Precious Metals

Highlights Rising recession risk, shaky economic fundamentals, and absence of positive yielding assets motivate us to reexamine which assets can be counted on to protect a portfolio in the future. We analyze 10 safe havens on four different dimensions: consistency, versatility, efficiency, and costs. Using this framework, we examine the historical performance of each safe haven and provide an outlook on their likely effectiveness over the next decade. We conclude that U.S. TIPS and farmland should provide the best portfolio protection. Cash, U.S. Treasuries and gold are other good alternatives. Meanwhile, U.S. investment-grade bonds, global ex-U.S. bonds, silver, and currency futures are likely to be poor protection choices. Feature For most investors, capital preservation is the most important goal when managing money. However, how to go about it remains a difficult question.  Investing in safe havens can be painful during bull markets, as their returns are usually lower than those of equities. Moreover, economic, political, and financial regimes change over time, which means that an asset that protected your portfolio in the past might not do so in the future. Therefore, it becomes good practice to review one’s safety measures periodically, even if one does not think that a crash is imminent. The current environment in particular, is a propitious time to review safe havens given that: Chart I-1A Great Time To Review Safety Measures A Great Time To Review Safety Measures A Great Time To Review Safety Measures A key recession signal is flashing red: The yield curve inverted in the United States in August (Chart I-1 – top panel). An inversion of the yield curve does not necessarily imply a recession, but historically it has been a very reliable signal of one, given that it indicates that monetary policy is too tight for the economy. Structural risks are rising: Rich equity valuations in the U.S. and high leverage levels elsewhere are signs that the pillars supporting this bull market might be fragile (Chart I-1 – middle panel). In addition, protectionism and populism, forces that BCA has long argued are here to stay, threaten to upend the regime of free trade that has benefited equities since the 1950s.1 Yields are near all-time lows: Historically, investors have been able to endure bear markets by hiding in safe assets with positive yield, as these assets will normally provide a reliable cash flow regardless of the economic situation. However, these type of assets are increasingly hard to find, particularly in the government bond space, where 50% of developed country bonds have negative yields (Chart I-1 – bottom panel). Considering these factors, how should investors protect their portfolios in the next decade? To answer this question, we analyze 10 safe havens divided into five broad asset classes: Nominal government bonds: U.S. Treasuries and global ex-U.S. government bonds. Other fixed income: U.S. investment-grade credit and U.S. TIPS.2 Currencies: yen futures and Swiss franc futures. Precious metals: gold futures and silver futures. Other assets: farmland and U.S. cash. We look at historical performance since 1973 for all safe havens except for global ex-U.S. bonds and farmland. For these assets, we look at performance since 1991 due to limited data availability. We mainly look at quarterly returns in order to compare illiquid assets to publicly traded ones. We do not consider each safe haven in isolation, but rather as an addition to equities within a portfolio. Specifically, we explore our safe haven universe relative to the MSCI All Country World equity index from the perspective of a U.S. investor. For our non-U.S. clients, we will release a report from the perspective of other countries if there is sufficient interest. Importantly, we do not look only at historical performance. We also examine whether there is a reason to believe that future returns will be different from past ones, by analyzing how the properties of each safe haven might have changed. When evaluating each safe haven, we focus on four properties: Consistency: a safe haven should generate consistent positive returns during periods of negative equity performance, with returns increasing with the severity of the equity drawdown. Versatility: safe havens should perform well across different types of crises. Efficiency: a safe haven should produce enough upside during crises, so only a small allocation to the safe haven is necessary to reduce losses. Costs: drag to portfolio overall performance (opportunity costs) should be as small as possible. Readers who wish to see just our overall conclusions should read our Summary Of Results section below. For our analysis of how safe havens have performed in the past, please see the Historical Performance section. Finally, for our analysis of how we expect the performance of safe havens to change, please see our Outlook section. Summary Of Results The Best Safe Havens U.S. TIPS should be an excellent safe haven to protect a portfolio in the next decade. While TIPS might not be as cheap to hold as they have been in the past, upside potential remains strong, which means that a moderate allocation can provide substantial protection to an equity portfolio. Moreover, U.S. TIPS are one of the best hedges against crises triggered by rising rates and inflation, which in our view are the biggest structural risks that asset allocators face. Farmland could also be a great safe haven for investors who have the ability to allocate to illiquid assets given that it is the cheapest safe haven in terms of portfolio drag. However, investors should be aware that the current low yield could potentially affect its performance during crises. Good Alternatives Cash can be a good alternative to protect an equity portfolio, given its outstanding performance during equity drawdowns caused by inflation. Moreover, its opportunity costs should decrease relative to the past. However, investors should take into account that the efficiency of cash at the current juncture is poor, which means that a relatively large allocation is needed in order to achieve meaningful portfolio protection. A portfolio with a 30% allocation to Treasuries historically provided the same downside protection as a portfolio with a 44% allocation to gold. We also like gold futures as a safe haven since they offer some of the most attractive opportunity costs. In addition, their upside is greater than that of most safe havens due to their negative correlations with real rates. However, gold’s volatility makes it an unreliable asset, which prevents us from placing it higher in the safe haven hierarchy. Historically, U.S. Treasuries have been one of the best safe havens to hedge an equity portfolio. Will this performance continue in the future? We do not think so. While yields are still high enough to provide plenty of upside potential, they have fallen to the point where they have increased the opportunity costs of U.S. Treasuries and reduced their consistency. The Rest Global ex-U.S. bonds have very limited upside due to their low yields. Meanwhile U.S. investment-grade credit remains at risk from poor corporate balance sheets, compounded by the fact that credit no longer has an attractive yield cushion. Currencies like the yen and the Swiss franc will continue to be unreliable and very expensive safe havens. Finally, while silver’s costs and reliability could improve, its high cyclicality relative to other safe havens will make silver a poor protection choice. Historical performance Consistency How did safe havens perform when equities lost money? To assess consistency, we plot the performance of each safe haven during all quarters when global equities had losses (Chart I-2). Cash and farmland were the only assets to have positive returns during every equity drawdown. U.S. Treasuries and U.S. TIPS were also very consistent, and had the additional advantage that their returns tended to increase as equity losses worsened. Global ex-U.S. bonds, while not as consistent, generated positive returns most of the time. Chart I-2Safe Haven Returns During Drawdowns In Global Equities Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s On the other hand, investment-grade bonds, the yen, the Swiss franc, gold, and silver were much more inconsistent. In general, even though these assets had larger positive returns than other assets, they were prone to deep selloffs concurrent with equity drawdowns. Silver was the worst of all safe havens, being mostly a negative return asset during quarters of negative equity performance. Versatility How did the type of crisis affect the performance of safe havens? We classify crises according to their catalyst into the following four categories: bursts of U.S. asset bubbles (tech bubble, 2008 housing crisis), ex-U.S. crises (1998 EM crisis, European debt crisis), flash crashes/political events (1987 Black Monday, 9/11 terrorist attack),  rate/inflation shocks (1974 oil crisis, 1980 Fed shock) and others (every other equity drawdown we could not classify).3  We look at the performance of seven safe havens since 1973 (Chart I-3A) and of all 10 since 19914 (Chart I-3B): Chart I-3ASafe Haven Return During Different Type Of Crisis (1973 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-3BSafe Haven Return During Different Type Of Crisis (1991 - Present) Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s   During bursts of U.S. asset bubbles, U.S. Treasuries were the most effective hedge in both sample periods, followed by U.S. TIPS and farmland. Corporate bonds, cash, gold, and the Swiss franc also had positive returns, though they were small. Finally, the yen and silver had negative returns. During crises happening outside of the U.S., U.S. Treasuries were once again the best option. U.S. TIPS, yen futures, farmland, gold, and U.S. investment-grade bonds also provided strong returns.  Meanwhile, global ex-U.S. bonds and cash provided relatively weak returns, while both the Swiss franc and silver accrued losses. During flash crashes/political events, the Swiss franc had the best performance followed by global ex-U.S. bonds, though in general all safe havens but silver provided positive returns. Rate/inflation shocks were the most difficult type of crisis to hedge. Cash and U.S. TIPS were by far the best performers. Moreover, while U.S. Treasuries were able to eke out a small positive return, all other safe havens lost money during these crises. Efficiency How much allocation to each safe haven was needed to protect an equity portfolio? Chart I-4 show how adding incremental amounts of each safe haven5 to an equity portfolio reduced the overall portfolio’s 10% conditional VaR (the average of the bottom decile of returns).6 Since 1973, U.S. TIPS and U.S. nominal government bonds were the most efficient safe havens, providing the most protection per unit of allocation (Chart I-4 – top panel). Conditional VaR was reduced by almost half when allocating 40% to either Treasuries or TIPS. Cash, U.S. investment-grade, the yen, the Swiss franc, gold, and silver followed in that order. The difference between the safe havens was significant. As an example, a portfolio with a 30% allocation to U.S. Treasuries historically provided the same downside protection as a portfolio with a 36% allocation to U.S. IG credit, a 39% allocation to the yen or a 44% allocation to gold. Meanwhile, there was no allocation to silver which would have provided the same level of protection. When using a sample from 1991, the main difference was the reduced efficiency of cash – the result of lower average interest rates when using a more recent sample. Other than cash, the efficiency of most safe havens remained unchanged: U.S. Treasuries were the best option, followed by U.S. TIPS, farmland, U.S. investment-grade bonds, global ex-U.S. government bonds, cash, the yen, gold, the Swiss franc, and silver in that order (Chart I-4 – bottom panel). Chart I-4Historically, Fixed-Income Assets Were The Most Efficient Safe Havens Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Costs How do safe haven returns compare to equities? To evaluate opportunity costs, we compare the difference of the historical return of each safe haven versus global equities. Overall, hedging with currencies was extremely costly, as their return was well below that of equities in both samples (Chart I-5). Cash was also an expensive safe haven to hedge with, particularly in the most recent sample. On the other hand, fixed-income assets like U.S Treasuries, investment-grade credit, and U.S. TIPS had very low costs (global ex-U.S. bonds also had cost of around 2% in a limited sample).  Farmland had negative opportunity costs because it outperformed equities during the sample period.7 Chart I-5Historically Fixed Income Assets And Farmland Had The Lowest Opportunity Cost Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Outlook Chart I-6No More Yield Cushion Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Chart I-7Silver Has Become Less Cyclical Silver Has Become Less Cyclical Silver Has Become Less Cyclical For our outlook, we assess how the four traits under study have changed for all safe havens: Consistency: Will safe havens continue to be reliable in the absence of high coupons? Many of the safe havens in our sample were effective at hedging equities due to their high yield. Even if they had negative capital appreciation, total returns stayed positive thanks to the offsetting effect of the yield return. However, as rates have declined, yield return has also decreased substantially (Chart I-6). Therefore, safe havens, like cash, government bonds, and even farmland will not be as consistent as they were in the past. Credit could be even more vulnerable: the combination of a low yield, and unhealthy fundamentals will turn U.S. corporate bonds into a negative-return asset in the next crisis. Silver might be the lone safe haven to improve its consistency. Industrial use for silver has fallen substantially in the past 10 years, decreasing its cyclical nature (Chart I-7). Thus, while silver might still be an erratic safe haven, it should be more consistent in the future than its historical performance would suggest.   Versatility: What will the next crisis look like? Chart I-8Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Inflation and Political Crisis Will Plague The 2020s Determining what the next crisis will look like is crucial for safe haven selection. Below we rank the types of crises in order of how likely and severe we think they will be in the future: Inflation/rate shock: We expect inflation to be significantly higher over the next decade. This will be the highest risk for asset allocators in the future. As we explained in our May 2019 report, a change in monetary policy framework, procyclical fiscal policy, waning Fed independence, declining globalization, and demographic forces are all conspiring to lift inflation in the next decade.8 Importantly, we believe that the Fed will be dovish initially, as it cannot let inflation continue to underperform its target after missing the mark for the last 10 years (Chart I-8 – top panel). However, this will cause an inflationary cycle, which will eventually lead the Fed to raise rates significantly and trigger a recession. Political events/flash crashes: Political events will also pose a risk to the markets on a structural basis. The rise of China as a superpower has shifted the world into a paradigm of multipolarity, which historically has resulted in military conflict. Moreover, animus for conflict is not dependent on President Trump. The American public in general feels that the economic relationship with China is detrimental to the United States (Chart I-8 – bottom panel). This means that any president, Democrat or Republican will have a political incentive to jostle with China for economic and political supremacy for years to come. Ex-U.S. crises: We expect Emerging Markets in general, and China in particular, to be among the most vulnerable parts of the global economy as we enter the next decade. Over the last 10 years, China’s money supply has increased four-fold, becoming larger than the money supply of the U.S. and the euro area combined. In addition, corporate debt as a % of GDP stands at 155%, higher than Japan at the peak of its bubble and higher than any country in recorded history (Chart I-9). We rank this type of crisis slightly below the first two because Emerging Market assets are depressed already. Thus, while we believe that there is further downside to come for these economies, some weakness has already been priced in. U.S. asset bubble burst: We believe that there are no systemic excesses in the U.S. economy, making a U.S. asset bubble burst a lesser risk than other types of crises. Although it is true that U.S. corporate debt stands at all-time highs, it is still at a much lower level than in other countries. Moreover, weakness of corporate credit is not likely to have systemic consequences on the economy, given that leveraged institutions like banks and households hold only a small amount of outstanding corporate debt (Chart I-10). Chart I-9EM crises Are Also A Risk EM crises Are Also A Risk EM crises Are Also A Risk Chart I-10A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences A U.S. Corporate Debt Deblacle Will Not Have Systemic Consequences What does this ranking mean in terms of safe haven performance? U.S. TIPS and cash should be held in high regard as they will be some of the only assets that will perform well during an inflation/rate shock. The Swiss franc and global ex-U.S. bonds should be best performers during political crises, although U.S. TIPS could also provide adequate protection. Efficiency: Is there any upside left for safe havens when interest rates are near zero? As yields go below the zero bound it becomes harder for bonds to generate large positive returns. European or Japanese government bonds in particular would need their yields to go deep into negative territory to counteract a large selloff in equities (Table I-1). But can interest rates go that low? We do not think so. The recent auction of German bunds, where a 0%-yielding 30-year bond attracted the weakest demand since 2011, suggests that interest rates in these countries might be close to their lower bound.  