Monetary

Highlights Economic data suggest the current business cycle in China has not yet reached a bottom. Stimulus measures have not been forceful enough to fully offset a slowing domestic economy and weakening global demand. With possibly more U.S. tariffs to come, intensifying political unrest in Hong Kong and a currency set to depreciate further, the potential downside risks outweigh any potential upside over the near term. Investors who are already positioned in favor of Chinese equities should stay long. We are still early in a credit expansionary cycle, and we expect further economic weakness to pave the way for more policy support in China. However, we recommend investors who are not yet invested in Chinese assets to remain on the sidelines until clearer signs of materially stronger stimulus emerge. Feature Chart 1A Breakdown In Chinese Stocks A Breakdown In Chinese Stocks A Breakdown In Chinese Stocks Financial market volatility surged in the first half of the month following U.S. President Donald Trump’s recent tweet, vowing to impose a 10% tariff on the remaining $300 billion of U.S. imports of Chinese goods by September 1st. By the end of last week, prices of China investable stocks relative to global equities had nearly wiped out all their 2019 year-to-date gains. (Chart 1) The extent of the decline has left some investors wondering whether the time has come to bottom-fish Chinese assets. In our view, the answer is no. In this week’s report we detail five reasons why the near-term outlook for China-related assets remains negative. We remain bullish on Chinese stocks over the cyclical (i.e. 6-12 month) horizon and recommend investors who are already positioned in favor of China-related assets stay long. However, we also recommend investors who are not yet invested to remain on the sidelines until surer signs of materially stronger stimulus emerge. As we go to press, the U.S. Trade Representative Office announced that the Trump administration would delay imposing the 10% tariff on a series of consumer goods imported from China — including laptops and cell phones — until December.1 Stocks in the U.S. surged on the news. Today’s rally in the equity market highlights our view, that short-term market performance can be dominated and distorted by news on the trade front. However, market rallies based on headline news will not sustain without the support of economic fundamentals. Reason #1: Chinese Economic Growth Has Not Yet Bottomed In a previous China Investment Strategy report,2  we presented some simple arithmetic to help investors formulate their outlook on the Chinese economy. We argued that in a full-tariff scenario, investors should focus on the likely outcome of one of the two following possibilities: Scenario 1 (Bullish): Effects of Stimulus – Impact of Tariff Shock > 0 Scenario 2 (Bearish): Effects of Stimulus – Impact of Tariff Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. Scenario 2 denotes an outcome where China’s reflationary response is not larger than the magnitude of the shock. For now, we remain in scenario 2 due to Chinese policymakers’ continual reluctance to allow the economy to re-leverage. The magnitude of the credit impulse so far has been “half measured” relative to previous cycles.3  More than seven months into the current credit expansionary cycle, Chinese economic data have not yet exhibited a clear bottom. As a result, more than seven months into the current credit expansionary cycle, Chinese economic data have not yet exhibited a clear bottom, with the main pillars supporting China’s “old economy” still in the doldrums (Chart 2 and Chart 3). Chart 2No Clear Bottom, Yet No Clear Bottom, Yet No Clear Bottom, Yet Chart 3Key Economic Drivers Struggling To Trend Higher Key Economic Drivers Struggling To Trend Higher Key Economic Drivers Struggling To Trend Higher   In addition to a weakening domestic economy, China’s external sector has been weighed down by U.S. import tariffs as well as slowing global demand. (Chart 4).  The possibility of adding a 10% tariff by year end on the remaining $300 billion of Chinese goods exports to the U.S. may trigger another tariff “front-running” episode in the 3rd quarter. However, Chart 5 and Chart 6 highlight that any front-running would be against the backdrop of sluggish global demand. Therefore, not only the upside in Chinese export growth will be very limited in the subsequent months following the front-running, but export growth is also likely to fall deeper into contraction. Chart 4Domestic Demand More Concerning Than Exports Domestic Demand More Concerning Than Exports Domestic Demand More Concerning Than Exports Chart 5Pickup In Global Demand Not Yet Visible Pickup In Global Demand Not Yet Visible Pickup In Global Demand Not Yet Visible Chart 6Bottoming In Global Manufacturing Also Delayed Bottoming In Global Manufacturing Also Delayed Bottoming In Global Manufacturing Also Delayed Reason # 2: A-Shares Are Not Yet Signaling A Sizeable Policy Response Chart 7 In previous China Investment Strategy reports, we have written at length about how Chinese policymakers are reluctant to undo their financial deleveraging efforts and push for more stimulus. After incorporating July credit data, our credit impulse, at a very subdued 26% of nominal GDP, was in fact a pullback from June’s credit growth number (Chart 7). This confirms our view that the current stimulus is clearly falling short compared to the 2015-2016 credit expansionary cycle. It underscores Chinese policymakers’ commitment to keep their foot off the stimulus pedal. What’s more, the recent performance of China’s domestic financial markets has been consistent with a half-measured credit response, and is not yet signaling a meaningful change in China’s policy stance. The A-share market since last summer has been trading off of the likely policy response to the trade war. Chart 8Market Not Signaling Significant Policy Shift Market Not Signaling Significant Policy Shift Market Not Signaling Significant Policy Shift Chart 8 (top panel) shows that the A-share market has closely tracked China’s domestic credit growth over the past year. Given this, we believe that the A-share market is reacting more to the likely policy response to the trade war, in contrast to the investable market which rises and falls in near-lockstep with trade-related news (middle panel). The fact that A-share stocks have been trending sideways underscores that China’s domestic equity market continues to expect “half measured” stimulus. This week’s sharp decline in China’s 10-year government bond yield is in part related to escalating political unrest in Hong Kong (bottom panel), and in our view does not yet signal any major change in the PBOC’s stance. Finally, our corporate earnings recession probability model provides another perspective on the equity market implications of the current path of stimulus. If the current size of stimulus holds through the end of 2019, our model suggests that the probability of an outright contraction in corporate earnings lasting through year end remains quite elevated, at close to 50% (first X in Chart 9). The July Politburo statement signaled a greater willingness to stimulate the economy; as a result, we are penciling in a slightly more optimistic scenario on forthcoming credit growth through the remainder of the year, by adding 300 billion yuan of debt-to-bond swaps4 and 800 billion yuan of extra infrastructure spending5 to our baseline estimate for the rest of 2019. However, this would only add a credit impulse equivalent of 1 percentage point of nominal GDP and would only marginally reduce the probability of an earnings recession to 40% (second X in Chart 9). A 40% chance of an earnings recession is well above “normal” levels that would be consistent with a durable uptrend in stock prices, and in previous cycles, Chinese stock prices picked up only after business cycles and corporate earnings had bottomed (Chart 10). In sum, the current pace of credit growth, signals from the domestic equity market, and our earnings recession model all suggest that it is too early to bottom fish Chinese stocks. Chart 9A "Measured" Pickup in Stimulus Will Not Be A Game Changer A "Measured" Pickup in Stimulus Will Not Be A Game Changer A "Measured" Pickup in Stimulus Will Not Be A Game Changer Chart 10Too Early To Bottom Fish Too Early To Bottom Fish Too Early To Bottom Fish Reason #3: The Trade War Is Far From Over Our Geopolitical Strategy team maintains that the U.S. and China have only a 40% chance of concluding a trade agreement by November 2020, and that any trade truce is likely to be shallow.6 We agree with this assessment, which has clear negative near-term implications for Chinese investable stocks, even if temporary rallies such as what took place yesterday periodically occur. Since the onset of the trade war, Chinese investable stocks appear to have traded nearly entirely in reaction to trade-related events. Hence, until global investors are given proof that much stronger stimulus can and will offset the impact of the trade war on corporate earnings, Chinese stocks are likely to continue to underperform their global peers. Reason #4: The Hong Kong Crisis Is A Near-Term Risk Another near-term catalyst for financial market turbulence in China is the worsening situation in Hong Kong. For now, we hold the view that a full-blown crisis (i.e. China intervening with military force) can be avoided, but we are not ruling out the possibility of a severe escalation or its potential impact on market sentiment towards Chinese assets.  On the surface, China investable stocks (the MSCI China Index, the predominantly investable index that now includes some mainland A-shares) are not directly linked to businesses in Hong Kong: Out of the top 10 constituents of the MSCI China Index, which account for roughly 50% of the index’s market capitalization, seven are headquartered in mainland China and do not appear to have significant revenue exposure to Hong Kong. By contrast, at least 30% of Hang Seng Index-listed companies have business operations in Hong Kong. The remaining three companies in the top 10 MSCI China Index are Tencent (the largest component of the index, with a weight of approximately 15%), Ping An Insurance (4% weight), and China Mobile (3% weight) – all of which registered large losses in the past week. Both Tencent and Ping An Insurance are headquartered in Shenzhen, a southeastern China metropolis that links Hong Kong to mainland China. China Mobile appears to have the most revenue exposure to Hong Kong of any top constituent through its CMHK subsidiary, which is the largest telecommunications provider in Hong Kong. It is true that there has been little evidence so far that Chinese investable stocks have been more impacted by the escalation in political unrest in Hong Kong than by the escalation in the trade war. Indeed, the fact that the two escalations were overlapping this past week makes it difficult to isolate their effects. But if unrest in Hong Kong spirals out of control, it could result in mainland China intervening. According to an analysis done by BCA’s Geopolitical Strategy team,6 the deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries. The 1989 Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions. Should this to occur, the near-term idiosyncratic risk to Chinese stocks in both onshore and offshore markets will be significant. Reason #5: Further RMB Depreciation May Weigh On Stock Prices Whether due to manipulation or market forces, last week’s depreciation in the Chinese currency (RMB) was economically justified and long overdue. Chart 11RMB Depreciation Long Overdue RMB Depreciation Long Overdue RMB Depreciation Long Overdue Chart 11 shows the close relationship between the U.S.-China one-year swap rate differential and the USD/CNY exchange rate. The true source of the correlation shown in the chart remains somewhat of a mystery, given that Chinese capital controls, particularly following the 2015 devaluation episode, prevent the arbitrage activities that link rate differentials and exchange rates in economies with fully open capital accounts. However, Chart 11 clearly shows that China’s currency would have already weakened by now if it was fully market-driven, and we do not believe that the People’s Bank of China will be inclined to tighten monetary policy in order to reverse the recent devaluation. Hence, the path of least resistance for the CNY is further depreciation.  If the threatened 10% tariff on all remaining U.S. imports from China is imposed this year, our back-of-the-envelope calculation based on Chart 12 suggests that a market-driven “equilibrium” USD/CNY exchange rate should be at around 7.6. We have high conviction, based on previous RMB devaluation episodes, that China’s central bank will not allow its currency to depreciate in a manner that invites speculation of meaningful further weakness – meaning we are not likely to see a straight-lined or rapid depreciation down to the 7.6 mark. Chart 12Market Driven 'Equilibrium' Provides Some Guidance On The Exchange Rate Market Driven 'Equilibrium' Provides Some Guidance On The Exchange Rate Market Driven 'Equilibrium' Provides Some Guidance On The Exchange Rate A “managed” currency depreciation is in and of itself stimulative for the Chinese economy. At the same time, aggressive market intervention via the PBoC burning through its foreign exchange reserves is also unlikely: A “managed” currency depreciation is in and of itself stimulative for the economy. It improves Chinese export goods’ price competitiveness and helps mitigate some of the pain caused by increased tariffs. Therefore it is in the PBoC’s every interest to allow such depreciation. However, no matter how “orderly” RMB depreciation may be, the fact that the PBoC has signaled it is no longer defending a “line in the sand” exchange-rate mark is likely to trigger another round of “race to the bottom” currency devaluation from other regional, export-dependent economies.7 A weaker RMB and emerging market currencies will also contribute to USD strength. A strong dollar has been negatively correlated with global risky assets, implying that for a time, a weaker RMB will be a risk-off event for risky assets and thus presumably for Chinese and EM equity relative performance. Investment Implications Our analysis above highlights that the near-term outlook for Chinese stocks is fraught with risk, and it is for this reason that we recommended an underweight tactical position in Chinese stocks for the remainder of the year in our July 24 Weekly Report.8 However, by next summer (the tail-end of our cyclical investment horizon), it is our judgement that one of two things will have likely occurred: The trade war with the U.S. will have abated or been called off, and investors will have determined that a “half-strength” credit cycle is likely enough to stabilize Chinese domestic demand and the earnings outlook. In this scenario, Chinese stocks are likely to rise US$ terms over the coming year, relative to global stocks. The trade war with the U.S. will have continued, and Chinese policymakers will have acted on the need to stimulate aggressively further in order to stabilize domestic demand. In combination with an ultimately stimulative (although near-term negative) decline in the RMB, the relative performance of Chinese stocks versus the global benchmark will likely be higher in hedged currency terms. Because of the near-term risks to the outlook, we agree that investors who are not yet invested should remain on the sidelines until surer signs of materially stronger stimulus emerge. But investors who are already positioned in favor of Chinese equities should stay long, and should bet on the latter scenario: rising relative Chinese equity performance in local currency terms, alongside a falling CNY-USD / appreciating USD-CNY exchange rate.   Jing Sima  China Strategist JingS@bcaresearch.com   Footnotes 1      “US to delay some tariffs on Chinese goods”, Financial Times, August 13, 2019. 2      Please see China Investment Strategy Weekly Report, “Simple Arithmetic”, dated May 15, 2019, available at cis.bcaresearch.com. 3      Please see China Investment Strategy Weekly Reports, “Threading A Stimulus Needle (Part 1): A Reluctant PBoC”, dated July 10, 2019, and “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com. 4      The remaining of 14 trillion debt-to-bond swap program rounds up to 315 billion yuan. 5      The relaxed financing requirement for infrastructure projects can add 800 billion yuan. 6      Please see Geopolitical Strategy Weekly Report, “The Rattling Of Sabers”, dated August 9, 2019, available at gps.bcaresearch. 7      Please see Emerging Markets Strategy Weekly Report, “The RMB: Depreciation Time?”, dated May 23, 2019, available at ems.bcaresearch.com. 8      Please see China Investment Strategy Weekly Report, Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com. Cyclical Investment Stance Equity Sector Recommendations

