) Chart 9BEquities: Better Valuations Outside The U.S. (II) Equities: Better Valuations Outside The U.S. (II) Equities: Better Valuations Outside The U.S. (II) Better global growth prospects should cause the dollar to weaken. Stronger growth should also allow government bond yields to rise and yield curves to steepen. Investors should favor stocks over bonds for the next 12 months. Housekeeping: We were stopped out of our long EUR/JPY trade for a loss of 5%. We will consider reopening this trade once market volatility settles down.   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 10 Tactical Trades Strategic Recommendations Closed Trades

Feature The global manufacturing cycle looks dire at the moment. Around the world, manufacturing PMIs have fallen, profit growth has slowed, and capex has been reined back (Chart 1). This is clearly a risky moment for the economic expansion (and the equity bull market) which began in 2009. We hear that many clients are having vigorous debates on their investment committees about what to do – and indeed, at BCA, the views of our strategists are unusually divided.1 Recommendations Monthly Portfolio Update: Manufacturing Recession, Consumer Resilience, Dovish Central Banks Monthly Portfolio Update: Manufacturing Recession, Consumer Resilience, Dovish Central Banks Chart 1Heading Downhill Fast Heading Downhill Fast Heading Downhill Fast       Global Asset Allocation veers towards the optimistic camp. In brief, we expect the services and consumer sectors of major economies to remain robust, and that manufacturing will bottom out in the coming months, partly as a result of easier financial conditions, including the dovish turn by central banks and monetary stimulus in China. But we recognize the risks currently and have constructed our portfolio accordingly. We remain overweight equities versus bonds, but leaven that with an overweight on the most defensive equity market, the U.S. The global economy is a wonderful self-organizing system. The disparity between manufacturing and services is stark everywhere. Both the soft data, such as PMIs (Chart 2), and hard data, such as industrial production and retail sales (Chart 3), show that manufacturing almost everywhere is in recession (the U.S. is not yet, but is perhaps headed that way), but that services growth remains robust. Services have been held up by decent wage growth (even in the manufacturing-heavy eurozone) and generally easier fiscal policy (in the eurozone and China, in particular), which have allowed consumers to continue spending. (In the U.S., the risk of tighter fiscal policy next year has been alleviated by last month’s budget agreement which will produce a small positive fiscal thrust in 2020 – see Chart 4.) Chart 2Service Sector Surveys Look Healthier... Service Sector Surveys Look Healthier... Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data ...Supported By The Hard Data ...Supported By The Hard Data   Chart 4 Chart 5China Is The Root Cause China Is The Root Cause China Is The Root Cause   The manufacturing recession was clearly triggered by China – it is notable, for instance, that large exporting countries have seen no slowdown in sales to the U.S. but a big drop in those to China (Chart 5). In 2017-18, China slowed as a result of its tighter monetary policy and clamp-down on shadow banking. The countries that have been most affected by the slowdown over the past 18 months are, unsurprisingly then, those which have the largest manufacturing sectors, notably Korea, Germany and Japan (Chart 6). Chart 6 But the global economy is a wonderful self-organizing system. Historically, intra-expansion industrial cycles have typically lasted around 18 months from peak to trough, and 18 months from trough to peak (Chart 7). Lower commodity prices, easier financial conditions, and pent-up demand mean that, after a period of slowdown, demand and risk appetite build up. This self-equilibrating cycle breaks only if there is a major structural imbalance, usually excess debt or rising inflation. As we have argued previously, we do not see clear signs currently that either of these usual structural triggers of recession is present (Chart 8). Chart 7Close To The End Of The Down Wave? Close To The End Of The Down Wave? Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession No Structural Triggers For Recession No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased Financial Conditions Have Eased Financial Conditions Have Eased The Fed cut rates on July 31 as a risk management measure, “a mid-cycle adjustment to policy,” as Chair Powell put it in his post-FOMC press conference. With the stock market close to a record high and unemployment at a 50-year low, there is no obvious need for the Fed to implement a full-out easing campaign. But with inflation well below its 2% target, and a risk that the manufacturing slowdown could spill over into consumption (perhaps if companies start to lay off workers – something there is little sign of yet), an “insurance” cut seemed prudent. Financial conditions have eased significantly in the U.S. this year, and somewhat in Europe (Chart 9), and this should soon start to positively affect growth. China’s stimulus remains key. So far it has been half-hearted (Chart 10). This is because Chinese growth has to a degree stabilized, trade negotiations with the U.S. continue, and because the authorities have not abandoned their wish to delever the economy – it is notable that shadow-bank credit creation has not rebounded (Chart 11). Both fiscal and monetary stimulus will need to be ramped up in the second half if we are to see a repeat of 2016’s China-driven risk rally. Investors should see this as a put option – if Chinese growth slows again, and the trade talks break down (both of which are likely), the authorities will roll out a stimulus on the scale of their previous efforts. Chart 10China's Stimulus Is Only Half-Hearted China's Stimulus Is Only Half-Hearted China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Still Clamping Down On Shadow Banks Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? Have Stocks Already Discounted A Rebound? Have Stocks Already Discounted A Rebound? What is the biggest risk to our sanguine view? With global stocks up 16% and U.S. stocks 20% year-to-date, the bottoming-out of the manufacturing cycle and greater monetary easing may already be priced in. Chart 12 shows that year-on-year stock market moves typically follow the manufacturing PMIs closely. Even if stock prices remain only at their current level to year-end, they are already discounting a sharp bounce in the PMIs. Fixed Income: If we are right about the macro environment, U.S. Treasury bond yields should rise from their current 2%. Yields usually move in line with consensus GDP forecasts (Chart 13). Economists have cut their 2020 forecast to only 1.8% (from 2.5% for this year). If the 2020 number is revised up, as we expect, Treasury yields have some room to move back up. Moreover, the Fed is unlikely to cut rates twice more by year-end as the futures market implies. Therefore, we stay underweight duration. We have a neutral stance on credit, but this asset class should produce reasonable excess returns over coming quarters given current spreads (Chart 14). U.S. high yield (especially B and below) and eurozone investment grade bonds (which the ECB may start buying again) look attractive. Chart 13Yields Will Rise With GDP Forecasts Yields Will Rise With GDP Forecasts Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Some Credit Spreads Look Attractive Some Credit Spreads Look Attractive Equities: Given the uncertainties over the timing and strength of Chinese stimulus, we remain cautious on Emerging Markets and euro area stocks, the most obvious beneficiaries of this. Both regions have structural headwinds (excess foreign-currency debt in the case of EM, the fragile banking system and flattening yield curve for Europe) which mean that, even when Chinese stimulus comes, their outperformance may prove short-lived. For now, we prefer U.S. equities, although we recognize that upside for this year is limited. The key will be whether earnings can surprise analysts’ (over cautious) forecast of only 3% EPS growth in 2019. This seems likely since the Q2 earnings season, with almost half of companies having reported, is coming in at close to 80% beats on the bottom line. To hedge against the upside risk of Chinese stimulus, we continue to recommend building a position in Australian equities and in the Industrials sector. China’s stimulus remains key, but so far it has been half-hearted. Currencies: The U.S. dollar is a counter-cyclical currency and should start to depreciate once signs of a manufacturing recovery become apparent. Moreover, the Fed’s dovish move – and the fact that it has significantly more room to ease than other large DM central banks – should also prove to be dollar bearish eventually (Chart 15). One key cross to watch for signs that the global cycle is bottoming is AUD/JPY, since the Australian dollar is a very cyclical, and the Japanese yen a very defensive, currency (Chart 16). Chart 15Dovish Fed Is Dollar Bearish Dovish Fed Is Dollar Bearish Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom Watch AUD/JPY For Signs Of A Bottom Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Oil Has Further To Rise Oil Has Further To Rise Chart 18 Commodities: We continue to have a bullish outlook for oil. Although developed-world demand growth has slowed slightly this year, OPEC supply constraints mean that inventories should draw down further (Chart 17). We expect Brent crude to average $74 a barrel in 2H2019 (from $65 today). Gold has performed well this year, up 11%. Our colleagues in BCA’s Foreign Exchange Strategy and Commodity & Energy Strategy services conclude that this has largely been because of monetary and financial factors, mostly lower real rates (Chart 18).2 In the coming months, while rates may rise, gold should be helped by a weaker USD. We are neutral on the metal and see it more as an insurance asset. Our FX and Commodity strategists concur with GAA’s long-standing view that gold is a useful portfolio diversification tool to protect against financial, geopolitical, and inflation risks. Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see BCA’s Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open,” dated 19 July 2019, available at www.bcaresearch.com. 2      Please see Commodity & Energy Strategy Special Report, “All That Glitters…And Then Some,” dated 25 July 2019, available at ces.bcaresearch.com.   GAA Asset Allocation  

Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon.  Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S. The Capex Slowdown Has Been Less Severe In The U.S. The Capex Slowdown Has Been Less Severe In The U.S.   A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Semiconductor And Manufacturing Cycles Tend To Overlap Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin.  The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The Ebb And Flow Of Lending And Capex Go Hand In Hand The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak U.S. Private Sector Leverage Remains Below Its Previous Peak U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging The Capital Stock Is Aging The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply.   Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner China: The Deleveraging Campaign Has Been Put On The Backburner China: The Deleveraging Campaign Has Been Put On The Backburner   A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral ...But No Imminent Threat Of A Wage-Price Inflationary Spiral ...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle.   Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14).  Chart 14Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally The Worker-To-Consumer Ratio Has Started Shrinking Globally The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17). Chart 16   Chart 17   Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves     As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small Big Has Crushed Small Big Has Crushed Small   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1    The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 21 Tactical Trades Strategic Recommendations Closed Trades

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Chart II-1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Chart II-5 Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart II-7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (I) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I) Interest Rate Expectations Against The U.S. Should Narrow (II) Interest Rate Expectations Against The U.S. Should Narrow (II)   Chart II-14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart II-15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It ...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Global Stocks Historically Did Not Lead PMIs Chart II-19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps Chart II-21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets   Chart II-22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Switch Out Of Growth-Sensitives Into Healthcare Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. Chart II- Chart II-25 We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II) Equity Risk Premia Remain Elevated (II)   The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds   Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… Image …And The Bears Image Footnotes 1       To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5     France is a good proxy for the euro area. 6     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.