On the other hand, though U.S. yields are low, they are still high enough for U.S. Treasuries to provide high returns in case of a crisis. Table I-1No Room For Positive Returns In The Government Bond Space Outside Of The U.S. Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Low rates also have an effect on the efficiency of U.S. investment-grade bonds, cash, and farmland because their upside during crises does not come from capital appreciation but rather from their yield, (the price of IG credit actually declines during most crisis). As mentioned earlier, their yield has declined substantially compared to the past, which means that a larger allocation will be necessary to counteract a selloff. Chart I-11Switzerland Has A High Incentive To Prevent The Franc From Appreciating Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s The upside of the yen could also be compromised. The Bank of Japan is likely to intervene aggressively in the currency market to prevent the Japanese economy from falling into a deflationary spiral, since it is very difficult for it to lower Japanese rates further. The Swiss franc is even more vulnerable. In contrast to Japan, Switzerland is a small open economy that has to import most of its products (Chart I-11). This means that the Swiss National Bank has a very high incentive to intervene in currency markets during a crisis, given that a rally in the franc could depress inflation severely. What about U.S. TIPS? In contrast to nominal government bond yields or even yields on corporate debt, U.S. real rates are not limited by the zero bound (Chart I-12).  This makes TIPS a more attractive option than other fixed-income assets, since real rates can have much more room for further downside than nominal ones. To be clear, this will only be the case if our forecast of an inflationary crisis materializes. Likewise, since gold is heavily influenced by real rates, it should also offer significant upside during the next crisis.9 Chart I-12Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Real Rates Have More Downside Potential Than Nominal Ones Costs: Can I afford to hold safe havens in a world of low returns? To provide an outlook for the expected cost of each safe haven, we use the return assumptions from our June Special Report.10 We subtract the expected return on global equities from the expected return for each safe haven to reach an expected cost value. However, three of the safe havens (global ex-U.S. government bonds, the Swiss franc and silver) did not have a return estimate. We compute their expected returns as follows: For the Swiss franc we use the methodology we used for all other currencies in our report. We base the expected return on the current divergence from the IMF PPP value, as well as the IMF inflation estimates. In addition, we add the relative cash rate assumed return for both our yen and Swiss franc estimates, as futures take into account carry return. For global ex-U.S. bonds we take the weighted average of the expected return of the euro area, Japan, U.K., Canada, and Australia government bonds. We weight the returns according to their market capitalization in the Bloomberg/Barclays government bond index. Due to silver’s dual role as an inflation hedge and industrial metal, silver prices are a function of both gold prices and global growth. To obtain a return estimate we run a regression on silver against these two variables and use our growth and gold return estimate to arrive at an assumed return for silver. Chart I-13 shows our results: while their cost will improve, currency futures remain the most expensive hedge. The opportunity cost of precious metals and cash will decrease, making them more attractive options than in the past. Meanwhile, low yields will increase the opportunity costs of most fixed-income assets. Finally, farmland will remain the cheapest safe haven, even with decreased performance. Chart I-13Oportunity Cost For Fixed Income Safe Havens Will Be Higher Than In The Past Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Juan Manuel Correa Ossa Senior Analyst juanc@bcaresearch.com Appendix A Safe Haven Review: A Guide To Portfolio Protection In The 2020s Safe Haven Review: A Guide To Portfolio Protection In The 2020s Footnotes 1 Please see Geopolitical Strategy Special Report, "The Apex Of Globalization – All Downhill From Here, " dated November 12, 2014, available at gps.bcaresearch.com. 2 We use a synthetic TIPS series for data prior to 1997. For details on the methodology, please see: Kothari, S.P. and Shanken, Jay A., “Asset Allocation with Inflation-Protected Bonds,” Financial Analysts Journal, Vol. 60, No. 1, pp. 54-70, January/February 2004. 3 For a detailed list of how we classified each equity drawdown, please see Appendix A. 4 The only crises caused by a rate/inflation shock occurred in 1974 and 1980. Thus we have this type of drawdown only in Chart 3A and not in Chart 3B. 5 For yen, Swiss franc, silver and gold futures we assume an allocation to an ETF which follows their performance. Since futures have zero initial costs they cannot be directly compared to traditional assets in terms of percentage allocation. 6 We prefer this measure over VaR given that it captures the properties of the left tail of returns more accurately. 7  While the farmland index subtracts management fees, we recognize that there are costs involved in holding these illiquid assets which are not necessarily captured by the return indices. Thus, the real historical cost of holding farmland was not negative but likely close to zero. 8 Please see Global Asset Allocation Strategy Special Report "Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises," dated May 22, 2019, available at gaa.bcaresearch.com. 9 Please see Commodity & Energy Strategy Special Report "All that Glitters…And Then Some" dated July 25, 2019, available at ces.bcaresearch.com. 10 Please see Global Asset Allocation Strategy Special Report "Return Assumptions - Refreshed and Refined" dated June 25, 2019,  

The once-reliable negative correlation between gold and the USD was indefinitely suspended beginning in 4Q18 by the pervasive economic uncertainty we identified last week as the culprit holding back global oil demand growth via a super-charged dollar.1 This uncertainty is most pronounced in the U.S. and Europe vis-à-vis gold, and partly explains the performance of safe havens, particularly the USD, which has soared to new heights on a trade-weighted goods basis, and gold (Chart of the Week). So far, gold has held its ground after breaking above $1,500/oz from the low $1,200s in mid-2018, indicating investors are much more concerned about economic risks arising from economic policy uncertainty than inflation and other diversifiable risks gold typically hedges (Charts 2A, 2B). Cyclically we remain positive on gold prices on the back of a lower dollar and rising inflation pressure in the U.S. Chart of the WeekDemand For Safe Havens Soars As Economic Policy Uncertainty Rises Demand For Safe Havens Soars As Economic Policy Uncertainty Rises Demand For Safe Havens Soars As Economic Policy Uncertainty Rises Economic policy uncertainty in Europe and the U.S. supports gold prices. Even so, we are putting a $1,450/oz stop-loss on our long gold portfolio hedge to cover tactical risks showing up in our technical indicators. In addition, as is the case with oil demand, if the ceasefire we are expecting in the Sino-U.S. trade war materializes in 1H20 and limited trade – mostly in ags and energy – is forthcoming, demand for safe-haven assets could weaken gold prices at the margin. Fiscal and monetary stimulus globally also could revive economic growth and commodity demand, pushing global yields higher, which would put negative pressure on gold at the margin, as well, given the high correlation between real rates and gold prices. Chart 2AU.S., Euro Economic Uncertainty Correlated With Gold Prices U.S., Euro Economic Uncertainty Correlated With Gold Prices U.S., Euro Economic Uncertainty Correlated With Gold Prices Chart 2BU.S., Euro Economic Uncertainty Correlated With Gold Prices U.S., Euro Economic Uncertainty Correlated With Gold Prices U.S., Euro Economic Uncertainty Correlated With Gold Prices Highlights · Energy: Overweight. Saudi Arabia and Kuwait are on the verge of signing an historic pact to restart production from the Neutral Zone. Kuwait expects to sign the pact within 30 to 45 days. Potential production from the jointly operated fields – Khafji and Wafra – is estimated at ~ 500k b/d. Ramping up production at the Wafra field could take up to 6 months. Importantly, both countries are expected to respect their production quota mandated under the OPEC 2.0 agreement expiring in 1Q20.2 Separately, Chevron’s waiver to operate in Venezuela was extended for three months from the Trump administration this week. · Base Metals: Neutral. Chile copper production was up 1% and 11% y/y in July and August, according to the World Bureau of Metal Statistics. Earlier this week, the Union of workers at Chile’s Escondida copper mine – the world’s largest – held a strike in support of broader protests sparked by the increase of metro fare last Friday. Chile’s President suspended the fare hike on Saturday, but the protests are still ongoing and have now caused 15 deaths.3 · Precious Metals: Neutral. The gold/silver ratio fell 9% since July 2019. Our tactical long spot silver recommendation is up 3% since inception in August 2019, and our strategic long gold position is up 21%. Cyclically, we remain positive on both silver and gold prices, more on this below. A tactical pullback is possible; money managers have started liquidating some of their long gold positions, dropping by 67k contracts from September levels, according to CFTC data. · Ags/Softs: Underweight. According to USDA data, corn and soybean harvest are 30% and 46% complete, lagging behind their respective 47% and 64% five-year average pace. For corn, the USDA rates 54% of the U.S. crop good or excellent, vs. 66% a year earlier. For beans, 56% of the crop is rated good or excellent, vs. 68% last year. Separately, China announced waivers allowing up to 10mm MT of U.S. soybeans to be imported by domestic and international crushing concerns. The waivers are in place until March 2020. Feature The once-reliable negative correlation between gold and the USD will remain muted over the short-term tactical horizon – 3 to 6 months – as economic policy uncertainty continues to stoke global demand for safe havens.4 The once-reliable negative correlation between gold and the USD will remain muted over the short-term. This can be seen in the elevated correlations between the USD’s broad trade-weighted goods index with the Baker-Bloom-Davis (BBD) Economic Policy Uncertainty (EPU) indexes for the U.S. and Europe (Chart 3).5 Rising economic uncertainty – particularly since 4Q18 – has created a rare environment in which both the USD and gold trended up simultaneously and continue to move in the same direction. The implication of this is that gold’s correlation with both the USD and EPU is weaker than before because economic policy uncertainty now is positively correlated with the dollar. Chart 3Strong USD, EPU Correlation Strong USD, EPU Correlation Strong USD, EPU Correlation Chart 4Correlation of Daily Gold, USD Returns Also Moving Sharply Higher Correlation of Daily Gold, USD Returns Also Moving Sharply Higher Correlation of Daily Gold, USD Returns Also Moving Sharply Higher There is a possibility global policy uncertainty could be reduced later this year if the U.S. and China can agree on a trade ceasefire... The typically negative correlation between daily returns of gold and the USD also is weakening, moving toward positive territory (Chart 4), as both the USD and gold trend higher simultaneously (Chart 5).   Chart 5Gold and USD Levels Trending Higher Gold and USD Levels Trending Higher Gold and USD Levels Trending Higher ...If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. Our short-term technical indicator is signaling an overbought gold market (Chart 6), and our fair-value model indicates gold should be trading ~ $1,450/oz (Chart 7). The latter signal off our fair-value model is less concerning, given the demand for safe-haven assets like the USD and gold now dominates gold’s typical drivers. Chart 6Gold Technical Indicators Signal Overbought Market Gold Technical Indicators Signal Overbought Market Gold Technical Indicators Signal Overbought Market Chart 7High USD Correlation Throws Off Fair-Value Model High USD Correlation Throws Off Fair-Value Model High USD Correlation Throws Off Fair-Value Model However, to be on the safe side, we are placing a $1,450/oz stop-loss on our long-term gold position, which as of Tuesday’s close was up 21% since inception on May 14, 2017. This is a precautionary measure, which recognizes the possibility global policy uncertainty could be reduced later this year if the U.S. and China can agree on a trade ceasefire, and global fiscal and monetary policy are successful in reviving EM income growth, which would revive commodity demand generally, pushing up global bond yields. If this occurs, the risk premium supporting gold will ease, and markets will once again turn their attention to possible inflationary consequences of the global stimulus. During that period, the monetary and fiscal aggregates we track as explanatory variables for gold prices will reassert themselves as the dominant drivers of gold prices (see below). This could produce tension between a falling USD and rising real rates as growth picks up, which would send us to a risk-neutral setting re gold, given the current high correlation between gold and real rates, which should remain strong until the Fed starts hiking rates again, most likely in 2020 (Chart 8). This is part of the reason we are including the stop-loss at $1,450/oz for our existing gold position: During this risky period going into 1H20 economic uncertainty could dissipate, and real rates could rise. Although the USD depreciation would mute these effects, rising real rates would be a risk to gold prices Chart 8Rising Real Rates Could Weaken Gold Prices Rising Real Rates Could Weaken Gold Prices Rising Real Rates Could Weaken Gold Prices Economic Uncertainty Dominates Gold’s Fundamentals At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. In Table 1, we collect the variables we consider when assessing gold’s fair value. At present, economic policy uncertainty overwhelms the other factors we typically use as explanatory variables when modeling gold prices. This variable broadly falls in the geopolitical risk we regularly account for in our analysis of gold markets. Table 1Fundamental And Technical Gold-Price Drivers Global Economic Policy Uncertainty Lifts Gold And USD Together Global Economic Policy Uncertainty Lifts Gold And USD Together If