Highlights A lot has changed in a week and a half, … : The FOMC meeting that we thought would mark the end of global market-moving news until September turned out to be a prelude for the real fireworks. … as U.S.-China trade tensions escalated, … : The imposition of tariffs on the only remaining subset of Chinese imports that had escaped duties so far inspired China to let the yuan fall below a key technical level. … and other countries braced for the fallout: China’s devaluation opened up a new front in the conflict, turning a bilateral tariff spat into a threat to other countries’ well-being and competitiveness. Asia-Pacific central banks swiftly followed with larger-than-expected rate cuts. Below-benchmark-duration positioning is no longer appropriate in the near term, and we recommend moving to benchmark duration: Interest rates will be hard-pressed to rise with global central banks squarely in easing mode. Although we still believe that inflation and the fed funds rate will surprise to the upside, it’s going to take a while. Feature Dear Client, There will be no U.S. Investment Strategy next week as we take our final summer break. U.S. Investment Strategy will return on Monday, August 26th. Best regards, Doug Peta So much for the idea that the July 30-31 FOMC meeting would be the last market-moving event before Labor Day. By lunchtime on August 1st, the S&P 500 was back to its July 30th close above 3,010; the 10-year Treasury yield had settled around 1.96%, ten basis points (“bps”) lower than its pre-meeting level; and gold had fallen by ten bucks, to $1,420, as markets digested the news that the Fed was less concerned about the economy than they were. Then the trade war reared its ugly head in the form of new tariffs on Chinese imports to the U.S., and the S&P slid to 2,822, the 10-year Treasury yield tumbled to 1.59%, and gold surged to $1,510. The new round would ensnare the subset of goods that had previously been spared from import duties, and Beijing promised to retaliate. It’s hard for rates to rise when every central bank has an easing bias as it nervously eyes the U.S.-China tilt.   Chart 1Beijing Plays The Currency Card Beijing Plays The Currency Card Beijing Plays The Currency Card The retaliation arrived Sunday night in the U.S., when Chinese officials allowed the renminbi to trade above 7 to the dollar for the first time since 2008 (Chart 1). The move provoked a global equity selloff, and the S&P 500 lost 3% in its worst session of the year. With the currency floodgates opened, the trade war morphed from a bilateral tariff spat into a global battle for competitiveness, and central banks in India, Thailand and New Zealand responded with larger-than-expected rate cuts. India is a comparatively closed economy battling a domestic downturn, but it is clear that countries with any reliance on exports are loath to be saddled with a strong currency that will hamstring their global competitiveness. It turns out that the Fed isn’t the only central bank that sees the appeal of taking out some insurance. That is an unfriendly backdrop for below-benchmark-duration positioning, and we are joining our fixed-income colleagues in raising our duration recommendation from underweight to neutral over the tactical timeframe (0-3 months). While we still believe that the fed funds rate and long yields will surprise to the upside, they cannot do so while bond investors are adamant that the Fed is going to have to adopt an easing bias over the near term. Our rates checklist, discussed in the rest of this report, supports the decision. The shift in the rates backdrop undermines our newly established agency mortgage REIT recommendation, and we are watching it closely. The Rates Checklist: The Fed Table 1Rates View Checklist When The Facts Change When The Facts Change Turning to our rates view checklist (Table 1), the first item is derived from our U.S. Bond Strategy service’s golden rule of bond investing.1 The golden rule asks one simple question to anchor views on Treasuries: Over the next 12 months, will the Fed move the fed funds rate by more or less than the bond market is currently discounting? Since 1990, when the Fed has surprised dovishly (the fed funds rate has turned out to be lower than the money market implied twelve months earlier), Treasuries have almost always generated positive excess returns over cash. Periods of negative excess returns have occurred nearly exclusively when the Fed has delivered a hawkish surprise. We still think inflation will become a problem, but it certainly isn’t one yet. Since we rolled out the checklist last year, we have consistently expected a hawkish surprise. Though we continue to believe that an extended cycle of rate cuts is not in the cards, markets disagree, and we concede that the Fed now has a near-term easing bias, despite Chair Powell’s demurrals at the post-meeting press conference. We are leaving the box unchecked because we believe that nearly four more 25-bps cuts over the next twelve months, equating to a target fed funds rate of 1.25-1.50% (Chart 2), are unlikely. The spread between our expectations and the market’s expectations is still wide enough to merit a below-benchmark-duration view over the next twelve months, even if benchmark duration makes more sense for the rest of the year. Chart 2Four More Rate Cuts Are A Stretch Four More Rate Cuts Are A Stretch Four More Rate Cuts Are A Stretch The yield curve’s inversion has become more pronounced in the wake of the re-escalation of the trade war (Chart 3), and we duly check the second box. As a reminder, we track the 3-month/10-year segment of the yield curve to define inversion because it is less susceptible to estimate error, and has been a timelier indicator of recessions, than the more frequently cited 2-year/10-year segment. We have argued before that the unprecedentedly large negative 10-year term premium makes the curve more prone to invert and makes it a less sensitive economic barometer, but part of the rationale of creating a checklist is to limit one’s discretion in interpreting events. Chart 3More Rate Cuts, Please More Rate Cuts, Please More Rate Cuts, Please The Rates Checklist: Inflation Inflation has gone AWOL around the globe. Although the U.S. no longer faces the negative output gaps that remain in other major economies, its main measures of consumer prices (Chart 4) do nothing to counteract the widespread view that the Fed has a free pass to devote its energies to shoring up growth. Inflation break-evens were making progress toward the 2.3-2.5% range consistent with the Fed’s 2% inflation target when we launched the checklist last year, but the plunge in oil prices stopped them in their tracks (Chart 5). Rather than encouraging the Fed to hike, soft inflation expectations helped drive the Fed’s dovish pivot. Chart 4Realized Inflation Is Below Target, ... Realized Inflation Is Below Target, ... Realized Inflation Is Below Target, ... Chart 5... And So Are Inflation Expectations ... And So Are Inflation Expectations ... And So Are Inflation Expectations Our view that the seeds of inflation pressures have been sown has not changed. After slowing on a real final domestic demand basis in the first quarter from the one-two punch of the government shutdown and the fourth quarter’s sharp tightening of financial conditions, the U.S. economy has resumed operating above capacity. Though we check the “sluggish-inflation” boxes, and acknowledge that inflation is not going to inspire a more restrictive turn in Fed policy any time soon, we do think it will become an issue down the road. The Rates Checklist: The Labor Market The labor market remains robust. The headline unemployment rate remains at a level last seen in 1969, and is well below the CBO’s estimate of NAIRU. NAIRU is the minimum structural unemployment rate, and wage gains quicken when the unemployment rate falls below it (Chart 6). The broader definition of unemployment, encompassing discouraged workers and involuntary part-time workers, fell to its lowest level since 2000 in July (Chart 7), and the job openings and job quits rates (Chart 8) indicate that demand for workers remains high. Chart 6Wage Gains Will Accelerate, ... Wage Gains Will Accelerate, ... Wage Gains Will Accelerate, ... Chart 7... As Slack Has Been Absorbed, ... ... As Slack Has Been Absorbed, ... ... As Slack Has Been Absorbed, ... Chart 8... And Demand Is Robust ... And Demand Is Robust ... And Demand Is Robust Chart 9   3.2% year-over-year growth in average hourly earnings may not be thrilling, but wages do remain in an uptrend. The laws of supply and demand (Chart 9), and the Fed’s best efforts, suggest that the uptrend will continue. We do not check any of the labor market boxes, and expect that we will not over the rest of the year. The Rates Checklist: Instability At Home And Abroad Chart 10No Overheating Yet No Overheating Yet No Overheating Yet There continue to be no signs of cyclical overheating in the U.S. economy, as the most cyclical segments of the economy are nowhere near the red end of the tachometer (Chart 10). Financial imbalances have moved to the back burner, but they are part of the Fed’s post-crisis mandate, and we are leaving the imbalances box unticked to reflect that the “low spreads and loosening credit terms” Governor Brainard decried last September2 may stay the Fed from embarking on a full-on easing cycle. We are checking the international duress box, at least for the time being, given the potential for a self-reinforcing rate-cutting cycle that could hold down the entire term structure of rates around the world. Bottom Line: The inverted yield curve, a lack of consumer price inflation, and the cloud cast by the trade war all suggest that bond markets will require some convincing before they allow rates to rise much higher. We conclude that a neutral duration stance is appropriate in the near term. Keeping Score We have been staunch supporters of below-benchmark duration positioning since the end of last July,3 given that we thought the 10-year Treasury yield was too low relative to our assessment of the strength of the U.S. economy and the potential for inflation to begin to rise. It appears that our stronger-than-consensus economic view was correct, but we were myopic in failing to grasp how punk growth in the rest of the world would keep long-maturity Treasury yields from making a sustained move higher. We were way early on inflation’s ETA, and slow to grasp how sensitive the Fed would be to faltering global growth and escalating trade tensions in its absence. In short, both our model of the Fed’s reaction function and the inputs to our model turned out to be faulty. The duration call stings, but our asset allocation recommendations have worked out. The fix we are making is to wait until inflation is a clear and present danger before assuming that the Fed will respond to it. Although we got the duration call wrong, investment-grade and high-yield corporate bonds have outperformed Treasuries in the aggregate since we upgraded them to overweight versus Treasuries at the end of January (Chart 11). BCA as a house niftily sidestepped the fourth-quarter selloff in equities by downgrading them to equal weight, and raising cash to overweight, late last June. We upgraded equities to overweight versus cash and fixed income in our first publication of the year, and the S&P 500 has handily outperformed Treasuries since that date, despite the nasty selloff following the July FOMC meeting and the new round of tariffs (Chart 12). Chart 11Spread Product Has Modestly Outperformed Treasuries, ... Spread Product Has Modestly Outperformed Treasuries, ... Spread Product Has Modestly Outperformed Treasuries, ... Chart 12... But Equities Have Crushed Them ... But Equities Have Crushed Them ... But Equities Have Crushed Them Agency Mortgage REIT Implications We recommended agency mortgage REITs a day before the FOMC meeting, suggesting that investors allocate capital away from equities and high yield as a way to reduce equity beta and boost portfolio income away from the herd chasing lower and lower high-yield bond yields. Through Thursday’s close, the Bloomberg Mortgage REIT Index has gained about 35 bps on a total return basis, while the Barclays High Yield Index is off 70 bps and the S&P 500 is down 2.7%. Unfortunately, the agency mREITs we sought out for their yield curve exposure have lagged badly as the yield curve has relentlessly flattened. For now, only the one agency mREIT with a dedicated adjustable-rate mortgage portfolio faces immediate earnings pressure. The rest are subject to refinancing volumes, which are likely to be higher than we expected when we projected that the 10-year Treasury yield wouldn’t fall much below 2%. The specter of increased prepayments makes the agency mREITs a less attractive investment than we thought they would be two weeks ago. On the other hand, their exclusively domestic exposure, and low credit risk, increases their value as a haven from global turmoil. Net-net, we are sticking with them, though they are now on a far shorter leash than they were when we made the recommendation. We will not stick with a position to save face, or to avoid looking irresolute. Flexibility and a willingness to admit mistakes are essential characteristics of successful investors. When the facts change, we change our mind, without the faintest hint of embarrassment. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the July 24, 2018 U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” available at usbs.bcaresearch.com. 2 Brainard, Lael (2018). “What Do We Mean by Neutral And What Role Does It Play in Monetary Policy,” speech delivered at the Detroit Economic Club, Detroit, Mich., September 12, 2018. 3 Please see the July 30, 2018 U.S. Investment Strategy Weekly Report, “The Rates Outlook,” available at usis.bcaresearch.com.