the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Checking off each of these groups, we see: · Demand for inflation hedges remaining muted over the short-term, as inflationary pressures remain weak. In line with our House view, however, we do expect inflation could move higher toward the end of next year and overshoot the Fed’s 2% target for the U.S. This would support gold prices. · Monetary and financial aggregates are working less well as explanatory variables for gold prices in a market dominated by economic policy uncertainty. The USD-gold correlation continues to be disrupted by strong demand for safe-haven assets. As inflation picks up next year, we expect nominal bond yields to rise. Real rates, however, could remain subdued, as long as the Fed is not aggressively raising rates to get out ahead of a possible revival of inflation (Chart 9). Later in 2020, the correlation between rates and gold should be supportive for gold prices – the correlation fades when the Fed tightens, which creates a demand for safe-haven assets like gold. All the same, an increase in real rates would be a risk to gold prices in 1H20. · At present, demand for portfolio-diversification assets via safe-haven assets is a powerful force in gold’s price evolution. It is worthwhile pointing out, however, that if global economic uncertainty is resolved and global growth does rebound, recession fears will diminish, thus reducing the marginal impact of geopolitical shocks. On the other hand, if the uncertainty captured by the EPU indexes is resolved, we would expect the dollar to fall and the negative gold-USD correlation to reassert itself and strengthen. Should that happen, short-term volatility in gold will rise (Chart 10). Chart 9Bond Yields Should Rise As Inflation Revives In 2H20 Bond Yields Should Rise As Inflation Revives In 2H20 Bond Yields Should Rise As Inflation Revives In 2H20 Chart 10Investors Expect Large Positive Moves In Gold And Silver Prices Investors Expect Large Positive Moves In Gold And Silver Prices Investors Expect Large Positive Moves In Gold And Silver Prices Investment Implications As India’s and China’s economic growth picks up, we expect income to grow, which would support physical gold demand in EM countries. Over a tactical horizon – i.e., 3 to 6 months – we expect global economic policy uncertainty to remain elevated. Going into 2020 – and particularly in 2H20 – we expect the USD to weaken on the back of global monetary accommodation policies and increased fiscal stimulus. We also are expecting a ceasefire in the Sino-U.S. trade war, which will revive trade somewhat and support EM income growth and commodity demand. These assumptions, which we’ve laid out in previous research, will be bullish cyclical factors supporting commodities generally. Bottom Line: A ceasefire in the Sino-U.S. trade war, coupled with global fiscal and monetary stimulus, will reduce some of the economic uncertainty dogging aggregate demand. This should be apparent in the data in 1H20. As a result, we continue to expect rising EM income growth to be cyclically bullish for commodities generally. This will allow inflation to revive – again, assuming the Fed does not become aggressive in raising rates. Chart 11EM Income Growth Will Support Demand For Gold EM Income Growth Will Support Demand For Gold EM Income Growth Will Support Demand For Gold Net, this will be bullish for gold: As India’s and China’s economic growth picks up, we expect income to grow, which would support physical gold demand in EM countries (Chart 11).   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1               Please see our report entitled “Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth,” published October 17, 2019. It is available at ces.bcaresearch.com. 2              Please see “Kuwait Sees Neutral Zone Oil Pact With Saudis Within 45 Days,” published by Bloomberg.com on October 19, 2019. 3              Please see “Chile lawmakers call for social reforms as protests mount,”  published by reuters.com on October 22, 2019. 4              We expect a ceasefire in the Sino-US trade war to be announced in 1H20, which will defuse – but not eliminate – an important risk for global growth in our analytical framework.  We expect this will allow the relationship between the USD and gold to move back to its previous equilibrium in 1Q20 or 2Q20. 5              For more info on the Baker-Bloom-Davis index, please see policyuncertainty.com   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Global Economic Policy Uncertainty Lifts Gold And USD Together Global Economic Policy Uncertainty Lifts Gold And USD Together Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary Of Trades Closed In 2018 Global Economic Policy Uncertainty Lifts Gold And USD Together Global Economic Policy Uncertainty Lifts Gold And USD Together Summary Of Trades Closed In 2017 Global Economic Policy Uncertainty Lifts Gold And USD Together Global Economic Policy Uncertainty Lifts Gold And USD Together Summary Of Trades Closed In 2016 Global Economic Policy Uncertainty Lifts Gold And USD Together Global Economic Policy Uncertainty Lifts Gold And USD Together

Highlights The world remains mired in a manufacturing recession. This has historically not been bullish for pro-cyclical currencies. The velocity of money in the euro area will need to rise vis-à-vis the U.S. to confirm a bottom in EUR/USD. Watch the gold/silver ratio in timing this shift. Feature The view on the dollar has hardly ever been more polarized. In the bullish camp are those who believe expected returns are currently highest in the U.S., whether in the bond, equity, or real estate markets. As such, deployment of fresh capital will naturally gravitate towards the U.S. Meanwhile, the bearish side has to contend with the fact that the dollar is expensive, the Federal Reserve is about to expand dollar liquidity, and central banks keep diversifying out of their dollar holdings at a rampant pace. Both camps make quite strong arguments. However, there is little discussion about how these trends will affect relative prices between the U.S. and its trading partners. Exchange rates constantly oscillate to equate prices between any two nations. And the most important of those prices is that of money or interest rates. Forecasting relative interest rates can be an arduous task, but at a minimum, one can observe whether they are in equilibrium or not. In this report, we do it via one lens: the velocity of money, with specific application to the EUR/USD exchange rate.    EUR/USD And The Velocity Of Money The velocity of money (V) is a difficult concept to define, but can be summarized by Irving Fisher’s classical equation MV=PQ, where P is the price level in the economy, Q is output, and M is the money supply. In other words, V=PQ/M. Classical monetarists believe that the velocity of money should exhibit a high degree of stability, allowing central banks to control prices by simply altering the money supply. However, over the past few decades, there has been no correlation between prices and money supply, at least in the U.S., which seems to suggest V has a life of its own.  Chart I-1Money Velocity And Interest Rates Money Velocity And Interest Rates Money Velocity And Interest Rates There are many debates on how to interpret the velocity of money, but it is generally accepted that it is related to interest rates. If money supply is expanding faster than output, then it must be that interest rates are falling, assuming the latter are the price of money. Ergo, one way to regard V is as the interest rate required by the underlying economy (the neutral rate), since it is measured using economic variables, while long rates are priced in the financial arena. Put another way, once economic agents start to increase the turnover of money in the system, it is an endogenous sign that the economy requires higher rates, similar to the signal from rising inflation. Ever since the European debt crisis, the velocity of money in the euro area has collapsed relative to that in the U.S. In the financial world, relative long bond yields have followed suit in tight correlation (Chart I-1). In a nutshell, the relative demand for holding money, perhaps precautionary demand, has been extremely high in the euro area, such that all the increase in relative money supply has been absorbed by falling relative velocity. Put another way, the neutral rate of interest in the euro area has been falling relative to that in the U.S. The velocity of money is observed ex-post, meaning it is not very useful as a forecasting tool. However, if we accept the premise that it measures the underlying neutral rate of interest in an economy, then observing it offers powerful insight into the underlying fundamental trends for any economy. One conclusion from this could be that outgoing European Central Bank President Mario Draghi might be justified in his delivery of powerful monetary stimulus last month, despite the rising chorus of dissent from the governing council. Chart I-2Structural Slowdown In European Growth Structural Slowdown In European Growth Structural Slowdown In European Growth Chart I-2 plots the relative growth performance of the euro area versus the U.S. superimposed with the exchange rate. The result is very evident: The collapse in the euro since the financial crisis has been driven by falling growth differentials between the Eurozone and the U.S. There is little the central bank can do about deteriorating demographic trends, but it can do something about falling productivity. One of those things is to lower the cost of capital in the entire Eurozone, such that it makes sense even for the less productive peripheral countries to borrow and invest. Of course, dynamics in the euro area are much more complex than this simple analogy, since rates do little to boost total factor productivity, and the capital stock in the euro area is quite high. But the fact that the biggest increase in investment since the end of the European debt crisis has been in the periphery is non-negligible evidence. A weaker exchange rate also helps. Global trade growth peaked in 2011, which means that since then, one of the few ways for countries to expand their trade pie has been via a “beggar thy neighbor” policy. Both the Germans and the Japanese are automobile geniuses. So, at the margin, the decision for an indifferent buyer comes down to cost. Chart I-3 shows that ever since the European debt crisis, the relative exchange rate between Japan and the euro area has followed the relative balance sheet expansion and contraction of both central banks. Until now, the Bank of Japan’s balance sheet was slated to expand much faster than that of the ECB. This would have been a powerful and unnecessary upward force on the EUR/JPY exchange rate, in the face of a trade war. Ever since the European debt crisis, the relative exchange rate between Japan and the euro area has followed the relative balance sheet expansion and contraction of both central banks. EUR/USD could face some near-term downside, judging from the spread between German bunds and Treasury yields (Chart I-4). Admittedly, hedged yields still favor the Eurozone over the U.S., especially in the periphery, but that advantage is fading rapidly. More importantly, yields across the periphery are converging rapidly towards those in Germany, solving a critical dilemma that has always plagued the Eurozone in general, and the euro in particular. In simple terms, ECB policy has historically always been too easy for some member countries while too stimulative for others. This has traditionally led to internal friction for the currency. However, with 10-year government bond yields in France, Spain, and even Portugal now at -26 basis points, 15 basis points and 14 basis points, respectively, this dilemma is slowly fading. Chart I-3ECB Action May Have Stalled A Euro Overshoot ECB Action May Have Stalled A Euro Overshoot ECB Action May Have Stalled A Euro Overshoot Chart I-4EUR/USD And ##br##Interest Rates EUR/USD And Interest Rates EUR/USD And Interest Rates The drop in the neutral rate of interest for the Eurozone versus the U.S. might have to do with internal dynamics in the euro area, but part of the reason may also lie in the performance of the manufacturing sector versus the services industry over the past few years. The end of the commodity bull market earlier this decade, the peak in global trade – partly driven by  China’s deliberate efforts to shift its economy more towards services, and the proliferation of “capital-lite” firms has decimated the manufacturing sector around the world. This maybe explains the underperformance of the Eurozone versus the U.S. It is clear that part of this shift is structural, but there has also been a cyclical component. Together with a lot of our leading indicators, one way to time the reversal will be to watch relative money velocity trends – between the U.S., the euro area, and China, for example. This brings us to the ratio of gold prices versus silver. Bottom Line: The world remains mired in a manufacturing recession. This has historically not been bullish for pro-cyclical currencies. The velocity of money in the euro area will need to rise vis-à-vis the U.S. to confirm a bottom in EUR/USD. Gold Versus Silver Chart I-5GSR At A Speculative Extreme GSR At A Speculative Extreme GSR At A Speculative Extreme The gold/silver ratio (GSR) was in a race towards major overhead resistance at 100 this summer, but finally hit a three-decade high of 93.3 and is now showing tentative signs of a reversal. The history of these reversals is that they tend to be powerful, quick, and extremely volatile (Chart I-5). This not only paves the way for an excellent entry point to short gold versus silver, but provides important information on the battleground between easing financial conditions and a pick-up in economic (or manufacturing) activity. In short, it provides insight on when to buy pro-cyclical currencies. Just like gold, silver benefits from low interest rates, plentiful liquidity, and the incentive for currency wars and fiat money debasement. However, the gold/silver ratio tends to rally ahead of an economic slowdown, but then peaks when growth is still weak but liquidity conditions are plentiful enough to affect the outlook for future global growth. Of course, a key assumption is that the global economy fends off a recession, which could otherwise sustain a high and rising GSR. The ratio of the velocity of money between the U.S. and China has tended to track the gold/silver ratio in a tight embrace. The ratio of the velocity of money between the U.S. and China has tended to track the gold/silver ratio in a tight embrace (Chart I-6). A falling ratio signifies that the number of times money is changing hands in China outpaces the number in the U.S. This also tends to coincide with a pickup in manufacturing activity, for the simple reason that silver has more industrial uses (Chart I-7).  Chart I-6Falling GSR = Rising Manufacturing Activity Falling GSR = Rising Manufacturing Activity Falling GSR = Rising Manufacturing Activity Chart I-7No Recession = Buy Silver No Recession = Buy Silver No Recession = Buy Silver A falling dollar also tends to benefit silver more than gold, because silver generally rises faster than gold during precious metal bull markets. Part of the reason is that the silver market is thinner and more volatile, with futures open interest that is about one-third that of gold. Put another way, volatility in silver has always been historically higher than gold (Chart I-8), just as manufacturing and exports tend to be the most volatile part of any economy. Chart I-8Silver Is More Volatile Than Gold Silver Is More Volatile Than Gold Silver Is More Volatile Than Gold This brings us to the sweet spot for silver (and procyclical currencies). Even if global growth remains tepid over the next few months, a lot of the bad news is already reflected in a high GSR, meaning the potential for upside will have to be nothing short of a deep recession. Relative speculative positioning hit a high of 36% of open interest and has been rolling over since. Relative sentiment hit a high of 33% and is also rolling over. More often than not, confirmation from both these indicators has led to a selloff in the GSR (Chart I-9). Chart I-9Tentative Signs Of A Top Tentative Signs Of A Top Tentative Signs Of A Top If global growth bottoms, then the rise in silver prices could be explosive. Silver fabrication demand benefits from new industries such as solar and a flourishing “cloud” industry that are capturing the new manufacturing landscape (Chart I-10). Meanwhile, we are entering a window where any pickup in demand could lead to a sizeable increase in the silver physical deficit. The sharp fall in silver scrap supply is an indication that the supply bottleneck is becoming acute (Chart I-11). Chart I-10Silver Fabrication Demand Uptrend Silver Fabrication Demand Uptrend Silver Fabrication Demand Uptrend Chart I-11Physical Silver Is In Deficit Physical Silver Is In Deficit Physical Silver Is In Deficit As for speculators, ETF demand for silver has just started to pick up, meaning the prospect for a speculative buying frenzy is significant. Similarly, in Shanghai, turnover in both gold and silver has been muted – fitting evidence that there has been a dearth of Asian physical demand, from Hong Kong to India (Chart I-12). We are following this turnover closely as it could be a good indication of a turnaround. Chart I-12Silver Turnover Is Low In Asia Silver Turnover Is Low In Asia Silver Turnover Is Low In Asia Bottom Line: A falling GSR provides important information about the battleground between easing financial conditions and a pickup in economic activity. We remain bullish on both gold and silver, but a trading opportunity has opened up for a short GSR position. Place a limit sell at 90.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mostly negative: Average hourly earnings growth fell from 3.2% year-on-year to 2.9% in September. Nonfarm payrolls decreased to 136,000, while the unemployment rate fell to a 50-year low of 3.5%. The trade deficit marginally widened to $54.9 billion in August. The NFIB’s business optimism index fell to 101.8 in September, down from 103.1 in August. Producer prices for final demand fell by 0.3% month-on-month in September. Services decreased by 0.2% while goods fell by 0.4%.  Initial jobless claims fell to 210,000 for the week ended October 4th. Both headline and core inflation were unchanged at 1.7% and 2.4% year-on-year in September. The DXY index increased by 0.1% this week. Fed chair Jerome Powell said in a speech on Tuesday that the Fed will begin increasing its securities holdings to maintain an appropriate level of reserves in order to avoid another cash supply shock. Balance sheet expansion may eventually help weaken the greenback. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have continued to disappoint: The Sentix confidence index in the euro area fell further to -16.8 in October.  German factory orders contracted by 6.7% year-on-year in August, while industrial production fell by 4% year-on-year. The trade surplus narrowed by roughly €2 billion to €18 billion in August. In France, the trade deficit widened by €0.5 billion to €5 billion in August. Industrial output fell by 0.9% month-on-month in August.  The EUR/USD increased by 0.4% this week. The incoming data are sending the same old message: that while services and domestic demand are holding up, manufacturing and exports continue to underperform. In an interview this week, European Central Bank Vice President Luis de Guindos stated that the ECB still has further headroom to ease policy.  Report Links: A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Japanese Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Both the coincident index and leading index fell to 99.3 and 91.7 in August. Labor cash earnings contracted by 0.2% year-on-year in August. The current account balance also widened to a surplus of ¥2.2 trillion in August. The ECO Watchers Survey shows an improvement of the current situation to 46.7 in September. However, the outlook index fell further to 36.9. Preliminary machine tool orders contracted by 35.5% year-on-year in September. The USD/JPY increased by 0.6% this week. The Bank of Japan is likely to introduce additional stimulus via stronger forward guidance. But the path of least resistance for the yen before then is down. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been dismal: Halifax house prices contracted by 0.4% month-on-month in September. Retail sales decreased by 1.7% year-on-year in September. Industrial production continued to fall by 1.8% year-on-year in August. Manufacturing production also decreased by 1.7% year-on-year. GDP fell by 0.1% month-on-month in August. The GBP/USD fell by 0.8% this week, weighed by Brexit uncertainties and weaker incoming data. Moreover, the FPC meeting minutes released this Wednesday highlighted the downside risks associated with a disorderly Brexit, including material debt vulnerabilities, structural illiquidity, and reduced space for monetary policy. The pound is extremely cheap, but volatility will persist in the near term. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been negative: The NAB’s business conditions index increased to 2 from 1 in September. However, the NAB confidence index fell to zero. The Westpac consumer confidence reading also plunged by 5.5% to 92.8 in October, its lowest since mid-2016.  Home loans grew by 1.8% month-on-month in August, following a monthly increase of 5% in July. The AUD/USD has been flat this week. Our bias remains pro-cyclical and we are constructive on the Aussie dollar from a contrarian perspective, especially against the kiwi. As an export-oriented economy, the Australian dollar is likely to respond well to positive U.S.-China trade talks. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 There is scant data from New Zealand this week: The Inflation gauge was unchanged at 0.3% month-on-month in September. The NZD/USD has been flat this week. As a small, open economy, New Zealand is highly tied to global growth, and heavily weighed down by the U.S.-China trade war. We continue to be long AUD/NZD however as a play on relative valuation. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been relatively strong: Exports and imports both increased in August. However, the trade deficit narrowed to C$0.96 billion in August from C$1.38 billion in July. The Ivey PMI fell to 48.7 in September, down from 60.6 in August. Building permits grew by 6.1% month-on-month in August. New housing prices contracted by 0.3% year-on-year in August. The USD/CAD fell by 0.1% this week, as Canada is gearing up for a federal election on October 21st. The latest opinion polls show the Liberal Party still ahead with 34.2% of votes, followed by the Conservative Party, closely behind. Our colleagues in Commodity & Energy Strategy point out that the most positive outcome for the Canadian energy sector is a Conservative majority. Our baseline scenario remains a second Trudeau term, producing a status quo result that does not materially change our energy sector outlook. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: The unemployment rate came in at 2.3% in September, the lowest over the past 18 years. USD/CHF has been more or less flat this week. As we argued in last week’s report, the Swiss domestic economy is holding up well. However, due to the highly export-driven nature of the Swiss economy, the Swiss National Bank is likely to weaponize its currency to keep tradeable goods prices in a favorable range. We will go long EUR/CHF at 1.06. Stay tuned.   Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mostly negative: Manufacturing output contracted by 1.1% month-on-month in August. Headline inflation slowed to 1.5% year-on-year in September. Core inflation, however, increased to 2.2% year-on-year. The producer price index increased by 3.6% month-on-month in September. The Norwegian krone continues to trade offside against the U.S. dollar, due to broad dollar resilience and weak oil prices. The USD/NOK increased by 0.2% this week. The EIA posted an increase of 2.9 million barrels in crude oil stocks this week, following an increase of 3.1 million barrels last week, much higher than expected. The increase in oil supply, together with a quick recovery of Saudi oil facilities are viewed as near-term bearish for oil prices. But if demand is able to recover, this will be positive. Remain long petrocurrencies for now. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden continue to disappoint: Industrial production grew by 2.5% year-on-year in August, following yearly growth of 3.1% the previous month. Total manufacturing new orders contracted by 1.1% year-on-year on a seasonally-adjusted basis in August. Headline inflation increased to 1.5% year-on-year in September. The Swedish krona has been the worst-performing G-10 currency this week, losing 1.1% against the U.S. dollar. Year-to-date, the USD/SEK has appreciated by a total of 12.3%. Swedish manufacturing new orders, a key indicator we watch in gauging the direction of the global economy, continued to deteriorate this week. Among sub-sectors, the largest decrease was recorded in the mines and quarries sector. We are watching Swedish data closely.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The global manufacturing cycle is likely to bottom soon, and consumption and services remain robust. The risk of recession over the next 12 months is low. This suggests that equities will continue to outperform bonds. But the risks to this optimistic scenario are rising. A denting of consumer confidence and worsening of geopolitical tensions could hurt risk assets. We hedge this by overweighting cash. China remains reluctant for now to use aggressive monetary easing. Until it does, the less cyclical U.S. equity market should outperform. We may shift into EM and European equities when China ramps up stimulus and the manufacturing cycle clearly bottoms. To hedge against this upside risk, we go tactically overweight Financials, and reiterate our overweight on Industrials and neutral on Australia. Bond yields should continue their rebound. We recommend an underweight on duration and favor TIPS. Credit should outperform on the cyclical horizon, but high corporate debt is a risk – we recommend a neutral position. Recommendations Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Feature Overview Hedges All Around This is a particularly uncertain time for the global economy – and so a tricky one for asset allocators. Will manufacturing activity bottom soon, or will it drag down the services sector and consumption with it? Will bond yields continue their strong rebound? Is the Fed done cutting rates? Will China now ramp up monetary stimulus? Will Iran escalate a confrontation with Saudi Arabia? What will President Trump tweet about next? This is the sort of environment in which portfolio construction comes into its own. We have our view on all these questions, but our level of conviction is somewhat lower than usual. The way for investors to react is to plan asset allocation in such a way that a portfolio is robust in all the most probable scenarios. We expect the global manufacturing cycle to bottom soon. The Global Leading Economic Indicator is already picking up, and the Global PMI shows some signs of bottoming (Chart 1). The shortest-term lead indicator, the Citigroup Economic Surprise Index, has recently jumped in every region except Europe (Chart 2). (See also What Our Clients Are Asking on page 7 for some more esoteric indicators of cycle bottoms.) The bottoming-out is due to easier financial conditions over the past nine months, a stabilization in Chinese growth, and simply time – the down-leg in manufacturing cycles typically last 18 months, and this one peaked in H1 2018. Chart 1First Signs Of Bottoming First Signs Of Bottoming First Signs Of Bottoming Chart 2Surprisingly Strong Surprises Surprisingly Strong Surprises Surprisingly Strong Surprises     At the same time, government bond yields should have further to rise. The Fed may cut rates once more but, given the resilient U.S. economy, no more than that. This is less than the 59 basis points of cuts over the next 12 months priced in by the Fed Fund futures. The recent pick-up in economic surprises suggests that the 10-year U.S. Treasury yield should return at least to where it was six months ago, 2.3-2.4% (Chart 3). This might be delayed, however, if there is an increase in political tensions, for example a break-up of the U.S./China trade talks (Chart 4). Chart 3Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Long-Term Rates To Rebound Further... Chart 4...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk ...But Geopolitical Tensions Remain A Risk This implies that equities are likely to continue to outperform bonds over the next few quarters, and so we remain overweight global equities and underweight global bonds on the 12-month investment horizon. However, the risks to this rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II, usually about 18 months in advance (Chart 5). The 3-month/10-year curve inverted in the middle of this year. We also worry that the weakness in the manufacturing sector may dent consumer confidence. There are some signs of this in Europe and Japan – but none significant yet in the U.S. (Chart 6). Accordingly last month, as a hedge against an economic downturn, we went overweight cash, which we see as a more attractive hedge, from a risk/reward point-of-view, than bonds. Chart 5Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Can We Ignore The Message From The Yield Curve? Chart 6Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence Some Signs Of Weaker Consumer Confidence     We also remain overweight U.S. equities, which are lower-beta and have fewer structural headwinds than equities in other regions. However, we continue to look for an entry point into the more cyclical equity markets which would also be beneficiaries of bolder China stimulus. China’s monetary easing remains more tepid than in previous stimulus episodes. It has probably been enough to stabilize domestic activity (Chart 7) but not to trigger a rally in industrial commodity prices, EM assets, and euro area equities, as it did in 2016. A pick-up in global PMIs and signs of stronger Chinese credit growth would clearly help EM and Europe (Chart 8) but we need higher conviction that these things are indeed happening before making that move. In the meantime, we are hedging the upside risk by raising the global Financials sector tactically to overweight, since it would likely do well if euro area stocks started to outperform. Earlier this year, we raised the Industrials sector to overweight and Australian equities to neutral, also to hedge against the upside risk from more aggressive Chinese stimulus. Chart 7Chinese Stimulus Has Merely Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chinese Stimulus Has Merelyy Stabilized Growth Chart 8Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets Europe And EM Are The Most Cyclical Markets     Chart 9Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions Oil Price Spikes Often Precede Recessions The biggest geopolitical risk to our sanguine scenario is the situation in the Middle East, after the attacks on Saudi oil refineries. Every recession in the past 50 years has been preceded by a 100% year-on-year spike in the crude oil price (though note that Brent would need to rise to over $100 a barrel by year-end, from $61 today, for that to eventuate (Chart 9)). A short-term oil shortage is not the problem since strategic reserves are ample. But the attack demonstrates the vulnerability of the Saudi installations. And a reprisal attack on Iran could lead it to block the Strait of Hormuz, through which more than 20% of global oil passes. We have an overweight on the Energy sector, partly as a hedge against these risks. BCA’s oil strategists expected Brent crude to rise to $70 this year, and average $74 in 2020, even before the recent attack. They argue that the risk premium in the oil price (the residual in Chart 10) is too low, given not only tensions with Iran, but also other potential supply disruptions in Iraq, Libya, Venezuela and elsewhere.   Chart 10Is The Oil Risk Premium Too Low? Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com     What Our Clients Are Asking Which Leading Indicators Should Investors Watch To Time The Rebound In Global Growth? Chart 11Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth Is Eurozone Manufacturing Close To A Bottom? Positive Signals For Global Growth During 2019, the global growth decline was a key driver of the bond rally and the outperformance of defensive assets. Thus, timing when this decline will reverse will be crucial, since it would also result in a change of leadership from defensive to cyclical assets. But how can this be done? Below we list three of our favorite indicators that have provided reliable leading signals on the global economy in the past: Carry-trade performance: The performance of EM currencies with very high carry versus the yen tends to be a leading indicator for global growth (Chart 11, panel 1). In general, carry trades distribute liquidity from countries where funds are plentiful but rates of return are low (like Japan), to places with savings shortfalls and high risk, but where prospective returns are high. Positive performance of these currencies tends to signal a positive shift in global liquidity, which usually fuels global growth. Swedish inventory cycle: The Swedish new-orders-to-inventories ratio is a leading indicator of the global manufacturing cycle (panel 2). Why? Sweden is a small open economy that is very sensitive to global growth dynamics. Moreover, Swedish exports are weighted towards intermediate goods, which sit early in the global supply chain. This makes the Swedish inventory cycle a good early barometer of the health of the global manufacturing cycle. G3 monetary trends: G3 excess money supply – measured as the difference between money supply growth and loan growth – is a leading indicator of global industrial production (panel 3). As base money and deposits become more plentiful in the banking system relative to the pool of existing loans, the liquidity position of commercial banks improves. This provides banks with the necessary fuel to generate more loan growth, a development which eventually provides a boon to economic activity. Importantly, all these leading indicators are sending a positive signal on the global economy. This confirms our view that rates should go up as global growth strengthens. Therefore, investors should remain overweight equities and underweight bonds in their portfolios.   Is It Time To Buy Euro Area Banks? In a Special Report on euro area banks in December 2018, we noted that “Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected”.1 Our recommendation back then was that “long-term investors should avoid banks in the region, but investors with a more tactical mandate and much nimbler style could use the valuation indicators to ‘time’ their entry into and exit out of banks as a short-term trade.” Since then, banks have continued to underperform the overall market by over 10%, further pushing down relative valuation metrics. Currently, both relative P/B and relative dividend yield are at extreme levels that have historically heralded at least a short-term bounce. The euro area PMI is still below 50, but there are signs that the euro area economy could rebound later this year, which should be positive for banks’ relative earnings. Already, forward EPS growth has been stabilizing relative to the broad market (Chart 12, panel 4). In addition, two of the key concerns back in December 2018 were Italian government debt and the unwinding of QE. Now Italian debt is no longer in crisis and the ECB has relaunched QE. As such, investors with a tactical mandate and a nimble style should buy (overweight) banks in the euro area. Long-term investors should still avoid such a short-term trade because structural issues remain. Chart 12Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks Tactically Upgrade Euro Area Banks   Is The Gold Rally Over? Spot gold prices have increased 17% year-to-date, on the back of global growth weakness, dovish central banks, and rising political tensions. Should investors now pare back their gold exposure? Common sense would suggest they should. However, these are not ordinary times. In the short term, gold prices might suffer from some profit-taking due to overbought technicals and excessively positive sentiment (Chart 13, panel 1). Moreover, gold prices have moved this year due to increased market expectations of central bank easing (panel 2). We expect that markets will be disappointed going forward by only limited rate cuts, which could put downward pressure on gold. On the other hand, with approximately 27%, or $14.9 trillion, of global debt with negative yields at the moment, investors will continue to shift to the next best asset – zero-yielding gold (panel 3). This is clear from the rise in holdings of gold over the past few years by both central banks and investors (panels 4 & 5). We expect this trend to persist as investors continue their search to avoid negative yields and focus on capital preservation. Geopolitical tensions have intensified since the beginning of the year: ongoing yet inconclusive trade negotiations between the U.S. and China, implementation of further tariffs, Brexit uncertainty, and the recent military attacks in the Middle East (panel 6). This environment should also continue to push gold prices higher. We continue to recommend gold as a hedge against inflation – which we see picking up over the next 12 months – as well as against any further deterioration in global growth and the geopolitical situation. Chart 13Gold: Sell Or Hold? Gold: Sell Or Hold? Gold: Sell Or Hold? Risks to the rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II. How Low Can Rates Go? The zero lower bound is a thing of the past. Last month, Denmark’s central bank cut rates to -0.75%, and 10-year government bonds in Switzerland hit a historic low for any major country, -1.12%. In the next recession, how much further could interest rates theoretically fall? For individuals, cash rates might be limited by the cost of storing paper currency, which has a zero yield (unless governments find a way to ban cash or charge an annual fee on it). A bank safety deposit box costs about $300 a year, and a professional-quality safe big enough to store $1 million (which would be a pile of $100 bills 31 x 55 cms, weighing 10 kg) costs $2,000 with installation costs. Amortize the latter over 10 years, and the cost of storing $1 million is about 0.2%-0.3% a year. Swiss franc bills – maximum denomination CHF1,000 – would cost less to store. But storage costs for physical gold are around 2% a year. Since rates have fallen below this, there must be other constraints. Individuals would find storing money in cash possibly dangerous and certainly very inconvenient (imagine having to transport the cash to a bank to pay a tax bill). And the cost for a rich individual or company of storing, say, $1 billion (weighing 10 tonnes) would be much higher. Given the history in even low-rate countries (Chart 14, panel 1), we suspect around -1% is the level at which cashholders would seek alternatives to bank deposits of government bills. Chart 14How Low Can They Go? How Low Can They Go? How Low Can They Go? Chart 15Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below Yield Curves When Rates Are At Zero Or Below   At the long end, the yield curve does not typically invert much when short-term rates are zero or negative (Chart 15). The biggest 3-month/10-year inversion was in Switzerland earlier this year, -0.05%. This points then to the absolute lowest level for 10-year bonds anywhere, even in the middle of a nasty recession, at around -1.1%. That is a worry for asset allocators. It means that the maximum mathematical upside for Swiss government bonds from their current level (-0.8%) is 3% while it is 5% for German bonds (currently -0.5%). This is not much of a hedge. Only the U.S. looks better: if the 10-year Treasury yield falls to 0%, the total return is 18%.   Global Economy Chart 16U.S. Growth Remains Solid U.S. Growth Remains Solid U.S. Growth Remains Solid Overview: Industrial-sector growth globally has been weak, with the manufacturing PMI in most countries falling below 50. But consumption and services almost everywhere have remained resilient, even in the manufacturing-heavy euro area. And there are tentative signs of a bottoming-out in manufacturing. However, a full-scale rebound will depend on further monetary stimulus in China, where the authorities still seem cautious about rolling out easing on the scale of what was done in 2016. U.S.: U.S. manufacturing has now followed the rest of the world into contraction, with the ISM manufacturing index slipping below 50 in August (Chart 16, panel 2). However, consumption and services are holding up well. Employment continues to expand (albeit at a slightly slower pace than last year, perhaps because of a lack of jobseekers), there is no sign of a rise in layoffs, and consumer confidence remains close to a historical high (though it slipped slightly in September). Housing has recovered after last year’s slowdown, and the recent congressional budgetary agreement means fiscal policy will be mildly expansionary over the coming 12 months. Only capex (panel 5) has slowed, as companies postpone investment decisions due to uncertainty surrounding the trade war. The consensus expects U.S. real GDP growth of 2.2% this year, above most estimates of trend growth. Euro Area: Given its higher concentration in manufacturing, European growth is weaker than in the U.S. The manufacturing PMI has been below 50 since February, and fell further to 45.6 in August. Industrial production is shrinking by 2% year-on-year. Italy has experienced two negative quarters of growth, and Germany may also enter a technical recession in Q3 (GDP shrank by 0.1% in Q2). However, there are some tentative signs that manufacturing is bottoming: the ZEW survey in September, for example, surprised on the upside. And, like the U.S., consumption remains strong. Even in manufacturing-heavy Germany, employment continues to grow, and retail sales in July were up 4.4% year-on-year. In the U.K., however, uncertainty surrounding Brexit has damaged business investment, though employment has been strong.2 Chart 17First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? First Signs Of A Rebound In The Rest Of The World? Japan: Consumption has already slipped, even before the consumption tax hike scheduled in October. Retail sales in July fell 2% year-on-year, due to negative wage growth and consumer sentiment falling to a five-year low. Manufacturing continues to suffer from China’s slowdown and the strong yen (up 6% over the past 12 months), with exports falling 6% and industrial production down 2% year-on-year over the past three months. The effect of the consumption tax hike may be cushioned by government measures (lowering taxes on autos and making high-school education free, for example). And a pickup in Chinese growth would boost exports. But there are scant signs yet of a bottoming in activity. Emerging Markets: China’s growth appears to have stabilized, with both manufacturing and non-manufacturing PMIs above 50 (Chart 17, panel 3). But confidence remains fragile, with retail sales growth slowing to a 20-year low and car sales down 7% in August, despite the introduction of cars compliant with new emissions standards. The authorities have responded with further easing measures (including a further cut in the reserve requirement in September) but seem reluctant to launch a full-scale monetary stimulus, similar to what they did in 2016. Elsewhere in EM, growth has slowed in countries with structural issues (latest year-on-year real GDP growth in Argentina is -5.7%, in Turkey -1.5% and in Mexico -0.8%) but remains fairly resilient elsewhere (India 5%, Indonesia 5%, Poland 4.2%, Colombia 3.4%). Interest Rates: Central banks almost everywhere have turned dovish, with the Fed cutting rates for a second time, the ECB restarting asset purchases, and the Bank of Japan signaling it will ease in October. But further monetary accommodation will probably be less than the market expects. The Fed signaled that its cuts were just a mid-cycle correction and that further easing is unlikely. And the ECB and BoJ have little ammunition left. With signs of growth bottoming, and the market understanding that central banks’ dovish turn is reaching its end, long-term rates, which have already risen in the U.S. from 1.45% to 1.72% in September, are likely to move higher. Investors should also carefully watch U.S. inflation, which is showing signs of underlying strength, with core CPI inflation rising 2.4% year-on-year in August (and as much as 3.4% annualized over the past three months).   Global Equities Chart 18Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Has Earnings Growth Bottomed? Still Cautious, But Adding An Upside Hedge: Global equities registered a small loss of 8 basis points in Q3 (Chart 18) despite all the headline risks from geopolitics and weakening economic data. Overall, our defensive country allocation worked well in Q3, since DM equities outperformed EM by 4.5%, and the U.S. outperformed the euro area by 2.8%. Our sector positioning did not do as well since underweights in Utilities and Consumer Staples and overweights in Industrials, Energy and Health Care all went in the wrong direction, even though the underweight in Materials did help to offset the loss. During the quarter, however, both sector and country rotations were evident within the global equity universe, in line with the wild swings in bond yields. September saw some reversals in DM/EM, U.S./euro area and cyclical/defensives. Going forward, BCA’s House View remains that global economic growth will begin to recover over the coming months, albeit a little later than we previously expected. As such, our defensive country allocation remains appropriate. We did put euro area and EM equities on upgrade watch in April,3 but the delay in the global recovery also implies that it is still not the time to trigger this call. With our view that bond yields have hit bottom,4 we are making one adjustment in our global sector allocation by upgrading Financials to overweight from neutral. We are financing this by cutting in half the double overweight in Health Care to overweight (see next page for more details). This adjustment also acts as a hedge against two possible outcomes: 1) that the euro area outperforms the U.S., and 2) that Elizabeth Warren wins in the upcoming U.S. presidential election.5   Upgrade Global Financials To Overweight From Neutral Chart 19Upgrade Global Financials Upgrade Global Financials Upgrade Global Financials The relative performance of global Financials to the overall equity market has been hugely affected by the movements in global bond yields (Chart 19, panel 1). As bond yields made a sharp reversal in September, so did the relative performance of Financials, even though it is barely evident on the chart given how much Financials have underperformed the broad market over recent years. It’s not clear how sustainable the sharp reversal in bond yields will be, but BCA’s House View is that bond yields will move higher over the next 9-12 months. As such, we are upgrading Financials to overweight from neutral, for the following additional reasons: Valuations are extremely attractive as shown in panel 2. More importantly, the relative valuation is now at an extreme level that historically heralded a bounce in Financials’ relative performance. Loan quality has improved. The U.S. non-performing loan (NPL) ratio is nearing the lows reached before the Global Financial Crisis (GFC). Even in Spain and Italy, NPL ratios have fallen significantly, though they remain higher than they were prior to the GFC (panel 3). U.S. consumption has been strong, housing has rebounded, and demand for loans is getting stronger (panel 4), in line with data such as the Citi Economic Surprise Index, suggesting that economic data may have hit bottom. To finance this upgrade, we cut the double overweight of Health Care to overweight, as a hedge against Elizabeth Warren winning next year’s U.S. presidential election and tightening rules on drug pricing. Government Bonds Maintain Slight Underweight On Duration. Our below-benchmark duration call was severely challenged by the global bond markets in the first two months of the third quarter. The U.S. 10-year Treasury yield hit 1.43% on September 3 in response to the weaker-than-expected ISM manufacturing index in the U.S., 57 bps lower than the level at the end of previous quarter, and just a touch higher than the historical low of 1.32% reached on July 6, 2016. The rebound in bond yields since September 5, however, was driven not only by the ebb and flow in the U.S./China trade policy dynamics, but also by the positive surprises in economic data releases, as shown in Chart 20. BCA’s Global Duration Indicator, constructed by our Global Fixed Income Strategy team using various leading economic indicators, is also pointing to higher yields globally going forward. Investors should maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Global inflation expectations have also rebounded after continuing their downtrend in the first two months of the quarter. This largely reflects the acceleration in