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

Highlights U.S.-China: The escalation of the trade war has renewed investor fears that uncertainty could create an even deeper drag on global growth, requiring a more aggressive easing of global monetary policy. Fed: The Fed had an opportunity last week to regain control of monetary policy from the markets, but opted for only a cautious rate cut that came off as too hawkish. The FOMC will be forced to play defense in the next 3-6 months, likely by cutting rates more than originally envisioned given the market turbulence stemming from the trade war escalation. Fixed Income Asset Allocation: Raise overall global portfolio duration to neutral on a tactical (0-3 months) basis, at least until equity markets stabilize. Maintain strategic (6-12 months) overweights to global corporate bonds, however, as global leading economic indicators are bottoming. Feature A Painful Repricing Chart of the WeekNot A Pretty Picture Not A Pretty Picture Not A Pretty Picture A long-overdue correction in risk assets, or the start of something more sinister? That is the question investors must now consider. Another Twitter blast from @realDonaldTrump has triggered chaos in global financial markets, with the imposition of fresh U.S. tariffs on Chinese imports. This shattered the market calm since the June G20 meeting, when an announced truce on the U.S.-China trade dispute led to optimism that a real deal could be reached. China retaliated to the new tariffs by allowing the USD/CNY exchange rate to depreciate beyond the perceived line in the sand at 7.0. The trade news came at a bad time for financial markets, a few days after the release of soft global manufacturing PMI data for July that highlighted how global growth remains highly vulnerable to trade war developments (Chart of the Week). The Fed did not help matters by delivering an interest rate cut last week but somehow coming across as hawkish (or, at least, not dovish enough). The market response to the renewed trade tensions and yuan weakness has been classic “macro risk-off” – sharply lower government bond yields, alongside big declines in global equity markets and commodity prices (Chart 2) and increases in the value of typical safe-havens like gold and the Japanese yen (Chart 3). Chart 2Growth-Sensitive Assets Not Doing Well Growth-Sensitive Assets Not Doing Well Growth-Sensitive Assets Not Doing Well Chart 3Safe Havens In Demand Safe Havens In Demand Safe Havens In Demand The nature of the fall in global bond yields has been consistent with what has been seen so far in 2019 – fairly coordinated moves in terms of size, with much smaller changes seen in cross-country yield spreads. This suggests that the unobservable “global” bond yield is falling in response to deteriorating global growth expectations, rather than country-specific factors driving local bond yields. Global trade uncertainty – and what that implies for future weakness in corporate profits, investment and employment – is indeed an “external shock” for every nation. We admit that our current duration recommendations have not been aligned to benefit from these moves. Our forecasting philosophy for government bond yields is based on what our colleagues at our sister service, BCA U.S. Bond Strategy, have dubbed “The Golden Rule of Bond Investing”.1 In that framework, the primary driver of government bond market returns (excess returns over cash, to be precise) is the outcome of central bank policy moves versus what is discounted in interest rate markets. In the U.S., we have been steadfast in our expectation that the Fed would disappoint market pricing that was calling for as much as 90bps of rate cuts over the next 12 months. Global trade uncertainty – and what that implies for future weakness in corporate profits, investment and employment – is indeed an “external shock” for every nation. Chart 4Rate Cuts Required - And Discounted - Everywhere Rate Cuts Required - And Discounted - Everywhere Rate Cuts Required - And Discounted - Everywhere Now, with the President giving markets the unpleasant news that a trade deal with China is not imminent, and new tariffs about to be imposed, the pressure is on the Fed to provide an offset through easier monetary policy. Some are even interpreting the timing of Trump’s latest Tariff Tweet in a Machiavellian fashion, as if he wanted to create more uncertainty to get to Fed to cut rates (and, by association, help deliver Trump’s goal of weakening the U.S. dollar). On the surface, Trump ratcheting up the trade tensions sounds like a risky economic game to play leading up to the 2020 Presidential election. Our colleagues at BCA Geopolitical Strategy, however, note that many of the leading Democratic presidential nominee contenders have themselves been pushing for a more hawkish stance on China. Trump may now feel politically emboldened to become even harder on China himself, to avoid being outflanked by the Democrats – even if it means the U.S. stock market suffers a nasty selloff as a result. Although, again, if the Fed cuts rates as a result, Trump will likely view that as a victory given his constant haranguing of Fed Chair Jay Powell over the past year. With Powell tipping his hand last week that trade uncertainty was something that could trigger additional Fed interest rate cuts, and with Trump now highly incentivized to create that uncertainty, the case for betting against the rate cuts discounted in U.S. interest rate markets has weakened – even though it is still debatable whether the U.S. economy has softened enough to justify a full-blown easing cycle. With Powell tipping his hand last week that trade uncertainty was something that could trigger additional Fed interest rate cuts, and with Trump now highly incentivized to create that uncertainty, the case for betting against the rate cuts discounted in U.S. interest rate markets has weakened Our Central Bank Monitors are now signaling a need for some easing of monetary policy in all the major developed economies, including the U.S. (Chart 4). Even though our 12-month Discounters also show that a lot of easing is already priced into Overnight Index Swap (OIS) curves in those same countries, the amount of cuts discounted is consistent with the dovish message from our Central Bank Monitors. Given the renewed trade tensions, alongside no signs of much improvement in overall global growth momentum, we are less certain at the moment that the amount of cuts discounted by markets will not be delivered. Thus, under our Golden Rule framework, a below-benchmark overall global duration stance is not warranted at this time. Therefore, this week, we are increasing our overall duration stance to neutral from below-benchmark, on a tactical basis. In our model bond portfolio on Page 10, we are implementing this view by “neutralizing” the duration exposures within each country. This is done by keeping the same total country weightings versus the benchmark index, but allocating across all maturities in line with the index weightings within each country. This adds about one-half of year of duration to the model portfolio to bring it up the same level as the benchmark index, but without altering the overall allocations to countries or spread product sectors. What To Do Beyond The Short-Term? Chart 5A Lot Of Bad News Discounted In Bond Yields A Lot Of Bad News Discounted In Bond Yields A Lot Of Bad News Discounted In Bond Yields Despite the near-term concerns and volatility stemming from the increased trade tensions, we do not advocate moving to a more defensive portfolio allocation (above-benchmark duration, underweight corporate bonds) to position for a deeper global growth slowdown, for the following reasons: A lot of bad news is already discounted in global bond yields. The rally in government bond markets this year has pushed bond yields down to stretched levels using typical valuation metrics (Chart 5) like the 5-year OIS rate, 5-years forward; the term premium on 10-year yields, and market-implied inflation expectations from CPI swaps or inflation-linked bonds. Additional sustainable declines will be harder to achieve from current levels. The U.S. economy is still holding up relatively well, especially compared to other major economies. Although the U.S. manufacturing sector data has slowed, U.S. Treasury yields already are in line with the diminished readings of the ISM Manufacturing index, which is still above the 50 level signifying expanding activity (Chart 6). The non-manufacturing (services) side of the economy has not seen the same degree of slowing, while consumer confidence and retail sales have both picked up of late. Also, the mean-reverting U.S. data surprise index – which is correlated to the momentum of bond yields – is very stretched to the downside, suggesting less downside potential for Treasury yields from weak U.S. data (Chart 7). Chart 6UST Yields Consistent With Slower Manufacturing UST Yields Consistent With Slower Manufacturing UST Yields Consistent With Slower Manufacturing In addition, the easing of U.S. financial conditions from the 2019 rally in U.S. equity and credit markets before the past few days does suggest a rebound in U.S. growth is likely beyond the next few months. It will take much bigger market declines than seen so far, something beyond a mere “garden-variety” correction in U.S. equities, to tighten financial conditions enough to offset the prior loosening. Chart 7Treasuries Are Vulnerable To Better Data Treasuries Are Vulnerable To Better Data Treasuries Are Vulnerable To Better Data Early leading indicators are flashing a future bottoming of global growth. Several of the more reliable leading economic signals, like our global LEI diffusion index and the China credit impulse, are both flashing the potential for a rebound in global growth to begin around the end of the year (Chart 8). If Chinese policymakers choose to offset the negative domestic economic impact of the new Trump tariffs with even more stimulus measures, as seems likely, then the odds of an eventual growth rebound would improve – especially if there is also a healthy dose of monetary easing from the Fed, ECB (both rate cuts and renewed asset purchases) and other major central banks. Early leading indicators are flashing a future bottoming of global growth. Summing it all up, we see the best way to protect against the risks of an even deeper near-term selloff in risk assets is to increase duration by buying liquid government bonds, rather than reduce credit exposure by selling less liquid corporate bonds. It would take signs that the improvement in leading economic indicators is reversing to justify downgrading global corporate bond exposure. We think it more likely that we’ll be reducing our recommended duration exposure back to below-benchmark sometime in the next few months. We will be watching news on global trade, China stimulus and U.S. non-manufacturing growth before making the next change to our duration call. We see the best way to protect against the risks of an even deeper near-term selloff in risk assets is to increase duration by buying liquid government bonds, rather than reduce credit exposure by selling less liquid corporate bonds. With regards to country allocation within developed market government bonds, we are choosing to stick with our current recommendations: overweight core Europe, the U.K., Japan, Australia and Spain; underweight the U.S. and Italy; and neutral Canada (Chart 9). Those allocations have served us reasonably throughout 2019, with the bulk of the overweights outperforming the Bloomberg Barclays Global Treasury index in hedged USD terms, and the U.S. actually only just matching the global hedged benchmark (thanks to the yield pickup for non-U.S. debt from hedging currency exposure back to higher-yielding U.S. dollars). Chart 8A Light At The End Of The Tunnel? A Light At The End Of The Tunnel? A Light At The End Of The Tunnel? Chart 9We're Sticking With Our Country Allocations We're Sticking With Our Country Allocations We're Sticking With Our Country Allocations Only in the case of Italy, were we have maintained an underweight stance given our concerns about weak Italian growth and the implications for debt sustainability, have we seen a significant underperformance of our recommendation. At current yield/spread levels, however, we remain reluctant to simply chase higher-yielding Italian bond yields in the absence of any sign of improving Italian growth that would justify lower Italian risk premia. Bottom Line: The escalation of the trade war has renewed investor fears that trade could create an even deeper drag on global growth, requiring a more aggressive easing of global monetary policy. Raise overall global portfolio duration to neutral on a tactical (0-3 months) basis, at least until equity markets stabilize. Maintain strategic (6-12 months) overweights to global corporate bonds, however, as global leading economic indicators are bottoming.