August in realized inflation measures such as core CPI, core PCE, and average hourly earnings. In addition, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. The oil price jumped initially by 20% following the attack on the Saudi Arabian oil production facilities. While it’s not clear how the geopolitical tensions will evolve in the Middle East, a conservative assumption of a flat oil price until the end of the year still points to much higher inflation expectations, supporting our preference for inflation-linked bonds over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds (Chart 21). Chart 20Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Bond Yields Have Hit Bottom Chart 21Favor Inflation Linkers Favor Linkers Favor Linkers We continue to look for an entry point into more cyclical markets which would benefit from a bolder Chinese stimulus. Corporate Bonds Since we turned cyclically overweight on credit within a fixed-income portfolio, investment-grade bonds and high-yield bonds have produced 220 and 73 basis points, respectively, of excess return over duration-matched government bonds. We remain bullish on the outlook for credit over the next 12 months, as we expect global growth to accelerate before the end of the year. Historically, improving global growth has resulted in sustained outperformance of credit over government bonds. Moreover, default rates should remain subdued over the next year given that lending standards continue to ease (Chart 22, panel 1). How long will we remain overweight credit? High levels of leverage, declining interest coverage ratios, and the high share of Baa-rated debt in the U.S. corporate debt market continue to make credit a risky proposition on a structural basis. However, with inflation expectations still very low, the Fed has a strong incentive to keep monetary policy easy. This dovish monetary policy should keep interest costs at bay, helping credit outperform over the next year. That said, we believe that there are some credit categories that are more attractive than others. Specifically, we recommend investors favor Baa-rated and high yield securities, given that there is still room for further credit compression in these credit buckets (panel 2 and panel 3). On the other hand, investors should stay away from the highest credit categories, as they no longer offer value (panel 4). Chart 22Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value Baa-rated And High-Yield Credit Offer The Most Value   Commodities Chart 23No Supply Shock In The Oil Market Quarterly Portfolio Outlook: Hedges All Around Quarterly Portfolio Outlook: Hedges All Around Energy (Overweight): September’s drone attack on Saudi crude facilities sent oil prices soaring as much as 20% in the days following, before falling back to pre-attack levels. Initial estimates estimated the supply disruption at 5.7 million barrels a day – approximately 5.5% of global supply – making it the largest crude supply outage in history. However, assuming the Saudis can return 70% of the lost output back online as they claim, OPEC’s spare capacity, approximately 1.8 million barrels a day, should be able to balance the market and cover the remaining lost production.6,7 In the longer-term, a pick-up in global oil demand, as economic growth rebounds, plus supply tightness should keep oil price elevated, with Brent reaching $70 this year and averaging $74 in 2020 (Chart 23, panels 1 & 2). Industrial Metals (Neutral): A combination of half-hearted year-to-date stimulus by Chinese authorities and a stronger USD in the second and third quarters of 2019 have driven industrial metals spot prices lower. However, the Chinese government announced additional stimulus in September, with further bond issuance to finance infrastructure projects and an easing of monetary policy (panel 3). This should give some upside for industrial metal prices over the coming six-to-12 months. Precious Metals (Neutral): We remain positive on gold, despite its strong performance year-to-date, since we see it as a good hedge against recession, inflation, and geopolitical risks. We discuss gold in detail in the What Our Clients Are Asking section on page 9. Silver also looks attractive in the short term. The nature of the use of silver has changed over the past two decades, from being mostly a base metal for industrial fabrication to becoming more of a precious metal viewed as a safe haven. The correlation between gold and silver prices has increased since the Global Financial Crisis from an average of 0.5 pre-crisis to 0.8 post-crisis (panels 4 & 5). Global growth and political uncertainty should support silver prices in the coming months. Currencies U.S. Dollar: The trade-weighted dollar has appreciated by 2.5% since we turned neutral in April. We expect that the steep drop in yields will continue to ease financial conditions and help global growth in the last quarter of the year. Given that the dollar is a counter-cyclical currency, an environment where global growth rallies have historically been negative for the greenback. Euro: Since we turned bullish in April, EUR/USD has depreciated by 2.7%. Overall, we continue to be positive on EUR/USD on a cyclical timeframe. After the ECB cut rates by 10 basis points and announced further rounds of quantitative easing, there is not much room left for the euro area to keep easing relative to the U.S. (Chart 24, panel 1). Moreover, improving expectations of profit growth in the euro area vis-à-vis the U.S. will drive money flows towards Europe, pushing EUR/USD up in the process (panel 2). Emerging Market Currencies: We remain bearish on emerging market currencies for the time being. That being said, they remain on upgrade watch for the end of the year. There are multiple signs that global growth is turning up, a consequence of the easy financial conditions caused by some of the lowest bond yields on record. Moreover, the marginal propensity to spend (proxied by M1 growth relative to M2 growth) in China, the main engine of EM growth, continues to point to further appreciation in emerging market currencies (panel 3). Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro The Euro Might Soon Pop Interest Rate And Profit Expectations Differentials Favor The Euro     Alternatives Chart 25Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Favor Hedge Funds Untill Global Growth Bottoms Return Enhancers: Over the past 12 months, we have recommended investors pare back on private equity and increase allocations to hedge funds – macro hedge funds in particular. This was due to our judgement that we are late in the economic cycle. While we expect growth to pick up over the coming months, this is not yet clear in the data (Chart 25, panel 1). This uncertain macro outlook will prove tough for private equity funds, especially given an environment of rising multiples and increasing competition for deals. We continue to see global macro hedge funds as the best hedge ahead of the next recession and would advise investors to allocate funds now, given the time it takes to move allocations in the illiquid space. Inflation Hedges: In the current environment, TIPS are likely a better inflation hedge than illiquid alternative assets. Our May 2019 Special Report 8 showed that TIPS produce a particularly attractive risk-adjusted return during times when inflation is rising, but still fairly low (below 2.3%). TIPS should do well, therefore, in the environment we expect over the next few months, where the Fed remains dovish, cutting rates perhaps once more, while condoning a moderate acceleration of inflation (panel 2). Volatility Dampeners: Structured products – mostly Mortgage-Backed Securities (MBS) – have had an excellent record of reducing portfolio volatility (panel 3). Despite that, we do not recommend more than a neutral allocation to MBS currently due to a less-than-attractive valuation picture. Despite Treasury yields falling by more than 100 basis points this year and refinancing activity picking up, nominal MBS spreads remained near their all-time lows. However, as Treasury yields bottom, we expect refinancing to slow, putting downward pressure on spreads. Risks To Our View The most likely upside risk comes from the Fed being too dovish and falling behind the curve. Underlying inflation pressures in the U.S. remain strong (with core CPI up 3.4% annualized over the past three months). After two rate cuts, the Fed Funds rate is now comfortably below the neutral rate: 0.1% in real terms compared to a Laubach-Williams r* of 0.8% (Chart 26). Tightness in the money markets have pushed the Fed to start expanding its balance sheet again. If manufacturing growth accelerates next year, and wages and profits begin to rise, a stock market melt-up, similar to that in 1999, would be possible. Eventually, though, the Fed would need to raise rates (perhaps sharply) to kill inflation, which could usher in the next recession. There are a broader range of possible downside risks. As argued throughout this Quarterly, there are various possible triggers of recession: failure of China to stimulate, and a loss of confidence by consumers, in particular. Some models of recession put the risk over the next 12 months as high as 30% (Chart 27). Structurally, the biggest risk is probably the high level of corporate debt in the U.S. (Chart 28). A breakdown in the junk bond market, as seen briefly last December, could lead to companies failing to refinance the large amount of debt maturing over the next 18 months. Geopolitical risks also remain elevated and are, by nature, hard to forecast. The outcome of Brexit remains highly uncertain – though we see low risk of a no-deal exit. We expect trade talks between the U.S. and China to drag on, without a comprehensive deal, while a clear breakdown would be negative. Impeachment of President Trump is probably not a significant market event, but might hurt market sentiment briefly (particularly if it makes the election of Elizabeth Warren more likely). The Iran/Saudi conflict could escalate. Risk premiums may need to rise to take into account these threats. Chart 26Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Is The Fed Turning Too Dovish? Chart 27What Risk Of Recession? What Risk Of Recession? What Risk Of Recession? Chart 28Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk? Is Corporate Debt The Biggest Risk?   Footnotes 1Please see Global Asset Allocation Special Report, titled "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated 20 September 2019, available at fes.bcaresearch.com. 3Please see Global Asset Allocation Quarterly, titled "Quarterly - April 2019" dated April 1, 2019, available at gaa.bcaresearch.com. 4Please see Global Investment Strategy Weekly Report, titled "Bond Yields Have Hit Bottom," dated September 6, 2019, available at gis.bcaresearch.com. 5Please see Global Investment Strategy Weekly Report, titled "Elizabeth Warren And The Markets," dated September 13, 2019, available at gis.bcaresearch.com. 6Dmitry Zhdannikov and Alex Lawler “Exclusive: Saudi oil output to return faster than first thought - sources,” Reuters, dated Sepetmber 17, 2019. 7Please see Geopolitical Strategy Special Alert titled, “Attacks On Critical Infrastructure In KSA Raises Questions About U.S. Response,” dated September 16, 2019, available at gps.bcaresearch.com. 8Please see Global Asset Allocation Special Report, titled “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019, available at gaa.bcaresearch.com GAA Asset Allocation

Gold's Rise Is Stretched Gold's Rise Is Stretched Neutral Global gold stocks have gone parabolic over the past four months and are in desperate need of a breather (top panel).  Simultaneously, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as market participants expect, this would likely exert upward pressure on global interest rates including the U.S. (bottom panel), especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Bottom Line: Downgrade the global gond mining index to neutral and move to the sidelines. Please see Monday’s Weekly Report for additional details. ​​​​​​​

Highlights Portfolio Strategy The contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. It no longer pays to be overweight gold mining equities as sentiment is stretched, the restarting of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on global gold miners. EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Recent Changes Trim the Global Gold Mining index to neutral, today. Downgrade the S&P Materials sector to underweight, today. Table 1 Extend And Pretend? Extend And Pretend? Feature Equities broke out of their trading range last week, but in order for this short-covering rally to become durable, and for volatility to subside, either global growth needs to turn the corner and alleviate recession fears or the trade war needs to de-escalate materially. On the recession front Central Banks (CBs) are doing their utmost to reflate their respective economies, but the early stages of looser monetary policy have been insufficient to change the global growth trajectory. With regard to the trade war, markets cheered the news that talks between the U.S. and China will resume in September and October. The dates for talks are conveniently chosen to follow the September FOMC meeting and the October 1 70th anniversary of the People's Republic of China. The latter date implies that Washington is considering delaying the October 1 tariff hike – and it could imply that Washington does not anticipate any violent suppression of Hong Kong protesters by that time. However, the harsh reality is that the two sides are just “kicking the can down the road”. The longer the Sino-American trade war takes to conclude, the more likely it will serve as a catalyst for a repricing of risk significantly lower (top panel, Chart 1). A technical correction may be necessary to force Trump to reduce the trade pressure significantly. Even if the October 1 tariff hike is postponed it will remain a source of uncertainty ahead of the final tariff tranche slated for December 15. The bond market may offer some clues as to the extent that the escalating trade war will eventually get reflected into stocks (bottom panel, Chart 1). The equity transmission mechanism is through the earnings avenue. Simply put, rising trade uncertainty deals a blow to global trade that boosts the U.S. dollar which in turn makes U.S. exports uncompetitive in global markets, deflates the commodity complex and with a lag weighs on SPX earnings. Chart 1Tracking Trade Uncertainty Tracking Trade Uncertainty Tracking Trade Uncertainty Speaking of the economically hypersensitive manufacturing sector, last week’s ISM release made for grim reading, further fueling recession fears (the New York Fed now pegs the recession probability just shy of 38% by next August). Not only did the overall survey fall below the boom/bust line (middle panel, Chart 2), but also new orders collapsed. In fact, the drubbing in new orders is worrying and it signals that the economy is going to get worse before it gets better (top panel, Chart 2). Tack on the simultaneous rise in inventories, and the sinking new orders-to-inventories ratio (not shown) warns of additional manufacturing ills in the coming months. Importantly, export orders suffered the steepest losses plunging to 43.3. The last three times that this trade-sensitive survey subcomponent was in such a steep freefall were in 1998, 2001 and 2008, when the SPX suffered peak-to-trough losses of 20%, 49% and 57%, respectively. In fact, since the history of the data, ISM manufacturing export orders have never been lower with the exception of the GFC (Chart 3). Such a retrenchment will either mark the bottom for equities or is a harbinger of a steep equity market correction. We side with the latter as the odds of President Trump striking a real trade deal (including tech) with China any time soon are low. Chart 2Like Night Follows Day Like Night Follows Day Like Night Follows Day Similar to the ISM manufacturing/non-manufacturing divergence (bottom panel, Chart 2), business confidence is trailing consumer conference by a wide mark. Historically this flaring chasm has been synonymous with a sizable loss of momentum in the broad equity market (Chart 4). One plausible explanation is that as business animal spirits suffer a setback, CEOs are quick to prune/postpone capex plans and, at the margin, corporations retrench and short-circuit the capex upcycle. Chart 3Export Carnage Export Carnage Export Carnage Chart 4Mind The Gap Mind The Gap Mind The Gap Circling back to last week’s capex update, national accounts corroborate the financial statement data deceleration, and in some cases contraction, in capital outlays (Chart 5). As a reminder our thesis is that the EPS-to-capex virtuous upcycle is morphing into a vicious down cycle.1 This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Crucially, tech investment, that comprises almost 30% of total investment according to national accounts, is decelerating, R&D and other intellectual property investment have also hooked down, non-residential structures are on the verge of contraction, and industrial, transportation and other equipment –that have the largest weight in U.S. capex – are also quickly losing steam (Chart 6). Chart 5Capex Blues Capex Blues Capex Blues Chart 6All Capex Segments… All Capex Segments… All Capex Segments… In more detail, Charts 7 & 8 further break down capital outlays in the respective categories and reveal that worrisomely the investment spending slowdown is broad based. Chart 7…Have Rolled Over… …Have Rolled Over… …Have Rolled Over… Chart 8…Except For One …Except For One …Except For One Adding it all up, the contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. As a reminder, this is U.S. Equity Strategy service’s view and it contrasts with BCA’s sanguine equity market house view. This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Downgrade Materials To Underweight… Heightened economic and trade policy uncertainty has claimed the S&P materials sector as one of its victims (Chart 9). Given that our Geopolitical Strategy service’s base case remains that there will be no Sino-American trade deal by the U.S. November 2020 election, there is more downside for materials stocks and we are downgrading this niche deep cyclical sector to a below benchmark allocation.2 Beyond the U.S./China trade war inflicted wounds that materials stocks have to nurse, there are four major headwinds that they will also have to contend with in the coming months. Chart 9Trade Uncertainty Sinking Materials Trade Uncertainty Sinking Materials Trade Uncertainty Sinking Materials First, the emerging markets (EM) in general and China in particular are in a prolonged soft patch that predates the Sino-American trade war. EM stocks and EM currencies are both deflating at an accelerating pace warning that relative share prices will suffer the same fate (Chart 10). Nothing epitomizes the infrastructure spending/capex cycle more than China’s insatiable appetite for commodities and the news on that front remains dire. The Li Keqiang index continues to emit a distress signal and that is negative for materials top line growth (bottom panel, Chart 10). Second, global inflation is in hibernation and select EM producer price inflation growth series are on the verge of contraction or already outright contracting. Chinese raw materials wholesale prices are in the deflation zone and warn that U.S. materials sector profits will underwhelm (Chart 11). Chart 10Bearish EM… Bearish EM… Bearish EM… Chart 11…And China Backdrops …And China Backdrops …And China Backdrops Base metal prices are a real time indicator of the wellness of the S&P materials sector. Currently, base metals are deflating both on the back of a firming U.S. dollar and contracting global manufacturing. Such a commodity price backdrop is dampening prospects for a profit-led materials sector relative share price recovery (top & middle panels, Chart 12). Third, the materials exports outlook is darkening. Apart from the deflating effect the appreciating U.S. dollar has on commodities it also clips basic materials companies’ exports prospects. How? It renders materials related exports uncompetitive in international markets leading to market share losses. Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Chart 12Weak Pricing Power And Declining Exports Weak Pricing Power And Declining Exports Weak Pricing Power And Declining Exports In addition, the latest ISM export order subcomponent plunged to multi-year lows reflecting trade war pessimism and falling global end-demand. The implication is that the export relief valve is closed for materials equities (bottom panel, Chart 12). Finally, materials sector financial statement metrics are moving in the wrong direction. Net debt-to-EBITDA is rising anew and interest coverage has likely peaked for the cycle at a time when free cash flow generation has ground to a halt (Chart 13). U.S. Equity Strategy’s S&P materials sector profit growth model encapsulates all these moving parts and warns that a severe profit contraction phase looms (Chart 14). Chart 13Financial Statement Red Flags Financial Statement Red Flags Financial Statement Red Flags Chart 14Model Says Sell Model Says Sell Model Says Sell Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Bottom Line: The time is ripe to downgrade the S&P materials sector to underweight. …Via Trimming Gold Miners To Neutral The way we are executing this downgrade in the materials sector to an underweight stance is by trimming the global gold mining index to a benchmark allocation. Our thesis that gold stocks serve as a sound portfolio hedge remains intact and underpinned when: economic and trade policy uncertainty are on the rise (top panel, Chart 15) global CBs start cutting interest rates and in some cases doubling down on negative interest rates currency wars are overheating Nevertheless, what has changed is the price, and we deem that global gold miners that have gone parabolic are in desperate need of a breather. The top panel of Chart 16 shows that gold stocks have rallied 58% since the May 5, 2019 Trump tweet. This outsized four-month relative return is remarkable and likely almost fully reflects a very dovish Fed and melting real U.S. Treasury yields (TIPS yield shown inverted, bottom panel, Chart 15). A much needed pause for breath is required before the next leg of the relative rally resumes, and we opt to move to the sidelines. Chart 15Positive Backdrop… Positive Backdrop… Positive Backdrop… Chart 16…But Reflected In Prices …But Reflected In Prices …But Reflected In Prices Moreover, on the eve of the ECB’s September meeting, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as markets participants expect, counterintuitively a selloff in the bond markets would confirm that QE and its signaling is working (bottom panel, Chart 16). Ergo, this would likely exert upward pressure on global interest rates including the U.S., especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise further. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Sentiment toward gold and global gold miners is stretched. Gold ETF holdings are at multi-year highs (second panel, Chart 17) and gold net speculative positions are at a level that has marked previous reversals. In addition, bullish consensus on gold is near 72%, a percentage last reached in 2012 (third & bottom panels, Chart 17). Similarly, relative share price momentum is also warning that global gold mining equities are currently extended (bottom panel, Chart 18). Chart 17Extreme… Extreme… Extreme… Chart 18…Sentiment …Sentiment …Sentiment Finally, while the bond market’s view of 100bps in Fed cuts in the next 12 months should have undermined the trade-weighted U.S. dollar, it has actually defied gravity and slingshot to fresh cycle highs. This is a net negative both for gold and gold mining equities as the underlying commodity is priced in U.S. dollars and enjoys an inverse correlation with the greenback. The implication is that the multi-decade inverse correlation will hold and will likely pull down gold and gold mining equities at least in the short-run (U.S. dollar shown inverted, Chart 19). In sum, the exponential rise in global gold miners is in need of a breather. Sentiment is stretched, the restating of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on relative share prices Chart 19Gold Miners/Dollar Correlation Re-establishment Risk Gold Miners/Dollar Correlation Re-establishment Risk Gold Miners/Dollar Correlation Re-establishment Risk Bottom Line: Downgrade the global gold mining index to neutral, but stay tuned.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      Please see U.S. Equity Strategy Weekly Report, “Capex Blues” dated September 3, 2019, available at uses.bcaresearch.com 2      Please see The Bank Credit Analyst Special Report, “Big Trouble In Greater China” dated August 29 , 2019, available at bca.bcaresearch.com Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps

Highlights Currency markets continue to fight a tug-of-war between deteriorating global growth and easing global financial conditions. Such an environment is typically fertile ground for a dollar bull market, yet the trade-weighted dollar is up only 2.3% this year. The lack of more-pronounced strength in the greenback suggests that other powerful underlying forces are preventing the dollar from gapping higher. The breakdown in the bond-to-gold ratio is an important distress signal for dollar bulls. As both political and economic uncertainty remain elevated, likely winners in the interim remain safe-haven currencies such as the yen and the Swiss franc. For the remainder of the year, portfolio managers should focus on relative value trades at the crosses, rather than outright dollar bets. Stand aside on the pound for now. Aggressive investors can place a buy stop at 1.25 and sell stop at 1.20. The Riksbank’s hawkish surprise was a welcome development for the krona. Remain long SEK/NZD. The SEK might be the best-performing G10 currency over the next five years. Feature Yearly performance is an important benchmark for most portfolio managers. As most CIOs return to their desks from a summer break, they will be looking at a few barometers to help them navigate the rest of 2019. On the currency front, here is what the report card looks like so far: The dollar has been a strong currency, but the magnitude of the increase has been underwhelming, given market developments. The Federal Reserve’s trade-weighted dollar is up only 2.3% this year. In contrast, the yen is up 3.6% and the Canadian dollar 2.3%. Meanwhile, the best shorts have been the Swedish krona (down 9.7%) and the kiwi. Through the lens of the currency market, the dollar has been in a run-of-the-mill bull market, rather than in a panic buying frenzy (Chart I-1). Chart I-1A Report Card On Currency Performance Preserving Capital During Riot Points Preserving Capital During Riot Points Gold has broken out in every major currency. This carries a lot of weight because it has occurred amid dollar strength, a historical rarity. Importantly, the breakout culminates the seven-or-so-year pattern where gold was stable versus many major currencies (Chart I-2). We are no technical analysts, but ever since gold peaked in 2011, all subsequent rallies have seen diminishing amplitude, which by definition were bull traps. This appeared to have changed since 2015-2016, which could be a signal that the dollar bull market is nearing an end. Commodities have been a mixed bag. Precious metals have surged alongside gold. Despite the recent correction, oil is still up 13.8% for the year. Meanwhile, natural gas is in a bear market. Among metals, nickel has surged 70%, while Doctor Copper is down 5.1%. The only semblance of agreement is among soft commodities, which have been mostly deflating (Chart I-3). In short, there has been no coherent theme for commodity currencies. All the talk of a Sino-U.S. trade war, Chinese A-shares are up 18.7% for the year. This more than makes up for any CNY depreciation.  Equities have performed well across the board, mostly up double digits. The only notable laggards have been in Asia, specifically Japan, Hong Kong and Korea. That said, of all the talk of a Sino-U.S. trade war, Chinese A-shares are up 18.7% for the year. This more than makes up for any CNY depreciation. This also suggests that capital flows into equities have not been a major driver of currencies this year. Chart I-2Gold Has Been The Ultimate Currency Gold Has Been The Ultimate Currency Gold Has Been The Ultimate Currency Chart I-3Commodities Are A Mixed Bag Commodities Are A Mixed Bag Commodities Are A Mixed Bag Yields have collapsed, with higher-beta markets seeing bigger drops. Differentials have mostly moved against the dollar in recent weeks as the U.S. 10-year yield plays catch-up to the downside. One important question is that with Swiss 10-year yields now at -0.96% and German yields at -0.67%, is there a theoretical floor to how low bond yields can fall (Chart I-4)? Chart I-4Yields Have Melted Yields Have Melted Yields Have Melted Heading back to his office, the CIO is now pondering how to deploy fresh capital. On one hand, the typical narrative that we have been operating in the quadrant of a deflationary bust, given the trade war, manufacturing recession, political unrest and rapidly rising probability of recession is not clearly visible in financial data. This would have been historically dollar bullish, and negative for other asset classes. However, the plunge in bond yields begs the question of whether this is a prelude to worse things to come. A more sanguine assessment is that we might be at a crossroads of sorts. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Time is of the essence, and strategy will be dependent on horizons. A review of the leading indicators for the major economic blocks is in order. Are We At The Cusp Of A Recession? Centripetal systems tend to stay in equilibrium, while centrifugal forces can explode in spectacular fashion. In the currency world, this means that the tug of war between deteriorating global growth and easing liquidity conditions cannot last forever. Either the dollar breakout morphs into a panic buying frenzy or proves to be a bull trap. Are we at the cusp of a bottom in global growth, or approaching a riot point? Let us start with the economic front: U.S.: Plunging U.S. bond yields have historically been bullish for growth. More importantly, the recent decline in the ISM Manufacturing Index is approaching 2008 recessionary levels. Either easing in financial conditions revive the index, or the decoupling persists for a while longer. The tone on the political front appears reconciliatory, which means September and October data will be critical. In 2008, the divergence between deteriorating economic conditions and falling yields was an important signpost for a riot point (Chart I-5). Eurozone: The Swedish manufacturing PMI ticked up to 52.4 in August. Most importantly, the new orders-to-inventories ratio is suggesting that the German (and European) manufacturing recession is reversing (Chart I-6). For all the debate about whether China is stimulating enough or not, the beauty about this indicator is that there are no Chinese variables in it (the euro zone and Sweden export a lot of goods and services to China). Any surge higher in this indicator will categorically conclude the euro zone manufacturing recession is over, lighting a fire under the euro in the process. Whatever the number is, if it can stabilize Chinese growth, a powerful deflationary force that dictated markets in 2018-2019 will dissipate.  China: Chinese bond yields have melted alongside global yields. This is reflationary, given the liberalization in the bond market over the past few years. Policy makers are currently discussing the quota for next year’s fiscal spending. Whatever the number is, if it can stabilize Chinese growth, a powerful deflationary force that dictated markets in 2018-2019 will dissipate. Chart I-5Is U.S. Manufacturing Close ##br##To A Bottom? Is U.S. Manufacturing Close To A Bottom? Is U.S. Manufacturing Close To A Bottom? Chart I-6Is Eurozone Manufacturing Close To A Bottom? Is Eurozone Manufacturing Close To A Bottom? Is Eurozone Manufacturing Close To A Bottom? Discussions among industry specialists suggest some anecdotal evidence that many manufacturers have been engaged in re-routing channels and parallel manufacturing chains to avoid the U.S.