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Trade War Worries: Once More, With Feeling Trade War Worries: Once More, With Feeling Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Markets expressed disappointment over last week’s FOMC meeting, … : Equities sold off, Treasury yields slid, and the curve flattened. … but we didn’t think there was all that much to get excited about, … : Data dependence remains the Fed’s mantra, and it was never likely that the FOMC would signal that policy through September has been pre-programmed. … though the specter of escalating trade tensions was a bummer: We have followed our repeated exogenous-shock caveat with an acknowledgement of the gravity of trade barriers. Our geopolitical strategists don’t expect a resolution any time soon, though, and White House tweets are here to stay. Marginally easier monetary policy is not likely to have all that much of an effect on the economy: A reduction in the fed funds rate from 2.5% to 2% isn’t likely to turbo-charge housing or corporate investment, but we do expect that the major central banks’ easing bias will support risk assets. Feature The FOMC delivered the result we expected at the conclusion of its meeting last week: a 25-basis-point cut and a dovish adjustment to its balance sheet runoff plans. Markets acted as if they’d been blindsided. Apparently it really isn’t what you say, it’s how you say it. Or maybe, as our colleague Martin Barnes has long contended, press conferences and all the other assorted communications strategies do more harm than good. We have nearly reached the point of Fed fatigue ourselves, but there’s no ignoring the elephant in the room. The Fed is squarely in the center of every investor’s mind and may well remain there for the rest of what was shaping up as a slow-news month before the latest tariff move. American and Chinese negotiators have called it quits until September; lawmakers have left the building in London and Brussels; the ECB’s Governing Council will be idle until mid-September; and the winnowing of the Democratic field is so far off that even Bill de Blasio remains a presidential candidate. We devote this week’s report to an examination of increased accommodation’s implications for financial markets and the U.S. economy. What did the FOMC do on Wednesday? Chart 1An Adjustment, Not A New Direction An Adjustment, Not A New Direction An Adjustment, Not A New Direction The FOMC cut the fed funds rate by 25 basis points, to a range of 2-2.25%, and terminated its modest balance sheet reduction effort two months ahead of time. It studiously kept its options open with regard to future policy rate adjustments, with Chair Powell describing the cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. The mid-cycle reference kiboshed hopes that the cut was meant to bring the curtain down on the tightening cycle that began at the end of 2015 (Chart 1). The hawkish surprise concerning the future direction of the fed funds rate overwhelmed the modestly dovish news that the Fed is immediately ending small-scale quantitative tightening. How did markets take the developments? Not so well, especially over the two hours of Wednesday afternoon trading following the decision. The S&P 500 sold off by close to 2% during the press conference, the dollar surged against the euro, and the yield curve flattened as long-dated Treasuries surged while the 2-year note sold off sharply. Equities recovered their losses in Thursday morning’s trading, though bonds and the dollar held much of their gains, before the latest salvo in the U.S.-China dispute sent investors in all markets scurrying for cover. Overall, financial markets were disappointed that they didn’t get a clearer signal that additional accommodation is on the way. Did markets overreact? In retrospect, it looks like they’d gotten their hopes up too high. The Fed wants to avoid surprises by keeping markets apprised of future developments, but it’s hard to envision it deliberately boxing itself in. It wants to preserve the flexibility to act as it sees fit, so data dependence remains the order of the day, just as it has for the last several years. We continue to take the Fed at its word that policy is not on a pre-set course. Markets seemed to be looking for a little more solicitousness from the Fed. Central bankers will presumably always attempt to guard their discretion, but the monetary policy path is far from clear, given elevated economic uncertainty. Between the stop-and-start trade hostilities with China and the Whack-a-Mole emergence of tariff threats against long-standing allies and trade partners, global manufacturing is reeling and corporate managers have every reason to hold back on capex. The differences of opinion within BCA reflect the lack of an obvious economic direction. Dissention within the Fed – Boston’s Rosengren and Kansas City’s George voted against last week’s cut, while Minneapolis’ Kashkari surely wanted it to be larger – shows that the way forward is not so clear-cut. So is it a good thing or a bad thing that the Fed cut rates? We view easier policy as a market positive over the one-year timeframe that drives most investors. There will come a point of diminishing returns, when risk assets no longer respond to incremental accommodation, but we don’t think we’re there yet. Equity multiples have room to expand before they become silly and the ECB is apparently preparing a new round of asset purchases. Given that it’s exhausted the supply of Eurozone sovereigns, it will have to proceed to evicting incumbent holders from their positions somewhat further out the risk curve, prodding them to venture out still further to redeploy the proceeds, putting downward pressure on spreads globally. How will a lower fed funds rate impact the economy? How much time do you have? The textbook answer is that a lower fed funds rate directly reduces the cost of financing big-ticket consumer purchases and corporate initiatives while indirectly nudging households and corporate managers to make them by boosting their confidence. Unconventional measures like asset purchases (QE) push investors further out the risk curve, lifting the prices of risky assets, lowering lending spreads and increasing asset holders’ wealth. They also promote a broader sense of well-being (the CNBC screen is framed in green, print headlines are cheerful, and jobs are increasingly easier to find), fueling confidence that helps reinforce the direct effects of easier policy. As Chair Powell put it in January, “Our policy works through changing financial conditions[,] … it’s … the essence of what we do.” The logic behind the textbook answer is undeniably sound, and it’s displayed in the simple six-channel model in Figure 1. People respond to incentives, and when the cost of consumption and investment falls, they are likely to save less and consume and invest more (Interest Rates/Substitution Effect). Increasing numbers of observers are becoming restless, however, as events on the ground don’t seem to jibe with the theory. Ten years of a negative real fed funds rate has failed to generate much oomph, and markets sputtered on cue once it tiptoed into positive territory (Chart 2), coinciding with the current global economic softness. Chart Chart 2Real Rates Are Still Low Relative To History Real Rates Are Still Low Relative To History Real Rates Are Still Low Relative To History Martin Barnes, our resident grumpy economist, scoffs at how little extraordinary accommodation has been able to achieve. (Don’t get him started on the communication strategies.) Even after adjusting for how a half-century of Scotland and Montreal weather has colored his perspective, he has a point. “Do you really want to buy equities and riskier bonds in an economy that needs this much help just to grow at 2%?” he might ask. For the time being, yes, we still do. Although the channels promoting economic activity are not functioning as reliably as they have in the past, the channels boosting asset prices – Portfolio Balance, Confidence/Risk Taking, and Interest Rates/Substitution – are still A-Okay (Figure 1). The initial reaction to the FOMC meeting suggests that it will be very hard for the Fed to surprise dovishly in a relative sense, blocking the Currency channel for the time being. The Credit channel is still hindered by post-crisis regulations from Basel to Capitol Hill, at least in terms of the official banking system. Trade tensions have roiled net exports via retaliatory tariffs and suppressed global aggregate demand.1 Shouldn’t housing be at the forefront of any pickup in activity? Chart 3Lower Rates Haven't Helped Much Yet Lower Rates Haven't Helped Much Yet Lower Rates Haven't Helped Much Yet Housing is the classic proxy for tracing the effects of easier policy on the domestic economy, since nearly all of its end consumers finance their purchases, and its domestic concentration insulates it from trade effects. It has failed to respond much to the monetary policy shifts that have brought 30-year fixed mortgage rates down nearly 100 basis points year to date (Chart 3). Fed skeptics suggest that the muted response is evidence of the declining efficacy of easy policy, though we have been inclined to read the data as an indication that homebuilders aren’t building enough starter and move-up homes to bring homeownership within reach of first-time homebuyers and median-income households. Housing should exhibit a high sensitivity to changes in monetary policy, but an abundance of other debt burdens and a lack of affordable supply may be holding it back.   One should have expected that the housing pickup would be muted, and slower to take hold in this expansion, given the severity of the recession and its mortgage-lending roots. Adjusted for inflation, private residential investment, which has declined slightly for four straight quarters, is just over two-thirds of its 2005 peak (Chart 4, middle panel). In the past, residential investment has been more sensitive to the level of the fed funds rate than its direction. Since 1961, the Fed has hiked rates in as many quarters as it has cut them, and the difference in annualized growth has been relatively modest: 2.8% when the Fed has been cutting rates, and 1.6% when it’s been raising them. Chart 4Residential Investment Responds To The Monetary Policy Backdrop... Residential Investment Responds To The Monetary Policy Backdrop... Residential Investment Responds To The Monetary Policy Backdrop... Per our equilibrium fed funds rate framework, we deem monetary policy to be accommodative when the fed funds rate is below our estimate of equilibrium, and restrictive when the funds rate exceeds it (Chart 4, top panel). Despite the fact that the Fed has hiked as often as it has cut since 1961, we estimate that policy has been easy for two-thirds of the time, and the difference in residential investment growth in the two policy states has been dramatic: 6.8% when policy is easy and -6.6% when policy is tight (Chart 4, bottom panel). With the Fed keeping policy easy for longer, housing will have the wind at its back, though it isn’t much more than a breeze at the moment. The same goes for construction employment, which has grown more rapidly under accommodative monetary policy (2.1% versus 0.7% when policy is tight), but has merely treaded water over the last 11 years of easy policy (Chart 5). Chart 5... And So Does Construction Employment ... And So Does Construction Employment ... And So Does Construction Employment The bottom line is that the jury is still out on housing activity. Low mortgage rates will help renters buy homes (and fill them with furniture and appliances), and put more cash in the pockets of homeowners who refinance their existing loans, but the market remains soft. Though it can’t be captured by the aggregate data, it does seem possible that median-income households may be burdened by too much student loan, automobile and/or credit card debt to save the required down payment.2 Disparities between households may well be holding the economy back, but they have a silver lining if they encourage the Fed to pursue accommodative policies for longer than it otherwise would. Will rate cuts give the economy a tangible lift? We don’t know for sure, but no one else does, either. We are convinced that easier monetary conditions will help the economy at the margin. Ten years into the expansion, though, it is not clear if the economy has pent-up demand that easier conditions will help release. Externally, worsening trade tensions could exacerbate the global manufacturing slowdown, further squeezing global aggregate demand, and exporting recession pressures to the U.S. Our mandate is not to forecast the economy in itself, though. We and our clients are investors, not government officials or public-policy professors, and we focus on the economy only to the extent that it impacts financial markets. In the near term, incremental accommodation should boost risk asset prices, provided that trade tensions don’t ratchet up enough to undermine investor, consumer and business confidence. Animal spirits matter, and if they shift decisively from greed and toward fear, they can become a self-fulfilling prophecy that sweeps monetary policy efforts before them. Ex-a significantly negative exogenous event, we remain constructive on the U.S. economy, and continue to look for a global revival outside of the U.S. Investment Implications The incremental information received this week – an FOMC meeting that mostly went off as we expected, a modest escalation in U.S. pressure on China in line with our geopolitical strategists’ warnings that a final deal is not at hand, mixed global manufacturing PMIs, a surge in U.S. consumer confidence, a straight-down-the-middle employment situation report, and an upward inflection in S&P 500 earnings growth that has 2Q EPS now tracking to a 2.7% year-over-year gain – did not change our perspective. We see U.S. economic growth decelerating from its 2018 pace, but remaining above trend, and an absence of imbalances that would make the economy more vulnerable. We have made our peace with recurring flare-ups of hostilities between the U.S. and China, and trade tensions will only change our investment outlook if they worsen materially. The Fed is not magic, but it is doing the best it can to keep the expansion going for the purpose of spreading its gains as broadly as possible, and the easing bias among major central banks is gathering force. On balance, the new information received last week didn’t do anything to change our overall take. We remain constructive, and think investment portfolios should as well. We recognize that the climate is uncertain, and that we should accordingly dial back our conviction. Part of the reason the agency mortgage REITs appeal to us at this juncture is that they offer the opportunity to reduce equity beta and enhance a balanced portfolio’s capacity to absorb shocks. We watched the flattening in the yield curve with dismay, but we continue to expect that incremental monetary accommodation will promote a steeper curve. Easier monetary conditions promote growth, boosting the real component of interest rates, and can stoke inflation pressures when an economy is operating at or above capacity, as the U.S. has been for over a year. We remain vigilant, but our base-case constructive take is unchanged.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 As we were preparing to go to press on Thursday, the U.S. announced the imposition of new tariff levies on the subset of Chinese imports that hadn’t yet been subjected to tariffs. The move supported our geopolitical strategists’ view that the trade war is unlikely to be settled soon. 2 Andriotis, AnnaMaria; Brown, Ken; and Shifflett, Shane, “Families Go Deep in Debt to Stay in the Middle Class,” Wall Street Journal, August 1, 2019.