-China tariffs. This is welcome news, since global exports and global trade are still in a downtrend. A key barometer to watch on whether the global slowdown is infecting domestic demand will be Chinese imports (Chart I-7). So far, the message is that traditional correlations have not yet broken down. As a contrarian, this is positive. Manufacturing slowdowns have tended to last 18 months peak-to-trough, the final months of which are characterized by fatigue and capitulation. However, unless major imbalances exist (our contention is that so far they do not), mid-cycle slowdowns sow the seeds of their own recovery via accumulated savings and pent-up demand. In the currency world, the dollar has tended to be an excellent counter-cyclical barometer. On the dollar, the bond-to-gold ratio is breaking down, in contrast to the rise in the DXY. This is not a sustainable divergence (Chart I-8). The last time the bond-to-gold ratio diverged from the DXY was in 2017, and that proved extremely short-lived. As global growth rebounded and U.S. repatriation flows eased, dollar support was quickly toppled over. Chart I-7Chinese Imports Could Soon Rebound Chinese Imports Could Soon Rebound Chinese Imports Could Soon Rebound Chart I-8Mind The Gap Mind The Gap Mind The Gap Ever since the end of the Bretton Woods agreement broke the gold/dollar anchor in the early 1970s, bullion has stood as a viable threat to dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick-for-tick. While U.S. yields remain attractive, portfolio outflows and a deteriorating balance-of-payments backdrop will keep longer-term investors on the sidelines. Chart I-9Dollar Bulls Need A More Hawkish Fed Dollar Bulls Need A More Hawkish Fed Dollar Bulls Need A More Hawkish Fed Capital tends to gravitate towards higher returns, and the U.S. tax break in 2017 was a one-off that is now ebbing. Meanwhile, despite wanting to resist the appearance of influence from President Trump, the Fed realises that the neutral rate of interest in the U.S. is now below its target rate, which should keep them on an easing path. A dovish Fed has historically been bearish for the dollar (Chart I-9). Bottom Line: In terms of strategy, heightened uncertainty can keep the greenback bid in the coming weeks, but we will be sellers on strength. Our favorite plays remain the Swedish krona, the Norwegian krone, and, for insurance purposes, the Japanese yen. Outright dollar shorts await confirmation from more economic data. What To Do About CAD? The Bank of Canada (BoC) decided to stay on hold at its latest policy meeting. This was highly anticipated, but the silver lining is that the BoC might later reflect on this move as a policy mistake, given the arms race by other central banks to ease policy. The three most important variables for the Canadian economy are a:) what is happening to the U.S. economy, b:) what is happening to crude oil prices and c:) what is happening to consumer leverage and the housing market. On all three fronts, there has been scant good news in recent weeks. Heightened uncertainty can keep the greenback bid in the coming weeks, but we will be sellers on strength.  The Nanos Investor Confidence Index suggests Canadian GDP might be at the cusp of a slowdown after an excellent run of a few quarters (Chart I-10). One of the key drivers for the CAD/USD exchange rate is interest rate differentials with the U.S., and the compression in rates could run further (Chart I-11). Unless the BoC adopts a looser monetary stance, a rising exchange rate is likely to tighten financial conditions. Rising energy prices will be a tailwind, but the Western Canadian Select discount, and persistent infrastructure problems are headwinds. As such, we think domestic conditions will continue to knock down whatever benefit comes from rising oil prices. Chart I-10Canadian Data Has##br## Been Firm Canadian Data Has Been Firm Canadian Data Has Been Firm Chart I-11A Firm Exchange Rate Could Tighten Financial Conditions A Firm Exchange Rate Could Tighten Financial Conditions A Firm Exchange Rate Could Tighten Financial Conditions On the consumer side, real retail sales are deflating at the worst pace since the financial crisis, but consumer confidence remains elevated given the robust labor market data (Chart I-12). However, if house prices continue to roll over, confidence is likely to crater (Chart I-13). Chart I-12Canada: Consumer Spending Is Weak Canada: Consumer Spending Is Weak Canada: Consumer Spending Is Weak Chart I-13Canada: The Housing Market Is Softening Canada: The Housing Market Is Softening Canada: The Housing Market Is Softening On the corporate side of the equation, the latest Canadian Business Outlook Survey suggests there has been no meaningful revival in capital spending. This is a big headwind, since Canada finances itself externally rather than via domestic savings. For external investors, the large stock of debt in the Canadian private sector and overvaluation in the housing market are likely to continue leading to equity outflows (from bank shares) on a rate-of-change basis (Chart I-14). Chart I-14Foreign Investors Are Fleeing Canadian Securities Foreign Investors Are Fleeing Canadian Securities Foreign Investors Are Fleeing Canadian Securities Technically, the USD/CAD failed to break below the upward sloping trend line drawn from its 2012 lows, and the series of lower highs since the 2016 peak is forcing the cross into the apex of a tight wedge. The next resistance zone on the downside is the 1.30-1.32 level. Our bias is that this zone will prove to be formidable resistance. We continue to recommend investors short the CAD, mainly via the euro. Housekeeping We were stopped out of our short XAU/JPY position amid fervent buying in gold. Even though we are gold bulls, the rationale behind the trade was that the ratio of the two safe havens was at a speculative extreme. We will stand aside for now and look to re-establish the position in the near future. The Risksbank left rates on hold this week. This was welcome news for our long SEK/NZD position. The weakness in the SEK this year was expected given the surge in summer volatility, but the magnitude of the fall took us by surprise. In general, as soon as President Trump ramped up the trade-war rhetoric and China started devaluing the RMB, the environment became precarious for all pro-cyclical currencies. In terms of strategy going forward, the SEK probably has some additional downside, but not a lot. It is currently the cheapest currency in the G10. Should the Riksbank be actively trying to weaken the currency ahead of ECB policy stimulus this month, the final announcement, depending on what it entails, might be the bottom for the SEK and top for the EUR/SEK. Finally, as the Brexit drama unfolds, the outlook for the pound is highly binary. Aggressive investors can place a buy stop at 1.25 and a sell stop at 1.20. Anything in between should be regarded as noise.    Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been firm: PCE deflator nudged up from 1.3% to 1.4% year-on-year in July. Core PCE was unchanged at 1.6% year-on-year. Michigan consumer sentiment index fell from 92.1 to 89.8 in August. Trade deficit narrowed marginally by $1.5 billion to $54 billion in July. Notably, the trade deficit with China increased by 9.4% to $32.8 billion in July. Initial jobless claims was little changed at 217 thousand for the past week. Unit labor cost increased by 2.6% in Q2. Nonfarm productivity remained unchanged at 2.3%. Factory orders increased by 1.4% month-on-month in July. More importantly on the PMI front, Markit manufacturing PMI was down from 50.4 in July to 50.3 in August. ISM manufacturing PMI deteriorated to 49.1 in August, while ISM non-manufacturing PMI increased to 56.4, up from the previous 53.7 and well above estimates. DXY index fell by 0.5% this week. The recent worries about a near-term recession since the 10/2 yield curve inverted last month has been supporting the dollar, together with possible additional tariffs against China and the Chinese yuan devaluation. Going forward, we believe the dollar strength will ebb, given fading interest rate differentials. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 Focusing On the Trees But Missing The Forest - August 2, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been firm: Unemployment rate was unchanged at 7.5% in July. Both headline and core preliminary inflation were unchanged at 1% and 0.9% year-on-year respectively in August. PPI fell from 0.7% to 0.2% year-on-year in July. On the PMI front, Markit composite PMI was little changed at 51.9 in August. Manufacturing component was unchanged at 47, while services component nudged up slightly to 53.5. Retail sales growth fell from upwardly-revised 2.8% to 2.2% year-on-year in July, still better than the estimated 2%. EUR/USD appreciated by 0.5% this week. While the manufacturing sector across Europe remain depressed, the services sector seems to be alive and well. The ECB monetary policy meeting next Thursday will be key for the path of the euro. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 The Yen Chart II-5JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mixed: Housing starts fell by 4.1% year-on-year in July. Construction orders increased by 26.9% year-on-year in July, a positive shift from 4.2% contraction in the previous month. Capital spending growth slowed to 1.9% in Q2. Manufacturing PMI fell slightly to 49.3 in August, while services PMI jumped from 51.8 to 53.3. USD/JPY increased by 0.5% this week. The consumption tax hike in Japan is scheduled for October 1. The tax rate will rise from 8% to 10%, with possible exemption on several goods such as food and non-alcoholic beverages, which could be a drag on domestic spending. That being said, we continue to favor the Japanese yen due to the risk of a recession amid the escalating global trade war. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. continued to deteriorate: Nationwide house price index was unchanged in August. Markit composite PMI fell to 50.2 in August: Manufacturing component slowed to 47.4; Construction PMI fell to 45; Services component decreased to 50.6. Retail sales contracted by 0.5% year-on-year in August. GBP/USD increased by 1.2% this week. Brexit remains the biggest driver behind the pound. British PM Boris Johnson’s brother resigned this week, citing tension between “family loyalty” and “national interest”. Our Geopolitical Strategy upgraded a no-deal Brexit probability to about 33%, maintaining that it is not the base case since nobody wants an imminent recession. From a valuation perspective, the pound is quite cheap and currently trading far below its fair value. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mixed: Building approvals keep contracting by 28.5% year-on-year in July. Australian Industry Group (AiG) manufacturing index increased to 53.1 in August. The services index soared to 51.4 in August from a previous reading of 43.9. Current account balance shifted to A$5.9 billion in Q2, the first surplus since 1975. Retail sales contracted by 0.1% month-on-month in July. GDP growth slowed down to 1.4% year-on-year in Q2, the lowest rate in over a decade. Exports and imports both grew by 1% and 3% month-on-month respectively. Trade surplus narrowed marginally to A$7.3 million. AUD/USD increased by 1.4% this week. While Q2 GDP growth rate continued to soften, the current account and PMI data are showing tentative signs of a recovery. On Monday, the RBA kept interest rates unchanged at 1%. In the press release, the Bank acknowledged that low income growth and falling house prices limited household consumption in the first half of the year. Going forward, the tax cuts, infrastructure spending, housing market stabilization, and a healthy resources sector should all support the Australian economy, and put a floor under the Aussie dollar. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been negative: Consumer confidence improved slightly to 118.2 in August. Building permits continued to contract by 1.3% month-on-month in July. Terms of trade increased to 1.6% in Q2. NZD/USD increased by 1.2% this week. In a Bloomberg interview earlier this week, the New Zealand finance minister Grant Robertson expressed his confidence on the fundamentals of the domestic economy, especially the low unemployment rate and sound wage growth. The largest downside risk remains the global trade and manufacturing slowdown. As a small open economy, New Zealand is ultimately vulnerable to exogenous factors, especially those related to its large trading partners including U.S., China, and Australia. On the policy side, the finance minister believes that there is “still room to move” in terms of monetary policy. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in Canada have been mostly negative: Annualized Q2 GDP growth jumped from 0.5% to 3.7% quarter-on-quarter, well above estimates. Bloomberg Nanos confidence fell slightly from 57 to 56.4. Markit manufacturing PMI fell to 49.1 in August, right after a small rebound in July to 50.2.  Trade deficit widened to C$1.12 billion in July. USD/CAD fell by 0.5% this week. On Wednesday, BoC held its interest rate unchanged at 1.75%, as widely expected. In its monetary policy statement, the BoC sounded cautiously dovish, and expects economic activity to slow in the second half of the year amid global growth worries. The strong Q2 rebound was mostly driven by cyclical energy production and robust export growth, which could be temporary given the current market volatility. The rate cut probability next month is currently at 40%. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been positive: KOF leading indicator was unchanged at 97 in August. Real retail sales grew by 1.4% year-on-year in July, up from the previous 0.7%. Manufacturing PMI increased to 47.2 in August, up from 44.7 in the previous month. Headline inflation remained muted at 0.3% year-on-year in July. GDP yearly growth slowed to 0.2% in Q2, from a downwardly-revised 1% in Q1. USD/CHF fell by 0.2% this week. We remain positive on the Swiss franc. The global economic slowdown and increasing worries about a near-term recession remain tailwind for the safe-haven franc.  Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway have been mostly negative: Retail sales increased by 0.9% year-on-year in July. Current account surplus plunged by 60% from NOK 73.1 billion to NOK 30.6 billion in Q2, the lowest since Q4 2017. USD/NOK fell by 1.3% this week. The rebound in oil prices this week has supported petrocurrencies. On the supply side, the production discipline is likely to be maintained. On the demand side, fiscal stimulus globally should revive overall demand. A potential weaker USD should also support oil prices in the second half of the year, which will be bullish for the Norwegian krone. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been mixed: Manufacturing PMI increased slightly to 52.4 in August, from 52 in the previous month. Current account surplus narrowed from SEK 63 billion to SEK 37 billion in Q2. Industrial production increased by 3.2% year-on-year in July. Manufacturing new orders increased by 0.4% in July compared with last month. However, on a year-on-year basis, it fell by 2.2%. The Swedish krona rallied this week, appreciating by 1.4% against USD. The Riksbank held its interest rate unchanged at -0.25% this Thursday, and stated that they still plan to raise interest rates this year or early next, but at a slower pace than the previous forecast. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession A Psychological Recession? A Psychological Recession? President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions.   Chart 2The Total Market Value Of Risk Assets Is Elevated The Total Market Value Of Risk Assets Is Elevated The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Not Much Scope To Cut Rates Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn.   Chart 4The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well A Psychological Recession? A Psychological Recession? Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Inventories Are Making A Negative Contribution To Growth Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Auto Sector: The Culprit Behind The Manufacturing Slowdown Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy A Psychological Recession? A Psychological Recession?   Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy.  Chart 11Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China.  Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? Would China Really Be Better Off Negotiating With A Democrat As President? Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Equity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) Equity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency The U.S. Dollar Is A Countercyclical Currency The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves     Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector A Psychological Recession? A Psychological Recession? Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores A Psychological Recession? A Psychological Recession? Tactical Trades Strategic Recommendations Closed Trades