Highlights Fed: The Fed will deliver a 25bp rate cut this week, despite a firmer tone to recent U.S. economic and inflation data, and the door will be left open to an additional “insurance” cut in September. ECB: The ECB will unveil a package of easing measures, from interest rate cuts to restarting asset purchases – including a healthy dose of corporate bond buying – in September. Fixed Income Strategy: The Fed is more likely to disappoint deeply dovish market expectations than the ECB over the next 6-12 months. European fixed income should outperform U.S. equivalents, both for government bonds and corporate debt, especially with the ECB ready to buy bonds again. Stay overweight Bunds vs Treasuries and euro area corporate debt vs U.S. equivalents on a USD-hedged basis. Feature Chart of the WeekData To Satisfy Both The Optimists & Pessimists Data To Satisfy Both The Optimists & Pessimists Data To Satisfy Both The Optimists & Pessimists In normal years, the final days of July are a quiet time for financial markets, with investors focused on preparations for August vacations rather than fretting about the performance of their portfolios. This is not one of those years. Central banks are springing into action to combat a global manufacturing downturn, creating a peculiar divergence of market price signals - elevated stock prices and depressed bond yields. BCA exposed our own internal debate on the growth outlook, and the implications for financial markets, in a recent Special Report.1 Our latest discussions with clients show similar splits within investment committees. While Global Fixed Income Strategy is in the optimist camp at BCA, we do recognize that there is enough news and data at the moment to satisfy both bullish and bearish investors (Chart of the Week). The growth bears can point to the continued deceleration of global trade and manufacturing data, with our global PMI indicator now sitting below the 2015/16 lows. The bulls, on the other hand, can highlight the bottoming of forward-looking data like our global leading economic indicator or the pickup in Chinese credit growth. Most importantly, the bulls are having a very enjoyable summer with interest rate cuts expected from the Fed and ECB, and the latter likely to restart quantitative easing. In this Weekly Report, we focus on monetary policy – specifically, the outlook for the Fed and ECB’s next moves over the next few months – and the implications for financial markets. Our conclusion is that the likely policy choices will benefit the relative performance of European fixed income markets versus U.S. equivalents over a 6-12 month horizon. The ECB’s Next Move: See You In September Chart 2A "Manufacturing-Only" Slump A "Manufacturing-Only" Slump A "Manufacturing-Only" Slump The global trade downturn has hit growth in the U.S. and Europe in a similar fashion, with PMI data showing substantially weaker activity in manufacturing compared to more domestically focused service industries (Chart 2). In Europe, there is an unprecedented divergence, with the services PMI rising and the manufacturing PMI plummeting over the past several months. At his press conference after last week’s monetary policy meeting, ECB President Mario Draghi described the European manufacturing data as “getting worse and worse”. He is right, as evidenced by the downtrends seen in other cyclical data like the ZEW and IFO surveys. European bond markets are betting that the ECB will focus on the manufacturing side of the export-heavy euro area economies and will soon ease monetary policy. Draghi gave strong indications that the ECB will deliver a package of easing measures at the September policy meeting, ranging from interest rate cuts to restarting the Asset Purchase Program (APP) for both government and corporate debt. Bond investors have been making large bets on the ECB delivering a big easing, with European bond yields plummeting to new cyclical lows. Investors remain highly skeptical that robust, inflationary growth – and higher interest rates – will ever return to Europe. The surge in the amount of debt trading at negative yields has gotten the attention of the market. By our count, 53% of all government bonds in the developed economies are now trading with a negative yield, with much of those in Europe (Chart 3). Investors are reaching for anything with a positive yield, including formerly toxic debt like Italian and Greek government bonds, with the benchmark 10-year yields in those markets now down to 1.6% and 2.1%, respectively. The rally has extended into spread product, creating oddities such as shorter-maturity EUR-denominated emerging market bonds – some with credit ratings below investment grade – trading at negative yields.2 From a longer-term perspective, the European bond rally continues a trend seen over the past decade where the relative performance of European equities versus government bonds, a.k.a. the stock-to-bond ratio, has been anemic compared to the similar metric in the U.S. (Chart 4). Investors remain highly skeptical that robust, inflationary growth – and higher interest rates – will ever return to Europe. Chart 3Positive Yields Are Getting Harder To Find Positive Yields Are Getting Harder To Find Positive Yields Are Getting Harder To Find Chart 4Structural Market Pessimism On Europe Structural Market Pessimism On Europe Structural Market Pessimism On Europe From a cyclical perspective, the case for a comprehensive easing package from the ECB now is a strong one, for several reasons: There is a broad-based slowing of growth and inflation within the euro area. Our diffusion indices of individual country data for real GDP growth and the OECD’s leading economic indicators show that the overwhelming majority of euro area nations are seeing slowing growth (Chart 5). Similar readings coincided with multiple interest rate cuts in 2001, 2008/09 and 2012. Chart 5Good Reasons For An ECB Rate Cut Good Reasons For An ECB Rate Cut Good Reasons For An ECB Rate Cut Chart 6Can The ECB Stop A Credit Crunch In Italy? Can The ECB Stop A Credit Crunch In Italy? Can The ECB Stop A Credit Crunch In Italy? Realized inflation and inflation expectations remain muted. Our diffusion indices for inflation rates among euro area countries are more mixed, with almost all nations actually seeing a slight uptick in core inflation over the past three months (bottom panel). Yet given the plunge in market-based inflation expectations, with the 5-year/5-year forward EUR CPI swap rate now down to 1.35%, the ECB must focus on trying to put a floor under growth to stabilize inflation expectations. Banks are starting to tighten lending standards. The ECB’s latest Bank Lending Survey showed a sharp tightening of lending standards to businesses during Q2/2019 (Chart 6) in France and, more worryingly, Italy where loan growth has been contracting on a year-over-year basis. The ECB already took action back in March to introduce a new targeted bank funding program (TLTRO3), largely to prevent a possible credit crunch in Italy where cheap ECB loans have funded 10% of total Italian bank lending. Yet with Italian banks already tightening lending standards to domestic borrowers, the ECB must take other actions to fight off a deeper contraction in Italian corporate loans. So what can the ECB plausibly do to ease monetary conditions that are already very loose? Cut the deposit rate. Given the ECB’s large balance sheet, swollen by asset purchases, the deposit rate on the excess reserves of banks is now effectively the ECB’s main policy rate. The deposit rate is currently -0.40%, and the ECB is concerned about the impact on European bank profitability by pushing that rate even deeper into negative territory. Draghi noted in his press conference last week that the ECB would consider “tiering” interest rates on excess deposits – essentially, exempting portions of European banks’ excess reserves from being charged negative deposit rates – to help offset the hit to bank profits from negative rates. Chart 7The ECB Can Help Finance European Companies The ECB Can Help Finance European Companies The ECB Can Help Finance European Companies Tiering has been introduced in other countries with negative deposit rates (Japan, Switzerland, Denmark), with limited impacts on bank profitability. The experience of those countries, however, suggests that an introduction of tiering by the ECB could put a floor under interest rate expectations, as it would indicate that additional rate cuts would be too damaging for European bank profitability to be considered by the ECB. For that reason, the ECB could decide to cut rates in September, but without tiering to ensure the maximum effect on European interest rates and bond yields. Restart the Asset Purchase Program (APP). This option is the most intriguing, as it would be a more direct way for the ECB to directly lower the cost of borrowing for European companies where credit conditions are becoming tighter. During the corporate bond buying phase of the APP in 2016-2018, the ECB was not only buying bonds in the secondary market but was buying corporates in the primary (new issue) market. At the peak, the central bank was buying around 18% of all the primary issuance by euro area companies eligible for the APP (Chart 7). This allowed many smaller European companies that relied entirely on bank loans to begin issuing publicly traded corporate bonds to diversify their sources of funding, with the ECB as a guaranteed buyer – in some cases, at interest rates even lower than corporate bank lending rates. With the ECB having fewer constraints on its corporate bond buying (i.e. no Capital Key as in the case of government bond purchases), the big policy surprise in September could be a bigger focus on corporates over sovereigns in the restarted APP. That would be good news for euro area corporate bond performance.  Chart 8Markets Discounting New ECB Corporate Bond Purchases? Markets Discounting New ECB Corporate Bond Purchases? Markets Discounting New ECB Corporate Bond Purchases? Investors seem to have already priced in some expectation of a resumption of the ECB’s corporate bond buying program, as euro area credit spreads have tightened sharply despite weakening economic growth (Chart 8). The spread tightening has occurred across all countries and investment grade credit tiers, pushing valuations back to towards the levels seen during the height of the ECB’s last period of corporate bond buying in 2017. The ECB will likely have to start out fairly aggressively with its pace of corporate bond buying, likely with more than €10bn/month, to justify current valuations. With the ECB having fewer constraints on its corporate bond buying (i.e. no Capital Key as in the case of government bond purchases), the big policy surprise in September could be a bigger focus on corporates over sovereigns in the restarted APP. That would be good news for euro area corporate bond performance. Bottom Line: The ECB will unveil a package of easing measures, from interest rate cuts to restarting asset purchases – including a healthy dose of corporate bond buying – in September. The Fed’s Next Moves: Insurance Cuts In July & September, No More After That The latest batch of data from the U.S. suggests that tomorrow’s widely-expected Fed rate cut will not be the start of a full-blown easing cycle. Expect a 25bp cut, with forward guidance suggesting another 25bps in September to protect against the adverse effects on the U.S. from any additional trade policy uncertainty and the associated deterioration of non-U.S. economic growth. Any further easing beyond that is unnecessary given the current state of U.S. growth and inflation. While the year-over-year growth rates of real GDP and core durable goods orders have slowed, the annualized changes over the past six months have shown some reacceleration (Chart 9). Consumer spending has also perked up after the sharp drop fueled by the government shutdown back in January, while the lagged impact of the sharp fall in mortgage rates over the past year should provide a moderate boost to housing activity. A similar dynamic is seen on the inflation front, where the marginal 6-month annualized rate of change of core PCE inflation has picked up to 2% (Chart 10). Less volatile inflation gauges like the Dallas Fed’s trimmed mean core PCE inflation rate are also at 2%. Furthermore, one of the main causes of the unexpected downturn in core PCE inflation in 2018, the Financial Services component, is already rebounding – a trend that will continue given the U.S. equity market’s strong gains in 2019 (bottom panel). Chart 9U.S. Growth Rebounding U.S. Growth Rebounding U.S. Growth Rebounding Chart 10U.S Inflation Rebounding U.S Inflation Rebounding U.S Inflation Rebounding Look for the Fed to signal a cautious tone tomorrow, but without sounding overly pessimistic on U.S. growth prospects. Bottom Line: The Fed will deliver a 25bp rate cut this week, despite a firmer tone to recent U.S. economic and inflation data, and the door will be left open to an additional cut in September. Additional moves after that are unlikely, given signs of reaccelerating momentum in U.S. economic growth and inflation. Investment Implications For The U.S. Versus Europe Over The Next 6-12 Months Looking ahead over the rest of 2019, relative economic performance should continue to favor the U.S. over Europe, creating a backdrop where relative monetary policies will support euro area fixed income returns versus U.S. equivalents.  Looking ahead over the rest of 2019, relative economic performance should continue to favor the U.S. over Europe, creating a backdrop where relative monetary policies will support euro area fixed income returns versus U.S. equivalents. Chart 11Too Soon To See An Export-Led Rebound In Europe Too Soon To See An Export-Led Rebound In Europe Too Soon To See An Export-Led Rebound In Europe The European economic downturn seen over the past year has come almost entirely from the trade side, when looking at the contributions to real GDP growth from net exports and domestic demand (Chart 11). This is also consistent with the manufacturing/services gap discussed earlier in this report, given the large share of manufactured goods in overall euro area exports. China will play a huge role in determining the future path of European economic growth through the trade channel, and already the pickup in Chinese credit growth is heralding a future rebound in European exports to China (third panel). A recovery in euro area exports to other countries besides China is also in store, based on our global leading economic indicator diffusion index (i.e. the net number of countries seeing a rising leading indicator). Yet given the long lead time before changes in those leading European export indicators and the subsequent growth of European exports – between 9-12 months – an improvement in euro area exports will not be visible in the hard data until late in 2019. It will likely be even longer than that given the additional publishing lags of the export data. Importantly, while the recent headlines have provided grounds for more cautious optimism on U.S.-China trade talks, any breakdown on that front would potentially delay any recovery in euro area exports (even if that is met by a bigger policy stimulus from China). At the moment, the U.S. economy is better positioned to withstand a renewed bout of trade uncertainty than the euro area, even though U.S. growth would take a hit through higher market volatility and tighter financial conditions if investors turn more risk averse on another failure of U.S.-China trade talks. Chart 12Not Much Downside Left For Bond Yields Not Much Downside Left For Bond Yields Not Much Downside Left For Bond Yields So after looking at the relative outlooks for economic growth in the U.S. and Europe, and the likely paths to be taken by the Fed and ECB, we come up with the following fixed income investment recommendations: Maintain below-benchmark overall global duration exposure: At an overall portfolio level, we continue to recommend a moderate below-benchmark global duration stance (Chart 12). Our global leading economic indicator diffusion index suggests that global real yields should soon bottom. At the same time, the annual rate of change of oil prices will accelerate over the rest of the year simply based on comparisons versus the sharp plunge in energy prices in the latter months of 2018. If the bullish oil forecast of BCA’s commodity strategists comes to fruition, the growth rate of oil prices will be even higher (see the “X” in the middle panel of Chart 12). Given the correlations between market-based inflation expectations and oil prices, a rebound in oil on a rate of change basis should put a floor under the inflation expectations component of government bond yields in the developed markets. Expect a rebound in the Treasury/Bund spread: The ECB is more likely to deliver on the policy expectations for the next twelve months discounted in Overnight Index Swap curves (-22bps of rate cuts) compared to the Fed (-89bps of rate cuts). This suggests that the spread between 10-year U.S. Treasury yields and 10-year German Bund yields is likely to widen, but coming first through higher relative market-based U.S. inflation expectations - a trend that is already starting to unfold (Chart 13).   ECB rate cuts, and the return of the ECB as a buyer of euro area non-financial corporate debt, will provide an obvious boost to the relative performance of euro area corporate debt (both investment grade and high-yield) over U.S. equivalents. Favor euro area corporates versus U.S. corporates: ECB rate cuts, and the return of the ECB as a buyer of euro area non-financial corporate debt, will provide an obvious boost to the relative performance of euro area corporate debt (both investment grade and high-yield) over U.S. equivalents. Another factor supporting European corporates is the better state of financial health among euro area companies, according to our Corporate Health Monitors (Chart 14). Chart 13Inflation Expectations Bottoming Out, Led By The U.S. Inflation Expectations Bottoming Out, Led By The U.S. Inflation Expectations Bottoming Out, Led By The U.S. The gap between the “bottom-up” versions of the Monitors tracks the spread differentials of the benchmark corporate bond indices quite closely, and is currently pointing to a more solid fundamental underpinning for euro area corporates on a cyclical (6-12 months) horizon. Chart 14Favor Euro Area Corporates Over U.S. Corporates Favor Euro Area Corporates Over U.S. Corporates Favor Euro Area Corporates Over U.S. Corporates   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open”, dated July 19, 2019, available at bca.bcaresearch.com and gfis.bcaresearch.com. 2https://www.bloomberg.com/news/articles/2019-07-15/em-succumbs-to-sub-zero-epidemic-as-debt-pile-doubles-in-a-weekD The GFIS Recommended Portfolio Vs. The Custom Benchmark Index A Cure For The Summertime Blues A Cure For The Summertime Blues Recommendations Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (see chart). Bottom Line: On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Will The Fed Save The Day? Will The Fed Save The Day?

Fed Easing Demystified Fed Easing Demystified The stock market seems invincible despite increasing negative news flow both domestically and abroad, as bad economic news is translating into good news for stocks. Why? Because the mighty Fed’s (and other central banks’) looming easing cycle will save the day. However, taking a closer look at the relationship between stock market momentum and fed funds rate expectations is instructive. The middle panel of the chart showcases the leading properties of the bond market and suggests that SPX momentum will soon deflate. Importantly, zooming in the post-Mexican peso devaluation (Tequila Crisis) in December 1994 offers a close parallel to today. Back then, as the stock market was rebounding in Q1/1995 from the previous quarter’s drawdown, the bond market started pricing three Fed cuts, steeply diverging from stock market euphoria. Eventually, stocks came back to earth. Fast forward to today and short term momentum has surged in a near carbon copy to 1995, while bond investors are pricing in four Fed cuts. This divergence is unsustainable and will likely narrow via a fall in the former. Bottom Line: We would refrain from chasing this market higher and re-iterate our cautious broad market cyclical (3-12 month horizon) stance.  

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.

Highlights Global inflation will slow further, allowing central banks to ease policy. Liquidity indicators will have more upside as monetary policy will remain accommodative. Widening fiscal deficits, easing Chinese credit trends and rising U.S. consumer real income levels, all will allow improved liquidity to boost global growth in the second half of 2019. Important indicators are already flashing an increase in global growth. Yields have upside; keep a below-benchmark duration within bond portfolios. Commodity plays will perform well. The 12-month outlook for stocks remains positive, but they will churn over the coming six months. Equities will nonetheless outperform bonds. Favor cyclicals over defensives and international equities over the U.S. Feature Treasury yields are stuck near 2%, yet the S&P 500 is flirting with all-time highs. Investors are worried about global growth, still hoping that central banks will step in. The fears are well-placed: manufacturing has not stabilized, Asian trade is contracting, and the U.S. real estate sector is in the doldrums. Other concerns include the threat of U.S. President Donald Trump re-igniting the trade war and the U.S. corporate sector’s growing debt load. The positive news is that global inflation will remain low for the next 12 months or so. Without prices accelerating upward, global policymakers will continue to ease monetary and fiscal conditions. Consequently, nascent improvements in global liquidity conditions will blossom and growth will rebound in the second half of the year. Increased growth creates a paradox. At current levels, it is bearish for bonds and bullish for commodities. However, stock valuations will be undermined by higher bond yields, especially because earnings should experience additional downside this year. Consequently, the S&P 500 will churn sideways for the coming three to six months before taking off. In the meantime, stocks should outperform bonds. Blessed By Low Inflation The best news for the global economy is that inflation will stay low. Our U.S. Bond Investment Strategy colleagues recently showed that when the private sector does not quickly build large debt loads, rising inflation prompts all the post-war recessions.1  Today, the private sector’s debt vulnerability is limited. Nonfinancial private-sector leverage has only expanded by 2.1 percentage points of GDP since its trough four years ago (Chart I-1). In particular, after a drop from 134% to 106%, the household sector's debt-to-disposable income ratio has flat-lined for the past three years. Meanwhile, household debt-servicing costs as a percentage of after-tax income are at multi-generational lows. Even in the corporate sector, excesses are smaller than they appear. Despite accumulating US$5 trillion in credit since 2009, the nonfinancial corporate sector’s debt-to-asset ratio remains below its historical average of 22.4%. This sector is also generating free cash flows equal to 2.1% of GDP. Prior to recessions, the corporate sector consumed cash instead of generating it.2 Chart I-1No Excessive Debt Built-Up In The U.S. No Excessive Debt Built-Up In The U.S. No Excessive Debt Built-Up In The U.S. In this context, we are optimists because inflation is set to slow, leaving policymakers around the world a window to maintain generous monetary conditions and support growth. At the global level, we currently see a paucity of inflation. Among advanced economies, average core inflation is only 1.5%. Moreover, only 15% of these nations are experiencing rates of underlying inflation above the critical 2% level (Chart I-2). Chart I-2Global Inflation Will Stay Tame Global Inflation Will Stay Tame Global Inflation Will Stay Tame Going forward, risks are skewed toward a deceleration in prices. Inflation is the most lagging economic variable. Thus, the recent global economic slowdown will continue to exert downward pressure on prices. Singapore, a country highly dependent on trade, is an excellent barometer for global cyclical sectors. In the second quarter of 2019, Singapore’s annual GDP growth declined to 0.1%, its lowest level since the Great Financial Crisis. Historically, this has presaged a marked deceleration in global core CPI (Chart I-2, bottom panel). The weakness in global inflation also will translate into lower U.S. underlying inflation. U.S. import prices (excluding oil) are contracting by 1.4% on an annual basis. Despite U.S. tariffs, import prices from China are also shrinking by 1.5%, the deepest retrenchment since the deflationary scare of 2016. This will weigh on the price of U.S. goods. U.S. activity suggests imported disinflation will spill over into overall core CPI. Since 2009, the changes in the ISM manufacturing index and the annual performance of transport stocks relative to utilities have led core inflation (Chart I-3). Based on these relationships, core CPI should slow markedly. Pipeline inflation measures suggest this is a fait accompli. Core crude producer prices are melting, signaling lower inflation excluding food and energy. Chart I-3Deflationary Forces In The U.S. As Well Deflationary Forces In The U.S. As Well Deflationary Forces In The U.S. As Well Finally, there is only a slim chance that inflation will exceed 2.5% in the coming year, according to the St. Louis Fed’s Price Pressure Measure (Chart I-4, top panel). Import prices point toward lower goods prices, while core service CPI is quickly slowing and medical care CPI remains close to 2%, which is near record lows (Chart I-4, second panel). Meanwhile, shelter CPI shows little upward momentum (Chart I-4, third panel). Finally, the rebound in productivity growth to 2.4% is also limiting the inflationary impact of rising wages: unit labor costs are contracting at a 0.8% annual rate, despite a 3.1% year-over-year expansion in average hourly earnings (Chart I-4, bottom panel). Chart I-4Details Of U.S. CPI Details Of U.S. CPI Details Of U.S. CPI Evidence, therefore, points to inflation slowing down in advanced economies, even in the more robust U.S. Opening The Liquidity Spigots The lack of inflation allows central banks to ease policy in response to the slowdown in global growth. The Fed is set to trim rates by 25 basis points next week and again later this year. The ECB just telegraphed a rate cut and potentially a resumption of its QE program for September. The Reserve Bank of Australia has chopped rates twice this year, and the Reserve Bank of New Zealand, one time. Meanwhile, the People’s Bank of China has slashed the reserve requirement ratio (RRR) by 3.5% in the past 15 months. The Fed’s interest rate cuts are crucial for U.S. growth and emerging market liquidity conditions. Money moved into EM economies as interest rate markets priced in ever-deeper U.S. rate cuts after the Federal Open Market Committee’s dovish pivot this winter. As a result, EM currencies stabilized, allowing EM central banks to ease policy to support their sagging domestic economies. The Bank of India, the Bank of Indonesia, the Bank of Korea, the South African Reserve Bank, the Bank of Russia, Bank Negara Malaysia, and the Turkish Central Bank have all cut rates. Central banks in Brazil and Mexico are expected to follow suit.  Global policy easing should solidify an improvement in many global liquidity indicators and thus, support global growth in the next year: M2 growth in the U.S. bottomed last November. Concurrently, the growth of money of zero maturity in excess of credit has improved since late last year. This sends a positive signal for BCA’s Global Nowcast, BCA’s Global LEIs, and global and Asian export prices (Chart I-5). Chart I-5More Excess Money, More Activity More Excess Money, More Activity More Excess Money, More Activity Our U.S. Financial Liquidity Index continues to accelerate, corroborating the message about global growth conditions from our excess-money indicator (Chart I-6). Chart I-6Improving Global Liquidity Conditions Improving Global Liquidity Conditions Improving Global Liquidity Conditions Emerging Markets’ M1 is turning up, albeit at a depressed level. This improvement will likely morph into a recovery as EM and DM central banks ease policy. EM M1 has excellent leading properties on EM activity and profits. Gold, a traditional reflation gauge, has broken out as real rates remain depressed. Finally, TED spreads, both on a spot and a three-month forward basis, have tumbled to near all-time lows (Chart I-7). Plentiful global liquidity narrows these spreads. Moreover, their tightness indicates that there is minimal stress in the financial system. Also, TED spreads were more elevated and getting wider before previous recessions, during the euro area crisis and even during the 2015-16 slowdown. Chart I-7No Stress In TED Spreads No Stress In TED Spreads No Stress In TED Spreads Low inflation allows monetary authorities to nurture an improvement in liquidity, which would raise the odds that the cycle should soon bottom. Global Growth Indicators In addition to a supportive liquidity environment, important developments point toward a meaningful global growth pick in the second half of the year. At first glance, data continues to deteriorate. Aggregate capital goods orders in the U.S., Japan, and Germany are contracting at a 7.3% annual pace, the flash PMI numbers released this week were poor and the U.S. LEI shrunk last month on a sequential basis and only increased 1.6% year-on-year. However, these data points miss crucial undercurrents. Governments normally loosen fiscal policy – as measured by the changes in cyclically-adjusted primary balances – after a recession has begun. This time, governments are already expanding deficits. In the euro area, the fiscal thrust is moving from -0.3% of GDP to 0.4% of GDP, a 0.7% of GDP boost to growth compared to last year. In China, fiscal deficits are deepening. In response to large tax cuts and expanding subsidies to various sectors, Beijing’s official budget hole has grown from 3.7% of GDP in 2017 to 4.9% this year. Broader measures, which include provincial and local governments, and off-balance-sheet entities, recorded a deficit of 11% this year. In Japan, the government is implementing fiscal offsets as large, if not larger, than the upcoming VAT increase. Even in the U.S., fiscal policy will probably ease. The Congressional Budget Office tabulates a fiscal drag of 0.5% of GDP in 2020 because of the 2011 Budget Control Act. However, the national debt was set to hit its ceiling soon. In response, the GOP and the Democrats have agreed to a proposed funding measure that will ultimately boost spending by US$50 billion more than the previously tabulated fiscal retrenchment (Chart I-8). Chart I-8 Chinese credit policy is also increasingly supportive of global growth. Adjustments to the RRR normally take approximately 12 months to affect China’s adjusted total social financing (TSF) (Chart I-9, top panel). Changes to the RRR also lead global industrial activity, albeit more loosely, by 18 months (Chart I-9, second panel). This last relationship exists because soon after the TSF expands, Chinese economic agents use the proceeds to invest or spend on durable goods. This process boosts Chinese imports and lifts global economic activity (Chart I-9, bottom panel). Moreover, as we argued last month, we expect China’s reflationary efforts to continue for the rest of the year.3 Chart I-9The Impact Of The Chinese Stimulus Is Only Starting To Be Felt The Impact Of The Chinese Stimulus Is Only Starting To Be Felt The Impact Of The Chinese Stimulus Is Only Starting To Be Felt China’s stimulus is showing early signs of working, despite regulatory constraints on the banking sector. Construction and installation spending by Chinese real estate firms troughed in June 2018 and are growing at a 5.4% annual pace. The growth of equipment purchases is a stunning 22%, near its highest yearly rate in three years. Additionally, China’s intake of steel and cement is surging. These developments normally materialize ahead of rebounds in the PMI or the Li-Keqiang index. Even the outlook for China’s auto sales may be improving. Vehicle sales in China fell by 15.8% in May. In June, they remained soft despite heavy discounts by auto manufacturers. However, vehicle inventories are falling, indicating that auto production is poised to pick up. Importantly, real income levels for U.S. consumers are on the rise. Real average hourly earnings are growing by 1.8% year-on-year, the highest in this cycle. This is a dividend from the recent uptick in productivity (Chart I-10). Mounting productivity both puts a lid on inflation and enhances real incomes. Chart I-10Productivity Is The Name Of The Game Productivity Is The Name Of The Game Productivity Is The Name Of The Game Additional developments warrant optimism over global growth: The performance of EM carry trades funded in yen is rebounding. Historically, this has been a reliable leading indicator of global industrial activity (Chart I-11, top panel). As carry traders buy EM currencies and sell the yen, they borrow funds from an economy replete with excess liquidity and savings (Japan) and inject them where they are needed to finance investment and consumption (the EM). In the process, they bid up EM currencies and inject liquidity in those countries, supporting growth conditions globally.  Chart I-11Positive Signs For Growth Positive Signs For Growth Positive Signs For Growth The annual performance of the sectors most sensitive to global growth conditions – global semi, industrials and materials stocks – is bottoming relative to the broader market. Normally, this happens ahead of troughs in BCA’s Global Nowcast (Chart I-11, middle panel). European luxury stocks are performing strongly, which also usually precedes rebounds in global economic activity (Chart I-11, bottom panel). Shipping costs are moving up. The Baltic Dry Index, a measure of the cost of shipping commodities, has surged by 270% since February 2019 to its highest level since 2013. Some have argued this gauge overstates the economy’s potential strength. However, the Harpex index, a measure of the cost of shipping containers, has risen by 30% in the same period. This concurrence of moves suggests that the Baltic Dry is probably correct about the direction of growth, but might be overstating the size of the rebound. Our composite momentum indicator for ethylene and propylene – two chemicals that enter into the production of pretty much everything that makes the modern economy work – is forming a bullish price divergence (Chart I-12). The price of these chemicals normally rises when global growth accelerates. Chart I-12Chemical Technicals Point To A Rebound Chemical Technicals Point To A Rebound Chemical Technicals Point To A Rebound Bottom Line: Global growth should be buoyed by several indicators, specifically a low inflation environment, an easing in both monetary and fiscal policy, a positive outlook for already improving global liquidity conditions, a healthy U.S. consumer, and the lagged impact of China’s stimulus. Investment Implications: Strong Crosscurrents For Stocks Bonds At this juncture, bonds may be the easier asset class to call; a below-benchmark duration is appropriate for fixed-income portfolios. Pessimism towards global growth is most evident in the prices of safe-haven assets. According to the CFTC, asset managers’ net-long positions in all forms of listed Treasurys contracts are hovering near all-time highs. This makes bonds vulnerable to positive economic surprises. The long-term interest rate component of the ZEW survey corroborates this message. Expectations for global long-term interest rates are near record lows. If a recession is avoided, then readings this low offer a powerful contrarian signal for bonds (Chart I-13). Chart I-13Bonds: A Contrarian Bet Bonds: A Contrarian Bet Bonds: A Contrarian Bet A potential uptick in growth would confirm this bond-bearish setup. The improvement in Chinese TSF and the strength in European luxury goods makers point towards higher yields (Chart I-14). Bond prices would also suffer if the average price of ethylene and propylene can heed the bullish signal from its momentum oscillator. Moreover, in the post-war era, on average Treasury yields typically bottomed 12 months ahead of inflation. Chart I-14Cyclical Dynamics Point To Higher Yields Cyclical Dynamics Point To Higher Yields Cyclical Dynamics Point To Higher Yields Given that bonds are expensive, there is a greater likelihood that positioning and cyclical forces will push up yields. Our bond valuation model shows that Treasurys are expensive and various estimates of global term premia have never been this negative. This reflects the belief that policy rates will stay low forever. However, if global growth picks up, then the Fed is highly unlikely to cut rates over the coming 12 months by the 90 basis points currently discounted by the OIS curve. Moreover, stimulating at this point in the cycle increases the risk of generating inflation down the road. Accelerating inflation would ultimately force global central banks to boost rates in the next three to five years by much more than expected, warranting higher term premia around the world. Therefore, we expect inflation expectations and term premia – but not real rates – to drive up yields, at least until global central banks abandon their dovish biases. Commodities Commodities and related assets are attractive. A measure of growth sentiment based on futures positioning in stocks, oil, copper, the Australian dollar and the Canadian dollar relative to bets on Treasury of all maturities and the dollar index shows that investors have not moved into commodity plays (Chart I-15). Moreover, traders who manage money on behalf of clients are also massively short copper, one of the most growth-sensitive commodities (Chart I-16). Chart I-15Investors Are Not Positioned For A Rebound In Growth Investors Are Not Positioned For A Rebound In Growth Investors Are Not Positioned For A Rebound In Growth Chart I-16Copper Is An Attractive Bet For A Growth Rebound Copper Is An Attractive Bet For A Growth Rebound Copper Is An Attractive Bet For A Growth Rebound The six-month outlook is particularly positive for the Australian dollar. The RBA has already moved aggressively to ease policy and the purging of excesses in the Australian economy is well advanced. Property borrowing for investments has collapsed by 35%, housing activity has contracted by 22%, and building permits have fallen by 20%. However, the Australian labor market remains robust and early indicators of real estate activity in major cities are stabilizing. External forces are also positive for the AUD. Strong steel prices, which have contributed to the rally in iron ore, coupled with quickly growing Australian LNG exports, will boost the terms of trade for the AUD. Moreover, the rebound in Chinese TSF, which we expect to gather momentum, creates another tailwind (Chart I-17, top panel). What’s more, rising ethylene and propylene prices, as well as rallying stock prices of European luxury goods makers, are strong supports for commodity currencies (Chart I-17, second and third panel). Chart I-17The AUD Looks Increasingly Interesting The AUD Looks Increasingly Interesting The AUD Looks Increasingly Interesting Silver is another attractive play. Last month, we argued that easy global policy would create an important support for gold.4 Since then, silver has broken out of a downward sloping trend line in place since 2016. Unlike gold, silver is still trading near very depressed levels (Chart I-18). Moreover, according to net speculative positions, gold is overbought on a tactical basis and ripe for a pullback, whereas silver is not nearly as popular with speculators. Our optimistic stance on global growth is congruent with an outperformance of silver relative to gold. Silver has more industrial uses than gold and the gold-to-silver ratio generally falls when manufacturing activity perks up. Chart I-18Silver To Shine Brighter Than Gold Silver To Shine Brighter Than Gold Silver To Shine Brighter Than Gold Equities The window to own stocks remains open. Stocks have more upside on a 9- to 12-month basis, but are set to churn over the coming three to six months. The risk of sharp but temporary corrections is elevated. Stocks rarely enter a bear market if a recession is far away. Stock prices perform well in the 12 months prior to the last half-year before a recession begins (Table I-1). If we expect growth to pick up over the next 6 to 12 months and policy to remain easy, then a recession will not occur before late 2021/early 2022. Chart I- The improvement in our global liquidity indicators also supports a period of strong equity performance ahead (Chart I-19). Moreover, the 2-year/fed funds rate yield curve is inverted. Since the 1980s, after such inversions, the median 12-month return for the S&P 500 has been 14%. Stripping out recessionary episodes, the median returns would have been 18.6%, 13.1%, and 9.9%, over 12, 6 and 3 months, respectively (Table I-2). Chart I-19Liquidity Will Put A Floor Under Stock Prices Liquidity Will Put A Floor Under Stock Prices Liquidity Will Put A Floor Under Stock Prices Chart I- Technically, stocks are also on a strong footing. The equal-weight S&P 500 has broken out, indicating robust breadth. Our composite sentiment indicator for U.S. equities is not flagging any euphoria among market participants (Chart I-20). BCA’s Monetary, Technical and Intermediate Indicators show one should own stocks. Chart I-20BCA's Indicators Favor Stocks BCA's Indicators Favor Stocks BCA's Indicators Favor Stocks Nevertheless, important negatives for stocks also exist. The rally in equities has been fueled by hope, as our U.S. Equity Strategy team has highlighted. Since December 2018, the rally has been driven by multiples expansion (Chart I-21). Meanwhile, Section II’s debate shows that Anastasios’s earnings models all point to low earnings growth later this year. The weakness in core crude producer price inflation will weigh on margins and corporate profits (Chart I-22). It will therefore become increasingly difficult to justify widening P/E ratios. Furthermore, the S&P 500 has moved well ahead of the performance implied by earnings estimates revisions (Chart I-23).5 Chart I-21Multiples Inflation Multiples Inflation Multiples Inflation Chart I-22Profits Still Face Near-Term Hurdles Profits Still Face Near-Term Hurdles Profits Still Face Near-Term Hurdles Chart I-23EPS Revisions And Stock Prices Have Dissociated EPS Revisions And Stock Prices Have Dissociated EPS Revisions And Stock Prices Have Dissociated From a valuation perspective, the S&P’s price-to-book, price-to-sales, or cyclically adjusted P/E ratio, all are demanding by historical standards, but justifiable if Treasurys only offer a 2% yield. This rally based on hope is vulnerable to our expectations of higher yields. Only once earnings rebound, which will pull down multiples in a benign fashion, can stocks resume their uptrend. U.S. stocks will probably churn for the rest of the year. The media made much of the S&P 500 hitting new highs in September last year and this month, but the U.S. benchmark is only 3.5% above its January 2018 peak. U.S. stocks have been very volatile, but have gone nowhere for 18 months; this pattern should hold. We are overweight stocks relative to bonds given that we recommend maintaining a below-benchmark duration for fixed-income portfolios. At 1.9%, the S&P 500 dividend yield is in line with the yield to maturity of 10-year Treasurys, while the wide equity risk premium suggests that stocks are a bargain compared to bonds. Also, the stock-to-bond ratio performs well when global industrial activity rebounds (Chart I-24). Chart I-24If Growth Helps Chemical Prices, It Will Help Stocks Outperform Bonds... If Growth Helps Chemical Prices, It Will Help Stocks Outperform Bonds... If Growth Helps Chemical Prices, It Will Help Stocks Outperform Bonds... Cyclical stocks will likely outperform defensive equities on rebounding global growth. The bullish configuration in the price of chemicals is consistent with a period of outperformance for cyclical equities (Chart I-25). Cyclicals also perform well when yields are moving higher, especially when central banks remain accommodative. A positive view on commodities fits within this pattern. Chart I-25...And Cyclicals Outperform Defensives ...And Cyclicals Outperform Defensives ...And Cyclicals Outperform Defensives European stocks are better placed than their U.S. counterparts in the coming six to nine months. European stocks outperform U.S. ones when the Chinese TSF moves up (Chart I-26), reflecting their higher sensitivity to the global business cycle. Additionally, European equities are trading at a large discount. The forward P/E and price-to-book of an equally weighted average of European stocks stand at 14.4 and 2.1 respectively, versus 20.7 and 4.1 for the U.S. Chart I-26Look Into Upgrading Europe At The Expense Of The U.S. Look Into Upgrading Europe At The Expense Of The U.S. Look Into Upgrading Europe At The Expense Of The U.S. Loan volumes will benefit from the large easing in European financial conditions resulting from the 166-basis-point drop in peripheral yields this year, with BTP yields falling to a near three years low following the ECB’s dovish tilt. This will remove some of the negative impact of soft net interest margins on bank profits. European banks could be an attractive trade. Finally, global auto stocks are trading at their lowest levels relative to the global equity benchmark since the beginning of the 2000s (Chart I-27). Moreover, global auto stocks trade at 44% discount to the broad market on a 12-month forward P/E basis, the largest handicap since 2009. This sector should perform well in the next year based on purged global auto inventories, robust consumer real income, falling interest rates and rebounding global growth. Chart I-27Autos Are A Contrarian Play Autos Are A Contrarian Play Autos Are A Contrarian Play Mathieu Savary Vice President The Bank Credit Analyst July 25, 2019 Next Report: August 29, 2019   II. What Goes On Between Those Walls? BCA’s Diverging Views In The Open 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.6   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? 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). Chart II-1 (ANASTASIOS)The 1998 Episode Revisited The 1998 Episode Revisited The 1998 Episode Revisited 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? 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   Chart II-5 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? 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-7illustrates 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-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. 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).   Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend Stimulus Versus Marginal Propensity To Spend 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) 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. Chart II-14 (PETER)The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency 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? 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). Chart II-15 (ANASTASIOS)Gravitational Pull Gravitational Pull Gravitational Pull 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 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. Chart II-19 (ARTHUR)China And EM Profits Are Contracting China And EM Profits Are Contracting China And EM Profits Are Contracting 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). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps Continue To Avoid Small Caps Continue To Avoid Small Caps 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-21 (ANASTASIOS)Buy Hypermarkets Buy Hypermarkets Buy Hypermarkets 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). Chart II-22 (ANASTASIOS)Stick With Managed Health Care Stick With Managed Health Care Stick With Managed Health Care 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). 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 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. 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 (II) Equity Risk Premia Remain Elevated (I) Equity Risk Premia Remain Elevated (I) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (I) 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. 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 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-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 ​​​​​​   III. Indicators And Reference Charts The S&P 500 has limited cyclical downside for now, however, the short-term outlook is more troublesome. U.S. stocks are hovering near all-time highs, but they are not showing much conviction. Positive catalysts have moved into the rearview mirror now that a flurry of central banks have also cut rates, that it is certain that the Fed will cut rates next week, and that the ECB will follow in September. A volatile churning pattern will likely prevail over the coming three months. Our Revealed Preference Indicator (RPI) points to short-term risks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuation and policy, investors should lean against the market trend. A pick-up in global growth is needed to help earnings, which would cheapen valuations enough to clear the short-term clouds hanging over the stock market. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it is slightly deteriorating in Europe. The WTP indicator tracks flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips, creating a floor under stock prices in the process. Our Monetary Indicator continues to move deeper into stimulative territory, supporting our cyclically constructive equity view. Global central banks are easing policy in unison, creating very accommodative liquidity conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory. However, it is not elevated enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator continues to move further above its 9-month moving average. These dynamics confirm that equities have more cyclical upside and that dips should be bought. According to our model, 10-year Treasurys are now as expensive as at any point over the past five years. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Various rate-of-change measures for bond prices are flashing extremely overbought conditions as well. Additionally, duration surveys, positioning data, and sentiment measures are all showing that investors expect nothing but low yields. Considering this technical backdrop, BCA’s economic view implies that yields are likely to have bottomed earlier this month. On a PPP basis, the U.S. dollar remains very expensive. Additionally, our Composite Technical Indicator has formed a negative divergence with prices. The dollar’s recent strength could set it up for a substantial decline. If the dollar’s Technical Indicator falls below zero, the momentum-continuation behavior of the greenback will kick in. The USD would suffer markedly were this to happen. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-22Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals ​​​​​​​ COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Please see U.S. Bond Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence,” dated April 23, 2019, available at usbs.bcaresearch.com 2       The biggest concern with debt sustainability is the distribution of the debt. Aggregate ratios are currently flattered by the low debt loads and high cash holdings as well as cash generation power of the tech sector. Nonetheless, the low level of aggregate debt accumulation by the entire private sector, including households, points to a limited cyclical vulnerability to the economy created by leverage. However, this also means that a more-severe-than-usual default wave is likely to materialize outside the tech sector once a recession emerges. 3       Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 4       Please see The Bank Credit Analyst Monthly Report “July 2019,” dated June 27, 2019, available at bca.bcaresearch.com 5       Please see U.S. Equity Strategy Weekly Report, “Divorced From Reality,” dated July 15, 2019, available at uses.bcaresearch.com 6       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. 7       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 8       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 9       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 10     France is a good proxy for the euro area. 11     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY: