Precious Metals

Highlights Portfolio Strategy While equities will likely be higher in the coming 9-12 months, we would refrain from committing fresh capital to the market at this juncture. A better entry point lies ahead. Tactically, this market needs a breather to digest the V-shaped formation since last December’s G20 meeting before it resumes its bull run. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Augment positions to neutral. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Recent Changes Lift the S&P 1500 auto components index to neutral and cement gains of 36% today. From a portfolio management perspective, downgrade the S&P semi equipment index to neutral for a gain of 16% since the December 17, 2018 inception. Table 1 The Good, The Bad And The Ugly The Good, The Bad And The Ugly Feature The S&P 500 hit a trouble spot last week, despite positive news on the U.S./China trade tussle. Clearly, there is an element of “buy the rumor sell the news” in the market as equities have come a long way this year, reversing all of last December’s steep losses. But, the SPX now faces stiff resistance at the most important 2,800 level as we highlighted in recent research.1 Chart 1 shows “The Good”. From a sentiment/technical perspective, fresh all-time highs in the S&P 500 advance/decline line portend ongoing gains in this broad-based equity market advance. The junk bond market sends an equally encouraging signal: The Barclays total return high yield corporate bond index has vaulted to new highs, which bodes well for the SPX (middle panel, Chart 1). Finally, all three of the S&P risk parity total return indexes2 have slingshot into uncharted territory and suggest that the S&P 500 is headed there next. Chart 1The Good… The Good… The Good… Nevertheless, there are some cracks appearing in the U.S. economy. News of an abysmal retail sales report was quickly discredited by pundits, with some blaming poor data collection due to the government shutdown. Chart 2 shows “The Bad”. Worrisomely, contracting intermodal rail carloads and a nosedive in the “First Data merchant services dollar spend” at retailers likely corroborate the Commerce Department’s weak retail sales data. Moreover, the recent plunge in the Goldman Sachs MAP (Macro-data Assessment Platform) Surprise Index, which is now probing a three year low, suggests that the U.S. economy is in a soft-patch. Chart 2…The Bad… …The Bad… …The Bad… Charts 3 & 4 show “The Ugly”. Our Economic Impulse Indicator (EII) first introduced last October,3 has taken a turn for the worse. Six economic indicators encapsulating the U.S. economy comprise the EII, and there is clear deterioration in economic activity on a second derivative basis. The recent contraction in the overall business (manufacturing, wholesale and retail) sales-to-inventories (SI) ratio also warns of profit trouble in the coming quarters (Chart 4). Keep in mind that this data series only goes to November 2018 and once it gets updated to include December later this week, the SI ratio will likely fall deeper into the contraction zone. Chart 3…And The… …And The… …And The… Chart 4…Ugly …Ugly …Ugly So should investors take some chips off the table given this macro backdrop? Prior to answering the question, as a reminder, BCA’s view remains that the business cycle is alive and well and there is no recession on a cyclical time horizon. Therefore, equities should be higher in the coming 9-12 months. Our end-2019 SPX target remains at 3,000 based on $181 EPS for calendar year 2020 assuming a 16.5 multiple.4 Nevertheless from a shorter-term perspective, we would refrain from committing fresh capital to this market, as we believe a better entry point lies ahead. Tactically, this market now needs a breather to digest the V-shaped formation since last December’s G20 meeting, before it resumes its bull run. In addition, we would book gains on any alpha generating tactical trades; today we crystalize 16% gains in the S&P semi equipment tactical overweight position since the December 17, 2018 inception and downgrade to neutral. This week, we book handsome profits on a long-held underweight in a consumer discretionary subindex that Trump’s hawkish tariff rhetoric and actions have badly wounded. We also update a materials subsector that benefits from the ongoing global reflationary impulse. Auto Components: Aiming For Pole Position? We have successfully ridden down the S&P 1500 components index on a structural basis over the past four years. But now, factors are falling into place for an end to this multi-year bloodbath. We are lifting exposure to neutral from underweight, locking in relative gains of 36% since inception. Global auto sales are the main driver of auto components profits, thus identifying where we stand in the global auto sales cycle is key. Bellwether German automakers have been caught in an emissions-related downdraft with “Dieselgate” weighing heavily on this sector when new emissions-test procedures were implemented last quarter. The top panel of Chart 5 shows that the worst is likely behind this drubbing in German automobile production as new orders have recently gone vertical. Backlogs are also sky-high and suggest that a definitive turn looms in German motor vehicle output. The upshot is that global auto sales may come out of their recent funk. Chart 5Global Auto Sales Are About To Turn Global Auto Sales Are About To Turn Global Auto Sales Are About To Turn The Japanese car industry, the other global heavyweight, also suffered a minor setback last year, but leading indicators of Japanese auto production are also ticking higher. Japanese industrial robot shipments are at fresh cyclical highs and signal that global auto sales will hook up (bottom panel, Chart 5). In the U.S., light vehicle sales have been stable over the past five years, but auto industrial production growth has been roaring, rising 40 percentage points from the manufacturing recession trough (second panel, Chart 6). Chart 6Improving… Improving… Improving… All of this paints a brightening backdrop for U.S. auto components manufacturers. Indeed, auto components new orders are at all-time highs (middle panel, Chart 7), at a time when inventories remain tame. In fact the new orders-to-inventories ratio sits squarely above one and continues to firm, with unfilled orders also at all-time highs (Chart 8). As a result, selling prices are accelerating at a healthy clip (third panel, Chart 6). The upshot is that industry profits will likely overwhelm. Chart 7…Operating… …Operating… …Operating… Chart 8...Auto Component Metrics ...Auto Component Metrics ...Auto Component Metrics On the domestic demand front, the latest Conference Board consumer confidence release showed that consumers’ plans to purchase a car remain upbeat, and could serve as a catalyst to unlock excellent relative value (bottom panel, Chart 7). With regard to President Trump’s hawkish tariff rhetoric and the ongoing U.S./China trade tussle, automobile components makers have taken a big hit. But, there are high odds of an end to the U.S./China trade dispute. Tack on a softening greenback courtesy of a more dovish Fed. U.S. auto components producers will likely grab a larger slice of the global auto parts revenue pie (top panel, Chart 7). Despite these tailwinds, investors have relentlessly avoided auto component stocks. Technicals remain washed out and industry valuations are a small fraction of the broad market and below the historical mean as per the relative price-to-sales ratio (Chart 9). Chart 9Cheap And Oversold… Cheap And Oversold… Cheap And Oversold… Nevertheless, we refrain from turning outright bullish on this consumer discretionary subsector given the following risks: First, auto loan delinquencies are increasing rapidly, approaching last cycle’s peak. Second, car financing interest rates are still rising, which, at the margin, dents demand for new car sales. Third, auto credit growth is decelerating and demand for auto loans is also anemic according to the Fed’s latest Senior Loan Officer survey (Chart 10). This stands in marked contrast to the aforementioned Conference Board’s survey of consumers’ plans to buy a car. Finally, were President Trump to proceed with auto tariffs on European car manufacturers once he strikes a deal with China, U.S. auto parts producers will suffer a setback. Chart 10…But There Are Some Risks …But There Are Some Risks …But There Are Some Risks Netting it all out, the easy money has already been made by shying away from auto component manufacturers. Firming leading indicators of global auto sales, upbeat auto components industry operating metrics, a softening U.S. dollar, the looming truce in the U.S./China trade spat and depressed relative technicals and valuations all suggest that it no longer pays to be bearish the S&P 1500 auto components index. Bottom Line: Lift the S&P 1500 auto components index to neutral and crystalize gains of 36% today. The ticker symbols for the stocks in this index are: BLBG: S15AUTC – APTV, BWA, GNTX, GT, DAN, VC, FOXF, DORM, LCII, DJPH, AXL, ADNT, CTB, THRM, GTX, SMP, CPS, MPAA, SUP. A Modest Gold Portfolio Hedge Still Makes Sense Within our broad-based U.S. equity sector and subsector coverage, we continue to recommend a modest gold-related hedge via being overweight the global gold mining index (given that the S&P gold index only comprises a single stock) versus the MSCI All-Country World Index, expressed through the long GDX:US/short ACWI:US exchange traded funds. There is compelling evidence that gold bullion is a reliable reflationary gauge. The shiny metal troughed in mid-August, leading even the JP Morgan EM FX index. Since then, it has been in an uninterrupted run rising over $180/oz. or 15% and sniffing out a reflationary impulse. Not only is there a tight inverse correlation with the trade-weighted U.S. dollar, but over the past three years the Chinese renminbi also moves in close lockstep with gold (Chart 11). Now that Chinese policymakers have opened the credit spigots (January credit data revealed the largest ever month-over-month loan increase in the history of the data, please refer to the second panel of Chart 2 in last week’s publication)5 reflating their economy, there are high odds that gold can break out of its past five year trading range in a bullish fashion. Chart 11Gold Is Sniffing Out A Reflationary Impulse Gold Is Sniffing Out A Reflationary Impulse Gold Is Sniffing Out A Reflationary Impulse Commodity sentiment and positioning data suggest that gold’s run up will prove durable and continue to underpin the relative share price ratio (second & third panels, Chart 12). Chart 12Bullish Bullion Positioning Underpins Global Gold Miners Bullish Bullion Positioning Underpins Global Gold Miners Bullish Bullion Positioning Underpins Global Gold Miners Importantly, the precious metals industry has not stood still. It has embarked on a massive consolidation phase and the recent spike in M&A activity in global gold miners signals that there is more upside for relative share prices (top panel, Chart 12). But the good news does not stop there. Globally there is a slowdown that has infected a number of economies and BCA’s calculated Global ZEW economic sentiment index has lit a fire under gold mining stocks (Global ZEW shown inverted, second panel, Chart 13). The longer the global soft-patch lasts the longer Central Banks will remain on the sidelines or even ease monetary policy in order to rekindle growth. This macro backdrop represents fertile ground for gold and gold related equities (bottom panel, Chart 14). Chart 13Rising Uncertainty, Global Growth Softpatch And… Rising Uncertainty, Global Growth Softpatch And… Rising Uncertainty, Global Growth Softpatch And… Chart 14…Falling Real Rates Are Excellent Gold Mining Supports …Falling Real Rates Are Excellent Gold Mining Supports …Falling Real Rates Are Excellent Gold Mining Supports Keep in mind that gold bullion yields zero and the gold mining equities’ dividend yield trails the broad market by 100bps; thus, there is an opportunity cost to holding gold and gold related equities, especially now that even U.S. cash yields 2.5%. This explains the inverse correlation with real interest rates and the recent 30bps fall in the U.S. 10-year TIPS yield reinforces gold bullion and the relative share price ratio (TIPS yield shown inverted, middle panel, Chart 14). Moreover, the global policy uncertainty index is perking up given the ongoing U.S./China trade tussle (top panel, Chart 13), recent news of a no deal between the U.S. and North Korea and looming Brexit deadline. All of this underpins global gold stocks (top panel, Chart 13). Tack on the recent fear that gripped markets, and skyrocketing equity risk premia, and the ingredients are in place for additional gains in the relative share price ratio (third panel, Chart 13). While some semblance of normality has returned to global bourses year-to-date, fixed income investors do not share the euphoria their equity peers are emitting. Such a dichotomy favors global gold mining stocks. Finally, with regard to relative valuations and technicals, global gold equities remain in undervalued territory, but have recently recovered smartly from deeply oversold conditions (Chart 15). Chart 15Valuations Ready To Shine Valuations Ready To Shine Valuations Ready To Shine In sum, gold bullion is sniffing out a reflationary impulse that is bullish for global gold mining equities. The global economic soft patch that is exerting downward pressure on real interest rates, a soft U.S. dollar and rising global policy uncertainty, all signal that it still makes sense to hold a global gold mining equity portfolio hedge. Bottom Line: Stay overweight the global gold miners index (long GDX:US/short ACWI:US), and remove the downgrade alert.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Trader’s Paradise” dated January 28, 2019,available at uses.bcaresearch.com. 2      https://us.spindices.com/documents/methodologies/methodology-sp-risk-parity-indices.pdf?force_download=true 3      Please see BCA U.S. Equity Strategy Report, “Icarus Moment” dated October 22, 2018, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 5      Please see BCA U.S. Equity Strategy Report, “Reflationary Or Recessionary” dated February 25, 2019, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

The hiatus in the Fed’s rates-normalization policy in 1H19 in the wake of its capitulation to financial markets, supports our bullish view on gold prices, as it raises the risk of an inflation overshoot later this year. Per the Fed’s dual mandate, inflation and employment gauges are signaling the need for tighter policy, according to BCA’s proprietary Fed Monitor. The pause in hiking fed funds raises the likelihood the Fed will find itself behind the inflation curve, as the economy enters a late-cycle phase. Gold will outperform other commodities and equities in this phase. We remain long gold as a portfolio hedge. Highlights Energy: The U.S. imposed sanctions on state-owned Petróleos de Venezuela, S.A. (PDVSA), including a ban on the company’s Houston-based Citgo remitting earnings back to the parent company.  This raises the likelihood production and exports will fall sharply as we expect.  Separately, Saudi Energy Minister Khalid al-Falih said the country will reduce output below its recently agreed 10.3mm b/d cap in 1H19, in line with our own balances expectation.1 Base Metals/Bulks: Neutral.  Iron ore prices likely will continue to move higher, following the collapse of a wet-processing dam at Vale’s Córrego do Feijão mine.  The company suffered a similar breach at its Samarco mine in March 2016, which still has not re-opened. Output will fall, if it follows through with additional dam closures. Precious Metals: Neutral.  Gold prices will continue to move higher, as the Fed’s near-term capitulation on its rates-normalization policy raises the odds the U.S. central bank will find itself behind the inflation curve.  (See below.) Ags/Softs: Underweight.  USDA reported soybeans inspected for export to China during the week ended January 24 accounted for close to 37% of the total beans inspected.  This made China the No. 1 importer of American soybeans again. Feature In February 2018, we wrote that “price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here.” In line with this expectation, we suggested remaining long gold as a portfolio diversifier and hedge against mounting equity risks. This turned out to be an accurate call. Despite losing 8.4% between January and September 2018 because of an aggressive Fed, gold rose by 7.6% in 4Q18 amid the rising equity volatility and ended the year down a minor -1.5% compared to -6.2%, -11.2% and -7.1% for the S&P 500, global equities and the CRB commodity index. This reflects the convexity in gold returns and is the reason we favored gold in 2018. Gold returns are not simply a function of the U.S. dollar and real interest rates. As highlighted in our 2019 Key Views report last December, in mature economic cycles, gold’s ability to hedge against equity and inflation risks dominate its price formation, while its correlation with the U.S. Treasury yields diminishes (Chart of the Week).2 Chart of the WeekGold's Correlation With U.S. Rates Declines As The Cycle Matures Gold's Correlation With U.S. Rates Declines As The Cycle Matures Gold's Correlation With U.S. Rates Declines As The Cycle Matures As the current cycle extends to 2019, the skewness in gold return will prove profitable. The Fed’s retreat on its quarterly rate-hike cycle only adds to our positive view, as it increases the probability the U.S. central bank falls behind the curve. Stay long gold as a portfolio hedge. Fed’s Short-Term Capitulation Strengthens Our View The recent downward revision in the Fed’s rate-hike path reinforces our positive stance on gold prices, as risks of an overshoot in inflation rises. The dichotomy in U.S. vs. rest of the world growth puts the Fed in a difficult position. The current capitulation was mainly driven by tightening financial conditions – chiefly, the rising U.S. dollar, declining stock prices, and widening credit spreads. However, under the Fed’s dual mandate, inflation and employment still are signaling “tightening-required” per BCA Research’s Fed Monitor, a model maintained by our U.S. Bond strategists (Chart 2). Since economic growth cannot remain above-trend indefinitely, short-term productive capacity constraints (i.e. capital and labor factors of production) are already binding and will force the Fed to raise rates later this year as inflation creeps up. Chart 2Growth And Inflation Signal Tighter Money Is Required Growth And Inflation Signal Tighter Money Is Required Growth And Inflation Signal Tighter Money Is Required As it reaffirms its data dependence, the Fed is opening the door to falling behind the inflation curve, given inflation is a lagging indicator of the price pressures that are building up in the economy (Chart 3). As a result, we expect gold’s ability to hedge against inflation will support its price in 2H19. Chart 3Inflationary Pressure Will Rise In 2019 Inflationary Pressure Will Rise In 2019 Inflationary Pressure Will Rise In 2019 Short-term, a Fed pause also supports gold by readjusting investors’ expectations regarding the U.S. dollar and real interest rates lower. Our bond strategists identified two previous periods where similar conditions led to a false start in the Fed hiking cycle, 1997 and 2015. In both cases, the Fed’s capitulation led to a reversal in gold’s downward price trajectory, as the market perceived the central bank was keeping its short-term policy rate at a level that was inconsistent with the so-called R-star rate or natural rate of interest – i.e., “the real interest rate expected to prevail when the economy is at full strength” (Chart 4).3 Chart 4AGold Price's Trajectory Reversed In 1997... Gold Price's Trajectory Reversed In 1997... Gold Price's Trajectory Reversed In 1997... Chart 4B ... And In 2015 ... And In 2015 Using a conceptual four-quadrant framework developed by our colleagues at The Bank Credit Analyst to describe the Fed’s behavior, we currently believe the outcome with the highest probability of being realized by the Fed’s capitulation is Policy Mistake 2 (Table 1, lower right quadrant). If we’re right, this raises the odds of an inflation overshoot above the Fed’s 2% target later this year.4 Table 1Four Fed Policy Scenarios Inflation Overshoot More Likely; Stay Long Gold Inflation Overshoot More Likely; Stay Long Gold This is not a foregone conclusion. However, generally speaking, the higher the inflation uncertainty and the higher the perception the Fed will fall behind the curve, the higher gold is bid up. Recent price action seems to corroborate this. Chart 5 shows that the recent downward revision in the median long-term fed funds rate projection coincides with a rise in gold prices. At present, gold investors are signaling that the fed funds rate is below the neutral rate consistent with R-star. Chart 5Gold Markets Signal Monetary Policy Is Accommodative Gold Markets Signal Monetary Policy Is Accommodative Gold Markets Signal Monetary Policy Is Accommodative Gold And The U.S. Economic Cycle Gold prices are difficult to model and predict, given the collection of time-varying, often conflicting, components determining their evolution. Its core determinants change as we move through the economic cycle. In their current late-cycle environment, inflation and equity risks – i.e., fears of a sharp correction – usually gain in importance. In this report, we characterize the market’s late-cycle phase using two metrics: (1) the fed funds rate relative to R-star, (2) the phase of the yield curve cycle.5 We have already discussed (1) in our outlook and found that when the fed funds rate is rising yet still below the estimate of R-star, gold returns are highly skewed to the upside (Chart 6).6 For (2), we compared the yellow metal’s return to other assets returns in different phases of the U.S. Treasury yield curve’s evolution. We define these yield-curve phases as follow: Chart 6 Phase 1: Normal (i.e., positively sloped: 10-year rates are greater than 3-month rates). The 3-month/10-year treasury slope is above 75 bps. Phase 2: On its way to flattening and returning to normal. The 3-month/10-year Treasury slope is between 0 bps and 75 bps. We divide this in two sub-phases: (a) steepening, and (b) flattening. Phase 3: Inverted (i.e., negatively sloped). The 3-month/10-year Treasury slopes is below 0 bps (Chart 7).7 Chart 7Phases Of The Yield Curve Cycle Phases Of The Yield Curve Cycle Phases Of The Yield Curve Cycle We found that: first, DM and EM equities are the best performers in the group we looked at during Phase 1, when the slope of the yield curve is steep (above 75 bps). Second, there is wide difference between the steepening and flattening sections of Phase 2. EM equities and copper experience the largest rebound once the slope’s curve steepens from below zero. Lastly, gold performs best in the flattening section of Phase 2 and, critically, it outperforms oil, copper, broad commodity indices and equities (Table 2). Table 2Gold Returns Are Positive When The Yield Curve’s Slope Flattens Inflation Overshoot More Likely; Stay Long Gold Inflation Overshoot More Likely; Stay Long Gold Our U.S. Investment and Bond Strategists believe the Fed’s policy rate will remain in the below-r-star-and-rising range, and in Phase 2 of the yield curve cycle for most of 2019. We agree, and believe our analysis indicates gold prices will increase this year on the back of these factors. Recession Fear And Equity Risks Will Drive Gold For most of 2018, investor sentiment and positioning were primarily determined by the U.S. dollar and real rates. As these variables rose last year, investors’ sentiment and positioning turned overly bearish; this pushed our Gold Composite Indicator in the oversold territory (Chart 8).8 In our view, the other (important) drivers of gold prices were ignored during that period. The end-of-year equity selloff led to a reshuffle of the core determinants of the yellow metal’s price, pushing the equity risk factor higher on the list of variables explaining its price. Chart 8Sentiment Collapsed In 1H18 Sentiment Collapsed In 1H18 Sentiment Collapsed In 1H18 Chart 9 shows gold and the U.S. equity risk premium disconnected in 2018, until the October equity selloff. In general, these variables are positively linked. When risk aversion is elevated, investors demand higher compensations for holding risky assets, and increase their demand for safe-haven assets. This pushes up both the equity risk premium and gold prices. Chart 9Gold And Equity Risk Premium Correlation Picked Up Gold And Equity Risk Premium Correlation Picked Up Gold And Equity Risk Premium Correlation Picked Up Gold’s performance in 4Q18 supports our recommendation for holding it as a portfolio diversifier in 2018, and why we continue to do so this year (Chart 10). Chart 10 Separately, our U.S. dollar and rates-only model moved up recently, easing the downward pressure on gold (Chart 11). While we believe these two variables’ marginal impact diminished since 4Q18, they are included in our gold “fair-value” model, which currently indicates it is fairly valued and that its support remains intact. Chart 11Upside Pressures Are Building Upside Pressures Are Building Upside Pressures Are Building Bottom Line: The Fed’s near-term capitulation raises the odds the U.S. economy will experience an inflation overshoot. Our fair-value model also is supportive of gold prices. We remain long as a diversification and portfolio hedge. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1      Please see “Saudis Pledge Deeper Oil Cuts in February Under OPEC+ Deal,” published by bloomberg.com January 29, 2019.  See also “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone” published January 24, 2019, for our latest supply-demand balances and price forecasts.  It is available at ces.bcaresearch.com. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 3      Please see John C. Williams’s remarks delivered to the Economic Club of Minnesota May 15, 2018, entitled “The Future Fortunes of R-Star: Are They Really Rising?”  Williams was president and CEO of the Federal Reserve Bank of San Francisco at the time, and now has the same role at the NY Fed..  We explore this further below.  See also BCA Research’s U.S. Bond Strategy Weekly Report titled “An Oasis Of Prosperity,” published August 21, 2018. It is available at usb.bcaresearch.com. 4      Please see BCA Research’s The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. It is available at bca.bcaresearch.com. 5      The San Francisco Fed defines R-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. R-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 6      We presented this analysis in BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 7      For a similar analysis applied to different asset classes, please see BCA Research’s U.S. Bond Strategy Weekly Report titled “2019 Key Views: Implication For U.S. Fixed Income,” published December 11, 2018, and The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. These reports are available at usb.bcaresearch.com and bca.bcaresearch.com. Our approach is slightly different from our colleagues’ methodology. We used a threshold of 75 bps instead of 50 bps in order to increase the sample size of the Phase 2, flattening section. This improves the accuracy of using the average as our main descriptive statistic. Note that the yield curve can remain inverted for some time before a recession occurs, this explains why equity returns are positive in Phase 3 (curve inversion). 8      Our Gold Composite Indicator has three components: (1) Sentiment, (2) Speculative positioning and (3) Technical. It is meant to assess if there is any mismatch between our fundamental analysis and investors’ sentiment and expectations. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Image Commodity Prices and Plays Reference Table Summary Of Trades Closed In 2018 Image

… quick’s the word and sharp’s the action. Jack Aubrey1 Idiosyncratic supply-demand adjustments – some induced by head-spinning reversals of policy (e.g., the U.S. about-face on Iran oil export sanctions) – and uncertainty regarding monetary policy and trade will keep volatility in oil, metals and grains elevated in 2019. We remain overweight energy – particularly oil – expecting OPEC 2.0 to maintain production discipline, and for demand to remain resilient.2 We remain neutral base metals and precious metals, seeing the former relatively balanced, and the latter somewhat buoyant, even as the Fed continues its rates-normalization policy. We remain underweight ags, although weather-induced supply stress has reduced the global inventories some. While we continue to favor being long the energy-heavy S&P GSCI on a strategic basis, tactical positioning will continue to dominate commodity investing in 2019. Highlights Energy: Overweight. OPEC 2.0’s 1.2mm b/d of production cuts goes into effect in January vs. October levels, and should allow inventories to resume drawing. Base Metals: Neutral. Fundamentally, base metals are largely balanced, which is keeping us neutral going into 2019. Precious Metals: Neutral. Gold prices will remain sensitive to Fed policy and policy expectations. Palladium prices have soared as a growing physical deficit noted earlier widens.3 If China cuts sales taxes on autos again, demand could soar. Ags/Softs: Underweight. A strong USD will weigh on ag markets, particularly grains, next year. An agreement on contentious Sino – U.S. trade issues could re-open Chinese markets to U.S. exports. However, the arrest of the CFO of China’s Huawei Technologies in Canada for possible extradition to the U.S. complicates negotiations.   Feature Going into 2019, commodity markets once again are sending conflicting signals. While we continue to favor exposure to commodities as an asset class by being long the energy-heavy S&P GSCI index, which fell 6% this year on the back of the collapse in crude oil prices and flattening of the forward curves in Brent and WTI.  Nonetheless, we believe investors will continue to be rewarded by taking tactical exposure on an opportunistic basis. Volatility remains the watchword, particularly in 1H19, for the primary industrial commodities – oil and base metals. While idiosyncratic supply-demand adjustments will drive prices in each market, Fed policy also will contribute to volatility, as the U.S. central bank likely remains the only systemically important monetary authority following through on rates-normalization. In line with our House view, we expect the Fed to deliver its fourth rate hike of 2018 at its December meeting next week, and four additional hikes next year. On the back of Fed policy, we expect the broad trade-weighted USD to rise another 3-5% in 2019, following a 6% increase in 2018 (Chart of the Week). This will supress demand ex-U.S. for commodities priced in USD, by raising the USD cost of these commodities. Chart of the WeekStronger USD Pressures Commodity Demand Stronger USD Pressures Commodity Demand Stronger USD Pressures Commodity Demand Below, we highlight the key themes we believe will dominate commodities in 2019. Oil Markets Still Re-Calibrating Fundamentals We continue to expect global oil demand to remain strong next year, despite the slight downgrading of global GDP growth earlier this year by the IMF. We expect EM import volumes – one of the key variables we track to proxy EM income levels – to hold up in 1H19, which supports our assessment commodity demand will grow, albeit at a slower rate than this year (Chart 2).4 Chart 2Slowing Trade Volumes Might Pre-sage Softer Commodity Demand Slowing Trade Volumes Might Pre-sage Softer Commodity Demand Slowing Trade Volumes Might Pre-sage Softer Commodity Demand In 2H19, we see the volume of EM imports dipping y/y from higher levels, then recovering toward year-end. This indicates the all-important level of EM income – hence commodity demand – will remain resilient, but the rate of growth in incomes will slow. This is confirmed by the behavior of the Global Leading Economic Indicators we use to cross check our EM income expectation via import volumes (Chart 3). Chart 3Global Leading Economic Indicators Lead EM Import Volume Changes Global Leading Economic Indicators Lead EM Import Volume Changes Global Leading Economic Indicators Lead EM Import Volume Changes There is a chance Sino – U.S. trade relations will thaw, which would remove a large uncertainty over the evolution of demand next year. This would be supportive for EM trade volumes generally, particularly imports. However, this is not a given, and we are not assuming any pick-up in demand in anticipation of such a development. We need to see concrete actions, followed by tangible trade improvement first. On the supply side, oil markets still are in the process of re-adjusting to an extraordinary policy reversal by the Trump administration on its Iranian oil-export sanctions last month – i.e., the last-minute granting of waivers to Iran’s largest oil importers. However, following OPEC 2.0’s decision last week to cut 1.2mm b/d of production to re-balance markets in 1H19, we continue to expect prices to recover. Indeed, going into the OPEC 2.0 meeting last week, we had already lowered our December 2018 production estimates for OPEC 2.0, and also reduced 2019 output estimates by ~ 1mm b/d, so the producer coalition’s action did not come as a surprise (Chart 4).5 Chart 4BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts BCA's Global Oil Balances Anticipated OPEC 2.0 Cuts In addition to the cuts by OPEC 2.0, the Alberta, Canada, government mandated production cuts, which will become effective January 1, 2019, to clear a persistent supply overhang that was decimating producers’ revenues in the province. We estimate there is ~ 200k b/d of trapped Alberta supply – i.e., excess production over takeaway capacity (pipeline and rail) – along with ~ 35mm bbls of accumulated excess production in storage the government intends to draw over the course of 2019 at a rate of ~ 96k b/d. This will lower overall OECD inventories, even if the Canadian barrels are transferred south. Net, in addition to the 1.2mm b/d of cuts from OPEC 2.0, the ~ 300k b/d coming from Canada next year will mean close to 1.5 mm b/d of production, or ~1.4mm b/d of actual supply when accounting for the inventory release, is being cut or curtailed from these two sources. We cannot, at this point, forecast over-compliance with the OPEC 2.0 accord, which was one of the signal features of the deal in 2017 and 1H18. The Trump administration’s waivers for Iran’s eight largest oil importers expire May 2019. We view it as highly unlikely the Trump administration will re-impose export sanctions in full on Iranian exports following the expiration of waivers, and fully expect they will be extended at least for 90 days. This is because oil fundamentals will remain tight next year, despite the massive de-bottlenecking of the Permian Basin in West Texas. While an additional 2mm b/d of new takeaway capacity will be added to the region, it will not be fully operational until 4Q19. We have ~ 300k b/d of additional supply coming out of the Permian after the pipeline expansions are done in 2H19. Even as pipeline capacity is filled, the U.S. still needs to significantly increase its deep-water oil-export capacity to get this crude to market.6 Bottom Line: We expect the oil market to re-balance in 1H19, as production falls by ~ 1.4mm b/d – the combination of OPEC 2.0 and Canadian production cuts – and consumption grows by a similar amount. The USD will continue to appreciate next year, which, at the margin, will temper demand growth and prices. Gold: Remaining Long Equity And Inflation Risks Trump Higher Rates in 2019 As the U.S. economic cycle matures and advances into its final innings, we continue to recommend holding gold in a diversified portfolio. U.S. inflationary pressure will surprise to the upside in 2019, per our House view, which will offset the effects of somewhat less accommodative U.S. monetary policy in the U.S. The October equity correction is a reminder that, when rising UST yields drag stocks down in late-cycle markets, gold works as an effective hedge against equity risks, and can outperform bonds. In fact, both of the corrections we saw in 2018 likely were caused by a sharp increase in bond yields. This convexity on the upside and downside is what makes gold our preferred portfolio hedge. Easy Monetary Policy + Rising Rate = Bullish Gold Prices Despite being negatively correlated with interest rates, gold tends to perform well when the fed funds rate is below r-star – known as the “natural rate of interest” – and is rising (Chart 5, panel 1).7 When this happens, policy rates are below the so-called natural interest rate consistent with a fully employed economy, which, all else equal, is inflationary. In these late-cycle environments, gold’s ability to hedge against inflation and equity risks dominate its price formation, while its correlation with U.S. real rates diminishes. Chart 5Gold Will Stay in Trading Range Gold Will Stay in Trading Range Gold Will Stay in Trading Range In our view, gold will remain in an upward trading range until rates become restrictive enough to depress the inflation outlook (Chart 5, panel 2). Our U.S. strategists estimate the equilibrium fed funds rate is at ~ 3%, and project it will rise to ~ 3⅜% by end-2019. Therefore, despite our House view of four rate hikes next year, we expect the U.S. economy to remain in a below-r-star-and-rising phase for most of the year. Consistent with our House view, we believe U.S. inflation is likely to surprise to the upside next year, which will push gold prices higher (Chart 6, panel 1). The U.S. economy remains strong, particularly on the employment front. This means wage growth will work its way through inflation rates. Chart 6U.S. Inflation Likely to Surprise U.S. Inflation Likely to Surprise U.S. Inflation Likely to Surprise Admittedly, this is not the consensus view. Investors are not worried about significantly higher inflation (Chart 6, panel 2). However, our Bond strategists argue that long-maturity TIPS breakeven inflation is stuck below historical levels because of this abnormally low fear of elevated inflation (i.e. > 2.5%). Once inflation starts drifting higher, there will be an upward shift in investors’ inflation expectations. Any short-term dip in inflation on the back of lower oil prices will be transitory, given our view that oil prices will recover next year. If such a transitory dip, or concerns about a global growth slowdown spilling back into the U.S. causes the Fed to pause, we would add to our precious metal view position, given our assessment that this would raise the probability of an inflation overshoot. Lastly, gold prices recently have been depressed by an abnormally high correlation with the U.S. dollar (Table 1). We put this down to speculative positioning: Net speculative positions are stretched for both the U.S. dollar and gold, Table 1Gold Vs. USD Correlations Running Higher Than Normal 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets therefore, any change in expectations likely will be amplified by a reversal in positioning (Chart 7). In the medium-term, we expect the gold-dollar correlation to converge back to its average, which would mute the dollar’s impact on gold. This would, all else equal, raise inflation and equity risks factors. Chart 7Spec Positioning Stretched Spec Positioning Stretched Spec Positioning Stretched Bottom Line: We continue to recommend gold as a portfolio hedge for investors, given its convexity – it outperforms during equity downturns, and participates on the upside (albeit not as much). Given our out-of-consensus House view for inflation, we believe gold also will provide a hedge against this risk. Palladium: China Tax Policy Could Lift Price Palladium soared to dizzying heights this year, on the back of an expanding physical deficit (Chart 8). Were it not for the loss of an automobile-tax break in China, which reduced the rate of growth in sales there to unchanged y/y, this deficit likely would have been considerably wider, inventories would have drawn even harder, and palladium prices would have been higher (Chart 9). Chart 8Palladium's Physical Deficit Expanding Palladium's Physical Deficit Expanding Palladium's Physical Deficit Expanding Chart 9Palladium Inventories Collapse Palladium Inventories Collapse Palladium Inventories Collapse Palladium’s demand is mainly driven by its use in catalytic converters for gasoline-powered cars, which dominate sales in the U.S. and China, the world’s two largest car markets (Chart 10). U.S. sales growth has leveled off this year (Chart 11), as has China’s. However, the China Automobile Dealers Association (CADA) is pressing policymakers to reduce the 10% auto sales tax by half, which could keep palladium demand elevated relative to supply, should it happen.8 Chart 10Auto Catalyst Demand Dominates Palladium 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Chart 11China Car Sales Could Revive With Tax Cut China Car Sales Could Revive With Tax Cut China Car Sales Could Revive With Tax Cut Russian producers, led by Norilsk Nickel, supply ~ 40% of the world’s palladium. Markets have been fearful U.S. sanctions could be imposed on Norilsk and other Russian producers throughout the year by the U.S., most recently in re Russia’s seizure of Ukrainian naval vessels in international waters, and over Russia’s response to the threatened withdraw from the Intermediate-Range Nuclear Forces (INF) Treaty by the U.S., which could be keeping a risk premium firmly embedded in palladium prices.9 With platinum trading below $800/oz, or ~ 65% of palladium’s value, autocatalyst makers could begin to switch out their catalysts (Chart 12). Chart 12Platinum Could Fill Palladium Supply Gap Platinum Could Fill Palladium Supply Gap Platinum Could Fill Palladium Supply Gap Base Metals: Trade Tensions, USD Cloud Outlook Base metals remain inextricably bound up with EM income growth. When EM incomes are growing, commodity demand – particularly for base metals – is growing, and vice versa. This typically shows up in EM GDP and import volume levels, which we use as explanatory variables in our base-metals price modeling (Chart 13). Chart 13Base Metals Demand Tied To EM Income, Trade Volumes Base Metals Demand Tied To EM Income, Trade Volumes Base Metals Demand Tied To EM Income, Trade Volumes There are, in our view, two significant risks to EM income growth over the short and medium terms: Sino – U.S. trade disputes, which erupted earlier this year. They carry the risk of spreading globally and unwinding supply chains that have taken decades to develop between DM and EM economies;10 Fed monetary policy, which is immediately reflected in USD levels. A strong dollar raises the local-currency costs of commodities for consumers ex-U.S., and debt-servicing costs in EM economies. In addition, it lowers the local-currency costs of producing commodities ex-U.S., which incentivizes producers to raise production to capture this arbitrage, since they are paid in USD. The trade-war risk remains, despite the agreement between presidents Trump and Xi at the G20 in Buenos Aires to work on a trade deal. Even so, the actual level of tariffs imposed by both sides is trivial relative to the level of global trade, which is in excess of $20 trillion p.a. – ~$17 trillion for goods, $5 trillion for services, according to the WTO (Chart 14). Chart 14Sino – U.S. Tariffs Remain Trivial Relative to Overall Global Trade 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Fed policy, on the other hand, is a threat of far greater moment to EM income growth, and, through this, import volumes, which we use to proxy that growth. The LMEX index, a gauge of base-metals prices traded on the LME, is extremely sensitive to changes in EM import volumes. This is not unexpected, given the income elasticity of trade for EM economies is greater than 1.0. Our modeling finds a 1% increase in EM import volumes translates to a 1.3% increase in the LMEX, which is consistent with the World Bank’s estimate of EM income elasticity of trade.11 Per our House view, we believe markets are too sanguine regarding the possibility of a Sino – U.S. trade deal. Such an event, should it occur, would immediately affect base metals markets, as China accounts for roughly half of base metals demand globally(Chart 15). Market participants’ default setting appears to be the U.S. and China will resolve their trade differences in short order – i.e., by the March 1, 2019, deadline agreed at the G20 meeting – resulting in a win-win for both countries and the world. We are hopeful this view is correct, but we would not take any positions in base metals in expectation of such an outcome. Instead, we think the substantive technological and strategic differences between the two countries, and underlying distrust, will result in a renewed escalation of tensions. Chart 15China Demand Remains Pivotal Base Metals Demand Could Wobble China Demand Remains Pivotal Base Metals Demand Could Wobble China Demand Remains Pivotal Base Metals Demand Could Wobble Bottom Line: We remain neutral base metals going into 2019. Fundamentally, most of the metals in the LME index are in balance, or can get there in short order. The Fed’s rates-normalization policy continues to represent a larger short-term risk to EM income growth than Sino – U.S. trade tensions, but, longer term, we continue to expect tension between the world’s dominant economies to escalate. Ags: Trade Tensions, USD Cloud Outlook That’s not a typo in the sub-head above; ags – particularly soybeans – are dealing with the same headwinds bedeviling base metals. The agreement to work on a trade agreement reached at the G20 summit between the U.S. and China lifted grain markets, and supported the upward trend in grain and bean prices. All the same, Sino – U.S. trade relations are prone to go off the rails at any time. The Buenos Aries understanding, after all, only holds for 90 days. In addition to the hoped-for agreement to resolve trade-war issues, grain prices received support from the signing of the United States-Mexico-Canada Agreement (USMCA). This helped align supply-demand fundamentals globally with prices. Focusing too much on China can obscure the fact that the USMCA, which replaces the North American Free Trade Agreement (NAFTA), eliminated major uncertainties over the fate of U.S. grain exports to Mexico, the second-largest destination for U.S grains, beans and cotton. In fact, Mexico accounts for 13% of all U.S. ag exports (Chart 16).12 Chart 16Trade Negotiations Hit American Farmers Hard 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets All the same, the Sino – U.S. trade war is hitting U.S. ags hard, particularly soybeans. The 25% tariff on China’s imports of U.S. grains created two parallel agriculture markets. In one market, China is scrambling to secure supplies, creating a deficit. In the other, U.S. farmers are struggling to market their produce overseas, suffering from storage shortages and in some cases left with no option but to leave their crops to rot. Close to 60% of U.S. bean exports historically went to China. The U.S. – China trade war caused a soybean shortage in Brazil, as demand from China for its crops soared, while a record 11% of American beans are projected to be left over after accounting for exports and domestic consumption (Chart 17). Chart 17Bean Shortage in Brazil, Supply Glut in the U.S. Bean Shortage in Brazil, Supply Glut in the U.S. Bean Shortage in Brazil, Supply Glut in the U.S. A successful resolution to the U.S. – China trade tensions is unlikely to reverse the over-supply of beans globally (Chart 18). In fact, we expect beans stocks-to-use (STU) ratios to build next year, unlike global corn and wheat stocks (Chart 19). This will set a record for the soybean STU ratios, pushing them above 30%. Chart 18Expect Another Bean Surplus Expect Another Bean Surplus Expect Another Bean Surplus Chart 19Bean STU Ratios Will Grow Bean STU Ratios Will Grow Bean STU Ratios Will Grow As is the case for metals, the USD will weigh on ag markets, which will make U.S. exports more expensive than their foreign competition (Chart 20). As is the case for all of the commodities we cover, a strong dollar will weigh on prices at the margin. Chart 20A Strong USD Will Make U.S. Exports Expensive A Strong USD Will Make U.S. Exports Expensive A Strong USD Will Make U.S. Exports Expensive Bottom Line: A thaw in the Sino – U.S. trade war should realign global grain markets, but will not keep soybeans from setting new global inventory records. A strong USD will be a headwind for ag markets, as it is for other commodity markets we cover.     Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      This is a fictional character in the movie Master and Commander, based on the novels of Patrick O’Brian. 2      OPEC 2.0 is the name we coined for the OPEC/non-OPEC coalition led by the Kingdom of Saudi Arabia (KSA) and Russia.  It was formed in November 2016 to manage oil production. 3      Please see “Silver, Platinum At Risk As Fed Tightens; Palladium Less So,” published by BCA Research’s Commodity & Energy Strategy February 15, 2018.  It is available at ces.bcaresearch.com. 4      Please see “The Role of Major Emerging Markets in Global Commodity Demand,” published as a Special Focus in the IMF’s Global Economic Prospects in June 2018 for a discussion of income elasticities for oil, base metals and other commodities in large EM economies. 5      In our current forecast for 2019, we expect Brent to average $82/bbl next year, and for WTI to trade $6/bbl below that.  Please see “All Fall Down: Vertigo In the Oil Market … Lowering 2019 Brent Forecast to $82/bbl,” published by BCA Research’s Commodity & Energy Strategy November 15, 2018.  We will be updating our supply-demand balances and price forecast next week. 6      At 11.7mm b/d and growing, the U.S. is the largest crude oil producer in the world, having recently eclipsed Russia’s total crude and liquids production of 11.4mm b/d, and the U.S. EIA’s projected 2019 output of 11.6mm b/d.  U.S. crude oil exports hit 3.2mm b/d for the week ended November 30, 2018, an all-time high, according to EIA data.  It is worthwhile recalling crude oil exports were illegal until December 2015.  U.S. product exports totalled 5.8mm b/d for the week ended November 30, and 6.3mm b/d the week before that.  Total U.S. crude and product exports are running ~ 9mm b/d at present, which placed them just above total imports of crude and products – i.e., the U.S. became a net exporter of crude and products at the end of November. 7      The San Francisco Fed defines r-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target.  r-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed.  Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 8      Please see “Exclusive: Reverse gear - China car dealers push for tax cut as auto growth stalls,” published by reuters.com October 11, 2018. 9      Please see “Is Norilsk Nickel too big to sanction?” published by ft.com on April 19, 2018, and “U.S. to Tell Russia It Is Leaving Landmark I.N.F. Treaty,” published by nytimes.com October 19, 2018. 10     We discuss this in “Escalating Trade Disputes Pressuring Base Metals,” published July 12, 2018, in BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 11     For a discussion of the World Bank’s trade elasticities, please see “Trade Wars, China Credit Policy Will Roil Global Copper Markets” published by BCA Research’s Commodity & Energy Strategy June 21, 2018. It is available at ces.bcaresearch.com. 12     Canada makes up a smaller share of U.S. exports, at ~ 2%. Investment Views and Themes Recommendations Strategic Recommendations Commodity Prices and Plays Reference Table Trade Recommendation Performance In 3Q18 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets Trades Closed in 2018 Summary of Trades Closed in 2017 2019 Key Views: Policy-Induced Volatility Will Drive Markets 2019 Key Views: Policy-Induced Volatility Will Drive Markets

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing Recent Softness In U.S. Housing Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Global Manufacturing Slowdown Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration China: Credit Impulse Remains Weak China: Credit Impulse Remains Weak Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising China: Debt Still Rising China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer Chinese Exports About To Suffer Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money bca.bca_mp_2018_12_01_c16 bca.bca_mp_2018_12_01_c16 Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions ...And Tightening Financial Conditions ...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed Real Yields Still Very Depressed Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Productivity Still Has Some Upside Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Demographics Past The Inflection Point Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low Term Premia Are Too Low Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Chart 25QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Forward Yields Are Too Low Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts EPS Growth Forecasts EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels... bca.bca_mp_2018_12_01_c35 bca.bca_mp_2018_12_01_c35   Chart 36A…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given the recent turbulence in financial markets. Our investments have done poorly in the past year and, with hindsight, I wish I had followed my instincts to significantly cut our equity exposure at the end of 2017, although we did follow your advice to move to a neutral stance in mid-2018. I remain greatly troubled by economic and political developments in many countries. I have long believed in open and free markets and healthy political discourse, and this all seems under challenge. As always, there is much to talk about. Ms. X: Let me add that I also am pleased to have this opportunity to talk through the key issues that will influence our investment strategy over the coming year. As I am sure you remember, I was more optimistic than my father about the outlook when we met a year ago but things have not worked out as well as I had hoped. In retrospect, I should have paid more attention to your view that markets and policy were on a collision course as that turned out to be a very accurate prediction. When I joined the family firm in early 2017, I persuaded my father that we should have a relatively high equity exposure and that was the correct stance. However, this success led us to maintain too much equity exposure in 2018, and my father has done well to resist the temptation to say “I told you so.” So, we are left with a debate similar to last year: Should we move now to an underweight in risk assets or hold off on the hope that prices will reach new highs in the coming year? I am still not convinced that we have seen the peak in risk asset prices as there is no recession on the horizon and equity valuations are much improved, following recent price declines. I will be very interested to hear your views. BCA: Our central theme for 2018 that markets and policy would collide did turn out to be appropriate and, importantly, the story has yet to fully play out. The monetary policy tightening cycle is still at a relatively early stage in the U.S. and has not even begun in many other regions. Yet, although it was a tough year for most equity markets, the conditions for a major bear market are not yet in place. One important change to our view, compared to a year ago, is that we have pushed back the timing of the next U.S. recession. This leaves a window for risk assets to show renewed strength. It remains to be seen whether prices will reach new peaks, but we believe it would be premature to shift to an underweight stance on equities. For the moment, we are sticking with our neutral weighting for risk assets, but may well recommend boosting exposure if prices suffer further near-term weakness. We will need more clarity about the timing of a recession before we consider aggressively cutting exposure. Mr. X: I can see we will have a lively discussion because I do not share your optimism. My list of concerns is long and I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: That is always interesting to do, although sometimes rather humbling. A year ago, our key conclusions were that: The environment of easy money, low inflation and healthy profit growth that has been so bullish for risk assets will start to change during the coming year. Financial conditions, especially in the U.S., will gradually tighten as decent growth leads to building inflationary pressures, encouraging central banks to withdraw stimulus. With U.S. equities at an overvalued extreme and investor sentiment overly optimistic, this will set the scene for an eventual collision between policy and the markets.  The conditions underpinning the bull market will erode only slowly which means that risk asset prices should continue to rise for at least the next six months. However, long-run investors should start shifting to a neutral exposure. Given our economic and policy views, there is a good chance that we will move to an underweight position in risk assets during the second half of 2018. The U.S. economy is already operating above potential and thus does not need any boost from easier fiscal policy. Any major tax cuts risk overheating the economy, encouraging the Federal Reserve to hike interest rates and boosting the probability of a recession in 2019. This is at odds with the popular view that tax cuts will be good for the equity market. A U.S. move to scrap NAFTA would add to downside risks. For the second year in a row, the IMF forecasts of economic growth for the coming year are likely to prove too pessimistic. The end of fiscal austerity has allowed the Euro Area economy to gather steam and this should be sustained in 2018. However, the slow progress in negotiating a Brexit deal with the EU poses a threat to the U.K. economy. China’s economy is saddled with excessive debt and excess capacity in a number of areas. Any other economy would have collapsed by now, but the government has enough control over banking and other sectors to prevent a crisis. Growth should hold above 6% in the next year or two, although much will depend on how aggressively President Xi pursues painful reforms. The market is too optimistic in assuming that the Fed will not raise interest rates by as much as indicated in their “dots” projections. There is a good chance that the U.S. yield curve will become flat or inverted by late 2018. Bonds are not an attractive investment at current yields. Only Greece and Portugal have real 10-year government bond yields above their historical average. Corporate bonds should outperform governments, but a tightening in financial conditions will put these at risk in the second half of 2018. The Euro Area and Japanese equity markets should outperform the U.S. over the next year reflecting their better valuations and more favorable financial conditions. Developed markets should outperform the emerging market index. Historically, the U.S. equity market has led recessions by between 3 and 12 months. If, as we fear, a U.S. recession starts in the second half of 2019, then the stock market would be at risk from the middle of 2018. The improving trend in capital spending should favor industrial stocks. Our other two overweight sectors are energy and financials. The oil price will be well supported by strong demand and output restraint by OPEC and Russia. The Brent price should average $65 a barrel over the coming year, with risks to the upside. We expect base metals prices to trade broadly sideways but will remain highly dependent on developments in China. Modest positions in gold are warranted. Relative economic and policy trends will favor a firm dollar in 2018. Unlike at the start of 2017, investors are significantly short the dollar which is bullish from a contrary perspective. Sterling is quite cheap but Brexit poses downside risks. The key market-relevant geopolitical events to monitor will be fiscal policy and mid-term elections in the U.S., and reform policies in China. With the former, the Democrats have a good chance of winning back control of the House of Representatives, creating a scenario of complete policy gridlock. A balanced portfolio is likely to generate average returns of only 3.3% a year in nominal terms over the next decade. This compares to average returns of around 10% a year between 1982 and 2017. As already noted, the broad theme that policy tightening – especially in the U.S. – would become a problem for asset markets during the year was supported by events. However, the exact timing was hard to predict. The indexes for non-U.S. developed equity markets and emerging markets peaked in late-January 2018, and have since dropped by around 18% and 24%, respectively (Chart 1). On the other hand, the U.S. market, after an early 2018 sell-off, hit a new peak in September, before falling anew in the past couple of months. The MSCI All-Country World index currently is about 6% below end-2017 levels in local-currency terms. Chart 1Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out Our 'Collision Course' Theme For 2018 Played Out We started the year recommending an overweight in developed equity markets but, as you noted, shifted that to a neutral position mid-year. A year ago, we thought we might move to an underweight stance in the second half of 2018 but decided against this because U.S. fiscal stimulus boosted corporate earnings and extended the economic cycle. Our call that emerging markets would underperform was on target. Although it was U.S. financial conditions that tightened the most, Wall Street was supported by the large cut in the corporate tax rate while the combination of higher bond yields and dollar strength was a major problem for many indebted emerging markets. Overall, it was not a good year for financial markets (Table 1). Table 1Market Performance OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence As far as the overall macro environment was concerned, we were correct in predicting that the IMF was too pessimistic on economic growth. A year ago, the IMF forecast that the advanced economies would expand by 2% in 2018 and that has since been revised up to 2.4% (Table 2). This offset a slight downgrading to the performance of emerging economies. The U.S., Europe and Japan all grew faster than previously expected. Not surprisingly, inflation also was higher than forecast, although in the G7, it has remained close to the 2% level targeted by most central banks. Table 2IMF Economic Forecasts OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Despite widespread fears to the contrary, the data have supported our view that Chinese growth would hold above a 6% pace in 2018. Nevertheless, a slowdown currently is underway and downside risks remain very much in place in terms of excessive credit and trade pressures. Another difficult year lies ahead for the Chinese authorities and we will no doubt return to this topic later. As far as our other key forecasts are concerned, we were correct in our views that oil prices and the U.S. dollar would rise and that the market would be forced to revise up its predictions of Fed rate hikes. Of course, oil has recently given back its earlier gains, but we assume that is a temporary setback. On the sector front, our macro views led us to favor industrials, financials and energy, but that did not work out well as concerns about trade took a toll on cyclical sectors. Overall, there were no major macro surprises in 2018, and it seems clear that we have yet to resolve the key questions and issues that we discussed a year ago. At that time, we were concerned about the development of late-cycle pressures that ultimately would undermine asset prices. That story has yet to fully play out. It is hard to put precise timing on when the U.S. economy will peak and, thus, when asset prices will be at maximum risk. Nevertheless, our base case is that there likely will be a renewed and probably final run-up in asset prices before the next recession. Late-Cycle Challenges Mr. X: This seems like déjà-vu all over again. Since we last met, the cycle is one year older and, as you just said, the underlying challenges facing economies and markets have not really changed. If anything, things are even worse: Global debt levels are higher, inflation pressures more evident, Fed policy is moving closer to restrictive territory and protectionist policies have ratcheted up. If it was right to be cautious six months ago, then surely we should be even more cautious now. Ms. X: Oh dear, it does seem like a repeat of last year’s discussion because, once again, I am more optimistic than my father. Obviously, there are structural problems in a number of countries and, at some point, the global economy will suffer another recession. But timing is everything, and I attach very low odds to a downturn in the coming year. Meanwhile, I see many pockets of value in the equity market. Rather than cut equity positions, I am inclined to look for buying opportunities. BCA: We sympathize with your different perspectives because the outlook is complex and we also have lively debates about the view. The global equity index currently is a little below where it was when we met last year, but there has been tremendous intra-period volatility. That pattern seems likely to be repeated in 2019. In other words, it will be important to be flexible about your investment strategy. You both make good points. It is true that there are several worrying problems regarding the economic outlook, including excessive debt, protectionism and building inflation risks. At the same time, the classic conditions for an equity bear market are not yet in place, and may not be for some time. This leaves us in the rather uncomfortable position of sitting on the fence with regard to risk asset exposure. We are very open to raising exposure should markets weaken further in the months ahead, but also are keeping careful watch for signs that the economic cycle is close to peaking. In other words, it would be a mistake to lock in a 12-month strategy right now. Mr. X: I would like to challenge the consensus view, shared by my daughter, that the next recession will not occur before 2020, and might even be much later. The main rationale seems to be that the policy environment remains accommodative and there are none of the usual imbalances that occur ahead of recessions. Of course, U.S. fiscal policy has given a big boost to growth in the past year, but I assume the effects will wear off sharply in 2019. More importantly, there is huge uncertainty about the level of interest rates that will trigger economic problems. It certainly has not taken much in the way of Fed rate hikes to rattle financial markets. Thus, monetary policy may become restrictive much sooner than generally believed. I also strongly dispute the idea that there are no major financial imbalances. If running U.S. federal deficits of $1 trillion in the midst of an economic boom is not an imbalance, then I don’t know what is! At the same time, the U.S. corporate sector has issued large amounts of low-quality debt, and high-risk products such as junk-bond collateralized debt obligations have made an unwelcome reappearance. It seems that the memories of 2007-09 have faded. It is totally normal for long periods of extremely easy money to be accompanied by growing leverage and increasingly speculative financial activities, and I don’t see why this period should be any different. And often, the objects of speculation are not discovered until financial conditions become restrictive. Finally, there are huge risks associated with rising protectionism, the Chinese economy appears to be struggling, Italy’s banks are a mess, and the Brexit fiasco poses a threat to the U.K. economy. Starting with the U.S., please go ahead and convince me why a recession is more than a year away. BCA: It is natural for you to worry that a recession is right around the corner. The current U.S. economic expansion will become the longest on record if it makes it to July 2019, at which point it will surpass the 1990s expansion. Economists have a long and sad history of failing to forecast recessions. Therefore, a great deal of humility is warranted when it comes to predicting the evolution of the business cycle. The Great Recession was one of the deepest downturns on record and the recovery has been fairly sluggish by historic standards. Thus, it has taken much longer than usual for the U.S. economy to return to full employment. Looking out, there are many possible risks that could trip up the U.S. economy but, for the moment, we see no signs of recession on the horizon (Chart 2). For example, the leading economic indicator is still in an uptrend, the yield curve has not inverted and our monetary indicators are not contracting. Our proprietary recession indicator also suggests that the risk is currently low, although recent stock market weakness implies some deterioration. Chart 2Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' Few U.S Recession 'Red Flags' The buildup in corporate debt is a cause for concern and we are not buyers of corporate bonds at current yields. However, the impact of rising yields on the economy is likely to be manageable. The interest coverage ratio for the economy as a whole – defined as the profits corporations generate for every dollar of interest paid – is still above its historic average (Chart 3). Corporate bonds are also generally held by non-leveraged investors such as pension funds, insurance companies, and ETFs. The impact of defaults on the economy tends to be more severe when leveraged institutions are the ones that suffer the greatest losses. Chart 3Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind Interest Costs Not Yet A Headwind We share your worries about the long-term fiscal outlook. However, large budget deficits do not currently imperil the economy. The U.S. private sector is running a financial surplus, meaning that it earns more than it spends (Chart 4). Not only does this make the economy more resilient, it also provides the government with additional savings with which to finance its budget deficit. If anything, the highly accommodative stance of fiscal policy has pushed up the neutral rate of interest, giving the Fed greater scope to raise rates before monetary policy enters restrictive territory. The impetus of fiscal policy on the economy will be smaller in 2019 than it was in 2018, but it will still be positive (Chart 5). Chart 4The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit The U.S. Private Sector Is Helping To Finance The Fiscal Deficit Chart 5U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 U.S. Fiscal Policy Still Stimulative In 2019 The risks to growth are more daunting outside the U.S. As you point out, Italy is struggling to contain borrowing costs, a dark cloud hangs over the Brexit negotiations, and China and most other emerging markets have seen growth slow meaningfully. The U.S., however, is a relatively closed economy – it is not as dependent on trade as most other countries. Its financial system is reasonably resilient thanks to the capital its banks have raised over the past decade. In addition, Dodd-Frank and other legislation have made it more difficult for financial institutions to engage in reckless risk-taking. Mr. X: I would never take a benign view of the ability and willingness of financial institutions to engage in reckless behavior, but maybe I am too cynical. Even if you are right that debt does not pose an immediate threat to the market, surely it will become a huge problem in the next downturn. If the U.S. federal deficit is $1 trillion when the economy is strong, it is bound to reach unimaginable levels in a recession. And, to make matters worse, the Federal Reserve may not have much scope to lower interest rates if they peak at a historically low level in the next year or so. What options will policymakers have to respond to the next cyclical downturn? Is there a limit to how much quantitative easing central banks can do? BCA: The Fed is aware of the challenges it faces if the next recession begins when interest rates are still quite low. Raising rates rapidly in order to have more “ammunition” for counteracting the downturn would hardly be the best course of action as this would only bring forward the onset of the recession. A better strategy is to let the economy overheat a bit so that inflation rises. This would allow the Fed to push real rates further into negative territory if the recession turns out to be severe. There is no real limit on how much quantitative easing the Fed can undertake. The FOMC will undoubtedly turn to asset purchases and forward guidance again during the next economic downturn. Now that the Fed has crossed the Rubicon into unorthodox monetary policy without generating high inflation, policymakers are likely to try even more exotic policies, such as price-level targeting. The private sector tends to try to save more during recessions. Thus, even though the fiscal deficit would widen during the next downturn, there should be plenty of buyers for government debt. However, once the next recovery begins, the Fed may feel increasing political pressure to keep rates low in order to allow the government to maintain its desired level of spending and taxes. The Fed guards its independence fiercely, but in a world of increasingly political populism, that independence may begin to erode. This will not happen quickly, but to the extent that it does occur, higher inflation is likely to be the outcome. Ms. X: I would like to explore the U.S.-China dynamic a bit more because I see that as one of the main challenges to my more optimistic view. I worry that President Trump will continue to take a hard line on China trade because it plays well with his base and has broad support in Congress. And I equally worry that President Xi will not want to be seen giving in to U.S. bullying. How do you see this playing out? BCA: Investors hoping that U.S. President Donald Trump and his Chinese counterpart Xi Jinping will reach a deal to end the trade war on the sidelines of the forthcoming G20 leaders' summit in Buenos Aires are likely to be disappointed. President Trump's fiscal policy is completely inconsistent with his trade agenda. Fiscal stimulus in a full-employment economy will suck in imports. It also forces the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. The result will be a larger U.S. trade deficit. Trump will not be able to blame Canada or Mexico for a deteriorating trade position because he just signed a trade agreement with them. The new USMCA agreement is remarkably similar to NAFTA, with the notable exception that it contains a clause barring Canada and Mexico from negotiating bilateral trade deals with China. This means Trump needs a patsy who will take the blame for America's burgeoning trade deficit and China will fill that role. For his part, President Xi knows full well that he will still be China’s leader when Trump is long gone. Giving in to Trump’s demands would hurt him politically. All this means that the trade war will persist. Mr. X: I see a trade war as a major threat to the economy, but it is not the only thing that could derail the economic expansion. Let’s explore that issue in more detail. The Economic Outlook Mr. X: You have shown in previous research that housing is often a very good leading indicator of the U.S. economy, largely because it is very sensitive to changes in the monetary environment. Are you not concerned about the marked deterioration in recent U.S. housing data? BCA: Recent trends in housing have indeed been disappointing, with residential investment acting as a drag on growth for three consecutive quarters. The weakness has been broad-based with sales, the rate of price appreciation of home prices, and builder confidence all declining (Chart 6). Even though the level of housing affordability is decent by historical standards, there has been a fall in the percentage of those who believe that it is a good time to buy a home. Chart 6Recent Softness In U.S. Housing Recent Softness In U.S. Housing Recent Softness In U.S. Housing There are a few possible explanations for the weakness. First, the 2007-09 housing implosion likely had a profound and lasting impact on the perceived attractiveness of home ownership. The homeownership rate for people under 45 has remained extremely low by historical standards. Secondly, increased oversight and tighter regulations have curbed mortgage supply. Finally, the interest rate sensitivity of the sector may have increased with the result that even modest increases in the mortgage rate have outsized effects. That, in turn, could be partly explained by recent tax changes that capped the deduction on state and local property taxes, while lowering the limit on the tax deductibility of mortgage interest. The trend in housing is definitely a concern, but the odds of a further major contraction seem low. Unlike in 2006, the home vacancy rate stands near record levels and the same is true for the inventory of homes. The pace of housebuilding is below the level implied by demographic trends and consumer fundamentals are reasonably healthy. The key to the U.S. economy lies with business investment and consumer spending and these areas are well supported for the moment. Consumers are benefiting from continued strong growth in employment and a long overdue pickup in wages. Meanwhile, the ratio of net worth-to-income has surpased the previous peak and the ratio of debt servicing-to-income is low (Chart 7). Last year, we expressed some concern that the depressed saving rate might dampen spending, but the rate has since been revised substantially higher. Based on its historical relationship with U.S. household net worth, there is room for the saving rate to fall, fueling more spending. Real consumer spending has grown by 3% over the past year and there is a good chance of maintaining that pace during most of 2019. Chart 7U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy U.S. Consumer Fundamentals Are Healthy Turning to capital spending, the cut in corporate taxes was obviously good for cash flow, and surveys show a high level of business confidence. Moreover, many years of business caution toward spending has pushed up the average age of the nonresidential capital stock to the highest level since 1963 (Chart 8). Higher wages should also incentivize firms to invest in more machinery. Absent some new shock to confidence, business investment should stay firm during the next year. Chart 8An Aging Capital Stock An Aging Capital Stock An Aging Capital Stock Overall, we expect the pace of U.S. economic growth to slow from its recent strong level, but it should hold above trend, currently estimated to be around 2%. As discussed earlier, that means capacity pressures will intensify, causing inflation to move higher. Ms. X: I share the view that the U.S. economy will continue to grow at a healthy pace, but I am less sure about the rest of the world. BCA: You are right to be concerned. We expected U.S. and global growth to diverge in 2018, but not by as much as occurred. Several factors have weighed on CEO confidence outside of the U.S., including trade wars, a strong dollar, higher oil prices, emerging market turbulence, the return of Italian debt woes, and a slowdown in the Chinese economy. The stress has shown up in the global manufacturing PMI, although the latter is still at a reasonably high level (Chart 9). Global export growth is moderating and the weakness appears to be concentrated in capex. Capital goods imports for the major economies, business investment, and the production of investment-related goods have all decelerated this year. Chart 9Global Manufacturing Slowdown Global Manufacturing Slowdown Global Manufacturing Slowdown Our favorite global leading indicators are also flashing yellow (Chart 10). BCA’s global leading economic indicator has broken below the boom/bust line and its diffusion index suggests further downside. The global ZEW composite and the BCA boom/bust indicator are both holding below zero. Chart 10Global Growth Leading Indicators Global Growth Leading Indicators Global Growth Leading Indicators Current trends in the leading indicators shown in Chart 11 imply that the growth divergence between the U.S. and the rest of the world will remain a key theme well into 2019. Among the advanced economies, Europe and Japan are quite vulnerable to the global soft patch in trade and capital spending. Chart 11Global Economic Divergence Will Continue Global Economic Divergence Will Continue Global Economic Divergence Will Continue The loss of momentum in the Euro Area economy, while expected, has been quite pronounced. Part of this is due to the dissipation of the 2016/17 economic boost related to improved health in parts of the European banking system that sparked a temporary surge in credit growth. The tightening in Italian financial conditions following the government’s budget standoff with the EU has weighed on overall Euro Area growth. Softer Chinese demand for European exports, uncertainties related to U.S. trade policy and the torturous Brexit negotiations, have not helped the situation. Real GDP growth decelerated to close to a trend pace by the third quarter of 2018. The manufacturing PMI has fallen from a peak of 60.6 in December 2017 to 51.5, mirroring a 1% decline in the OECD’s leading economic indicator for the region. Not all the economic news has been bleak. Both consumer and industrial confidence remain at elevated levels according to the European Commission (EC) surveys, consistent with a resumption of above-trend growth. Even though exports have weakened substantially from the booming pace in 2017, the EC survey on firms’ export order books remains at robust levels (Chart 12). Importantly for the Euro Area, the bank credit impulse has moved higher.The German economy should also benefit from a rebound in vehicle production which plunged earlier this year following the introduction of new emission standards. Chart 12Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster Europe: Slowing, But No Disaster We interpret the 2018 Euro Area slowdown as a reversion-to-the-mean rather than the start of an extended period of sub-trend growth. Real GDP growth should fluctuate slightly above trend pace through 2019. Given that the Euro Area’s output gap is almost closed, the ECB will not deviate from its plan to end its asset purchase program by year end. Gradual rate hikes should begin late in 2019, assuming that inflation is closer to target by then. In contrast, the Bank of Japan (BoJ) is unlikely to change policy anytime soon. The good news is that wages have finally begun to grow at about a 2% pace, although it required extreme labor shortages. Yet, core inflation is barely positive and long-term inflation expectations are a long way from the 2% target. The inflation situation will have to improve significantly before the BoJ can consider adjusting or removing the Yield Curve Control policy. This is especially the case since the economy has hit a bit of an air pocket and the government intends to raise the VAT in 2019. Japan’s industrial production has stalled and we expect the export picture to get worse before it gets better. We do not anticipate any significant economic slack to develop, but even a sustained growth slowdown could partially reverse the gains that have been made on the inflation front. Ms. X: We can’t talk about the global economy without discussing China. You have noted in the past how the authorities are walking a tightrope between trying to unwind the credit bubble and restructure the economy on the one hand, and prevent a destabilizing economic and financial crisis on the other. Thus far, they have not fallen off the tightrope, but there has been limited progress in resolving the country’s imbalances. And now the authorities appear to be stimulating growth again, risking an even bigger buildup of credit. Can it all hold together for another year? BCA: That’s a very good question. Thus far, there is not much evidence that stimulus efforts are working. Credit growth is still weak and leading economic indicators have not turned around (Chart 13). There is thus a case for more aggressive reflation, but the authorities also remain keen to wean the economy off its addiction to debt. Chart 13China: No Sign Of Reacceleration China: Credit Impulse Remains Weak China: Credit Impulse Remains Weak Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to about 260% of GDP at present (Chart 14). As is usually the case, rapid increases in leverage have been associated with a misallocation of capital. Since most of the new credit has been used to finance fixed-asset investment, the result has been overcapacity in a number of areas. For example, the fact that 15%-to-20% of apartments are sitting vacant is a reflection of overbuilding. Meanwhile, the rate of return on assets in the state-owned corporate sector has fallen below borrowing costs. Chart 14China: Debt Still Rising China: Debt Still Rising China: Debt Still Rising Chinese exports are holding up well so far, but this might only represent front-running ahead of the implementation of higher tariffs. Judging from the steep drop in the export component of both the official and private-sector Chinese manufacturing PMI, exports are likely to come under increasing pressure over the next few quarters as the headwinds from higher tariffs fully manifest themselves (Chart 15). Chart 15Chinese Exports About To Suffer Chinese Exports About To Suffer Chinese Exports About To Suffer The most likely outcome is that the authorities will adjust the policy dials just enough to stabilize growth sometime in the first half of 2019. The bottoming in China’s broad money impulse offers a ray of hope (Chart 16). Still, it is a tentative signal at best and it will take some time before this recent easing in monetary policy shows up in our credit impulse measure and, later, economic growth. A modest firming in Chinese growth in the second half of 2019 would provide a somewhat stronger demand backdrop for commodities and emerging economies that sell goods to China. Chart 16A Ray Of Hope From Broad Money bca.bca_mp_2018_12_01_c16 bca.bca_mp_2018_12_01_c16 Ms. X: If you are correct about a stabilization in the Chinese economy next year, this presumably would be good news for emerging economies, especially if the Fed goes on hold. EM assets have been terribly beaten down and I am looking for an opportunity to buy. BCA: Fed rate hikes might have been the catalyst for the past year’s pain in EM assets, but it is not the underlying problem. As we highlighted at last year’s meeting, the troubles for emerging markets run much deeper. Our long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Excessive debt is a ticking time bomb for many of these countries; EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart 17). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart 17, bottom panel). Chart 17EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... EM Debt A Problem Given Slowing Supply-Side... Decelerating global growth has exposed these poor fundamentals. EM sovereign spreads have moved wider in conjunction with falling PMIs and slowing industrial production and export growth. And it certainly does not help that the Fed is tightening dollar-based liquidity conditions. EM equities usually fall when U.S. financial conditions tighten (Chart 18). Chart 18...And Tightening Financial Conditions ...And Tightening Financial Conditions ...And Tightening Financial Conditions Chart 19 highlights the most vulnerable economies in terms of foreign currency funding requirements, and foreign debt-servicing obligations relative to total exports. Turkey stands out as the most vulnerable, along with Argentina, Brazil, Indonesia, Chile, and Colombia. In contrast, Emerging Asia appears to be in better shape relative to the crisis period of the late 1990s. Chart 19Spot The Outliers OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence The backdrop for EM assets is likely to get worse in the near term, given our view that the Fed will continue to tighten and China will be cautious about stimulating more aggressively. Our base case outlook sees some relief in the second half of 2019, but it is more of a “muddle-through” scenario than a V-shaped economic recovery. Mr. X: Perhaps EM assets could enjoy a bounce next year if the Chinese economy stabilizes, but the poor macro fundamentals you mentioned suggest that it would be a trade rather than a buy-and-hold proposition. I am inclined to avoid the whole asset class in 2019. Bond Market Prospects Ms. X: Let’s turn to fixed income now. I was bearish on bonds in 2018, but yields have risen quite a bit, at least in the United States. The Fed has lifted the fed funds rate by 100 basis points over the past year and I don’t see a lot of upside for inflation. So perhaps yields have peaked and will move sideways in 2019, which would be good for stocks in my view. BCA: Higher yields have indeed improved bond value recently. Nonetheless, they are not cheap enough to buy at this point (Chart 20). The real 10-year Treasury yield, at close to 1%, is still depressed by pre-Lehman standards. Long-term real yields in Germany and Japan remain in negative territory at close to the lowest levels ever recorded. Chart 20Real Yields Still Very Depressed Real Yields Still Very Depressed Real Yields Still Very Depressed We called the bottom in global nominal bond yields in 2016. Our research at the time showed that the cyclical and structural factors that had depressed yields were at an inflection point, and were shifting in a less bond-bullish direction. Perhaps most important among the structural factors, population aging and a downward trend in underlying productivity growth resulted in lower equilibrium bond yields over the past couple of decades. Looking ahead, productivity growth could stage a mild rebound in line with the upturn in the growth rate of the capital stock (Chart 21). As for demographics, the age structure of the world population is transitioning from a period in which aging added to the global pool of savings to one in which aging is beginning to drain that pool as people retire and begin to consume their nest eggs (Chart 22). The household saving rates in the major advanced economies should trend lower in the coming years, placing upward pressure on equilibrium global bond yields. Chart 21Productivity Still Has Some Upside Productivity Still Has Some Upside Productivity Still Has Some Upside Chart 22Demographics Past The Inflection Point Demographics Past The Inflection Point Demographics Past The Inflection Point Cyclical factors are also turning against bonds. U.S. inflation has returned to target and the Fed is normalizing short-term interest rates. The market currently is priced for only one more rate hike after December 2018 in this cycle, but we see rates rising more than that. Treasury yields will follow as market expectations adjust. Long-term inflation expectations are still too low in the U.S. and most of the other major economies to be consistent with central banks’ meeting their inflation targets over the medium term. As actual inflation edges higher, long-term expectations built into bond yields will move up. The term premium portion of long-term bond yields is also too low. This is the premium that investors demand to hold longer-term bonds. Our estimates suggest that the term premium is still negative in the advanced economies outside of the U.S., which is not sustainable over the medium term (Chart 23). Chart 23Term Premia Are Too Low Term Premia Are Too Low Term Premia Are Too Low We expect term premia to rise for two main reasons. First, investors have viewed government bonds as a good hedge for their equity holdings because bond prices have tended to rise when stock prices fell. Investors have been willing to pay a premium to hold long-term bonds to benefit from this hedging effect. But the correlation is now beginning to change as inflation and inflation expectations gradually adjust higher and output gaps close. As the hedging benefit wanes, the term premium should rise back into positive territory. Second, central bank bond purchases and forward guidance have depressed yields as well as interest-rate volatility. The latter helped to depress term premia in the bond market. This effect, too, is beginning to unwind. The Fed is letting its balance sheet shrink by about $50 billion per month. The Bank of England has kept its holdings of gilts and corporate bonds constant for over a year, while the ECB is about to end asset purchases. The Bank of Japan continues to buy assets, but at a much reduced pace. All this means that the private sector is being forced to absorb a net increase in government bonds for the first time since 2014 (Chart 24). Chart 25 shows that bond yields in the major countries will continue to trend higher as the rapid expansion of central bank balance sheets becomes a thing of the past. Chart 24Private Sector To Absorb More Bonds OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Chart 25QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices QE Unwind Will Weigh On Bond Prices Ms. X: I’m not a fan of bonds at these levels, but that sounds overly bearish to me, especially given the recent plunge in oil prices. BCA: Lower oil prices will indeed help to hold down core inflation to the extent that energy prices leak into non-energy prices in the near term. Nonetheless, in the U.S., this effect will be overwhelmed by an overheated economy. From a long-term perspective, we believe that investors still have an overly benign view of the outlook for yields. The market expects that the 10-year Treasury yield in ten years will only be slightly above today’s spot yield, which itself is still very depressed by historical standards (Chart 26). And that also is the case in the other major bond markets. Chart 26Forward Yields Are Too Low Forward Yields Are Too Low Forward Yields Are Too Low Of course, it will not be a straight line up for yields – there will be plenty of volatility. We expect the 10-year Treasury yield to peak sometime in 2019 or early 2020 in the 3.5%-to-4% range, before the next recession sends yields temporarily lower. Duration should be kept short at least until the middle of 2019, with an emphasis on TIPS relative to conventional Treasury bonds. We will likely downgrade TIPS versus conventionals once long-term inflation expectations move into our target range, which should occur sometime during 2019. The ECB and Japan will not be in a position to raise interest rates for some time, but the bear phase in U.S. Treasurys will drag up European and Japanese bond yields (at the very long end of the curve for the latter). Total returns are likely to be negative in all of the major bond markets in 2019. Real 10-year yields in all of the advanced economies are still well below their long-term average, except for Greece, Italy and Portugal (Chart 27). Chart 27Valuation Ranking Of Developed Bond Markets OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Within global bond portfolios, we recommend being underweight bond markets where central banks are in a position to raise short-term interest rates (the U.S. and Canada), and overweight those that are not (Japan and Australia). The first ECB rate hike is unlikely before the end of 2019. However, the imminent end of the asset purchase program argues for no more than a benchmark allocation to core European bond markets within global fixed-income portfolios, especially since real 10-year yields in parts of continental Europe are the furthest below their long-term average. We are overweight gilts at the moment, but foresee shifting to underweight in 2019, depending on how Brexit plays out. Ms. X: What about corporate bonds? I know that total returns for corporates will be poor if government bond yields are rising. But you recommended overweighting corporate bonds relative to Treasurys last year. Given your view that the next U.S. recession is more than a year away, it seems reasonable to assume they will outperform government bonds. BCA: We were overweight corporates in the first half of 2018, but took profits in June and shifted to neutral at the same time that we downgraded our equity allocation. Spreads had tightened to levels that did not compensate investors for the risks. Recent spread widening has returned some value to U.S. corporates. The 12-month breakeven spreads for A-rated and Baa-rated corporate bonds are almost back up to their 50th percentile relative to history (Chart 28). Still, these levels are not attractive enough to justify buying based on valuation alone. As for high-yield, any rise in the default rate would quickly overwhelm the yield pickup in this space. Chart 28Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside Corporate Bond Yields Still Have Upside It is possible that some of the spread widening observed in October and November will reverse, but corporates offer a poor risk/reward tradeoff, even if the default rate stays low. Corporate profit growth is bound to decelerate in 2019. This would not be a disaster for equities, but slowing profit growth is more dangerous for corporate bond excess returns because the starting point for leverage is already elevated. As discussed above, at a macro level, the aggregate interest coverage ratio for the U.S. corporate sector is decent by historical standards. However, this includes mega-cap companies that have little debt and a lot of cash. Our bottom-up research suggests that interest coverage ratios for firms in the Bloomberg Barclays corporate bond index will likely drop close to multi-decade lows during the next recession, sparking a wave of downgrade activity and fallen angels. Seeing this coming, investors may require more yield padding to compensate for these risks as profit growth slows. Our next move will likely be to downgrade corporate bonds to underweight. We are watching the yield curve, bank lending standards, profit growth, and monetary indicators for signs to further trim exposure. You should already be moving up in quality within your corporate bond allocation. Mr. X: We have already shifted to underweight corporate bonds in our fixed income portfolio. Even considering the cheapening that has occurred over the past couple of months, spread levels still make no sense in terms of providing compensation for credit risk. Equity Market Outlook Ms. X: While we all seem to agree that corporate bonds are not very attractive, I believe that enough value has been restored to equities that we should upgrade our allocation, especially if the next recession is two years away. And I know that stocks sometimes have a powerful blow-off phase before the end of a bull market. Mr. X: This is where I vehemently disagree with my daughter. The recent sell-off resembles a bloodbath in parts of the global market. It has confirmed my worst fears, especially related to the high-flying tech stocks that I believe were in a bubble. Hopes for a blow-off phase are wishful thinking. I’m wondering if the sell-off represents the beginning of an extended bear market. BCA: Some value has indeed been restored. However, the U.S. market is far from cheap relative to corporate fundamentals. The trailing and 12-month forward price-earnings ratios (PER) of 20 and 16, respectively, are still far above their historical averages, especially if one leaves out the tech bubble period of the late 1990s. And the same is true for other metrics such as price-to-sales and price-to-book value (Chart 29). BCA’s composite valuation indicator, based on 8 different valuation measures, is only a little below the threshold of overvaluation at +1 standard deviation because low interest rates still favor equities on a relative yield basis. Chart 29U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap U.S. Equities Are Not Cheap It is true that equities can reward investors handsomely in the final stage of a bull market. Chart 30 presents cumulative returns to the S&P 500 in the last nine bull markets. The returns are broken down by quintile. The greatest returns, unsurprisingly, generally occur in the first part of the bull market (quintile 1). But total returns in the last 20% of the bull phase (quintile 5) have been solid and have beaten the middle quartiles. Chart 30Late-Cycle Blow-Offs Can Be Rewarding OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Of course, the tricky part is determining where we are in the bull market. We have long viewed financial markets through the lens of money and credit. This includes a framework that involves the Fed policy cycle. The historical track record for risk assets is very clear; they tend to perform well when the fed funds rate is below neutral, whether rates are rising or falling. Risk assets tend to underperform cash when the fed funds rate is above neutral (Table 3). Table 3Stocks Do Well When The Fed Funds Rate Is Below Neutral OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence We believe the fed funds rate is still in easy territory. This suggests that it is too early to shift to underweight on risk assets. We may even want to upgrade to overweight if stocks become cheap enough, as long as Fed policy is not restrictive. That said, there is huge uncertainty about the exact level of rates that constitutes “neutral” (or R-star in the Fed’s lingo). Even the Fed is unsure. This means that we must watch for signs that the fed funds rate has crossed the line into restrictive territory as the FOMC tightens over the coming year. An inversion of the 3-month T-bill/10-year yield curve slope would be a powerful signal that policy has become tight, although the lead time of an inverted curve and declining risk asset prices has been quite variable historically. Finally, it is also important to watch U.S. profit margins. Some of our research over the past couple of years focused on the late-cycle dynamics of previous long expansions, such as the 1960s, 1980s and 1990s. We found that risk assets came under pressure once U.S. profit margins peaked. Returns were often negative from the peak in margins to the subsequent recession. Mr. X: U.S. profit margins must be close to peak levels. I’ve seen all sorts of anecdotal examples of rising cost pressures, not only in the labor market. BCA: We expected to see some margin pressure to appear by now. S&P 500 EPS growth will likely top out in the next couple of quarters, if only because the third quarter’s 26% year-over-year pace is simply not sustainable. But it is impressive that our margin proxies are not yet flagging an imminent margin squeeze, despite the pickup in wage growth (Chart 31). Chart 31U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat U.S. Margin Indicators Still Upbeat Margins according to the National Accounts (NIPA) data peaked in 2014 and have since diverged sharply with S&P 500 operating margins. It is difficult to fully explain the divergence. The NIPA margin is considered to be a better measure of underlying U.S. corporate profitability because it includes all companies (not just 500), and it is less subject to accounting trickery. That said, even the NIPA measure of margins firmed a little in 2018, along with the proxies we follow that correlate with the S&P 500 measure. The bottom line is that the macro variables that feed into our top-down U.S. EPS model point to a continuing high level of margins and fairly robust top-line growth, at least for the near term. For 2019, we assumed slower GDP growth and incorporated some decline in margins into our projection just to err on the conservative side. Nonetheless, our EPS model still projects a respectable 8% growth rate at the end of 2019 (Chart 32). The dollar will only be a minor headwind to earnings growth unless it surges by another 10% or more. Chart 32EPS Growth Forecasts EPS Growth Forecasts EPS Growth Forecasts The risks to EPS growth probably are to the downside relative to our forecast, but the point is that U.S. earnings will likely remain supportive for the market unless economic growth is much weaker than we expect. None of this means that investors should be aggressively overweight stocks now. We trimmed our equity recommendation to benchmark in mid-2018 for several reasons. At the time, value was quite poor and bottom-up earnings expectations were too high, especially on a five-year horizon. Also, sentiment measures suggested that investors were overly complacent. As you know, we are always reluctant to chase markets into highly overvalued territory, especially when a lot of good news has been discounted. As we have noted, we are open to temporarily shifting back to overweight in equities and other risk assets. The extension of the economic expansion gives more time for earnings to grow. The risks facing the market have not eased much but, given our base-case macro view, we would be inclined to upgrade equities if there is another meaningful correction. Of course, our profit, monetary and economic indicators would have to remain supportive to justify an upgrade. Mr. X: But you are bearish on bonds. We saw in October that the equity market is vulnerable to higher yields. BCA: It certainly won’t be smooth sailing through 2019 as interest rates normalize. Until recently, higher bond yields reflected stronger growth without any associated fears that inflation was a growing problem. The ‘Fed Put’ was seen as a key backstop for the equity bull market. But now that the U.S. labor market is showing signs of overheating, the bond sell-off has become less benign for stocks because the Fed will be less inclined to ease up at the first sign of trouble in the equity market. How stocks react in 2019 to the upward trend in yields depends a lot on the evolution of actual inflation and long-term inflation expectations. If core PCE inflation hovers close to or just above 2% for a while, then the Fed Put should still be in place. However, it would get ugly for both bonds and stocks if inflation moves beyond 2.5%. Our base case is that this negative dynamic won’t occur until early 2020, but obviously the timing is uncertain. One key indicator to watch is long-term inflation expectations, such as the 10-year TIPS breakeven inflation rate (Chart 33). It is close to 2% at the moment. If it shifts up into the 2.3%-2.5% range, it would confirm that inflation expectations have returned to a level that is consistent with the Fed meeting its 2% inflation target on a sustained basis. This would be a signal to the Fed that it is must become more aggressive in calming growth, with obvious negative consequences for risk assets. Chart 33Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Watch For A Return To 2.3%-2.5% Range Mr. X: I am skeptical that the U.S. corporate sector can pull off an 8% earnings gain in 2019. What about the other major markets? Won’t they get hit hard if global growth continues to slow as you suggest? BCA: Yes, that is correct. It is not surprising that EPS growth has already peaked in the Euro Area and Japan. The profit situation is going to deteriorate quickly in the coming quarters. Industrial production growth in both economies has already dropped close to zero, and we use this as a proxy for top-line growth in our EPS models. Nominal GDP growth has decelerated sharply in both economies in absolute terms and relative to the aggregate wage bill. These trends suggest that profit margins are coming under significant downward pressure. Even when we build in a modest growth pickup and slight rebound in margins in 2019, EPS growth falls close to zero by year-end according to our models. Both the Euro Area and Japanese equity markets are cheap relative to the U.S., based on our composite valuation indicators (Chart 34). However, neither is above the threshold of undervaluation (+1 standard deviation) that would justify overweight positions on valuation alone. We think the U.S. market will outperform the other two at least in the first half of 2019 in local and, especially, common-currency terms. Chart 34Valuation Of Nonfinancial Equity Markets Relative To The U.S. OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: It makes sense that U.S. profit growth will outperform the other major developed countries in 2019. I would like to circle back to emerging market assets. I understand that many emerging economies have deep structural problems. But you admitted that the Chinese authorities will eventually stimulate enough to stabilize growth, providing a bounce in EM growth and asset prices next year. These assets seem cheap enough to me to warrant buying now in anticipation of that rally. As we all know, reversals from oversold levels can happen in a blink of an eye and I don’t want to miss it. BCA: We are looking for an opportunity to buy as well, but are wary of getting in too early. First, valuation has improved but is not good enough on its own to justify buying now. EM stocks are only moderately undervalued based on our EM composite valuation indicator and the cyclically-adjusted P/E ratio (Chart 35). EM currencies are not particularly cheap either, outside of Argentina, Turkey and Mexico (Charts 36A and 36B). Valuation should only play a role in investment strategy when it is at an extreme, and this is not the case for most EM countries. Chart 35EM Stocks Are Not At Capitulation Levels... bca.bca_mp_2018_12_01_c35 bca.bca_mp_2018_12_01_c35   Chart 36A…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Chart 36B…And Neither Are EM Currencies ...And Neither Are EM Currencies ...And Neither Are EM Currencies Second, corporate earnings growth has plenty of downside potential in the near term. Annual growth in EM nonfinancial EBITDA, currently near 10%, is likely to turn negative next year, based on our China credit and fiscal impulse indicator (Chart 37). And, as we emphasized earlier, China is not yet pressing hard on the gas pedal. Chart 37EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside EM Earnings Growth: Lots Of Downside Third, it will take time for more aggressive Chinese policy stimulus, if it does occur, to show up in EM stocks and commodity prices. Trend changes in money growth and our credit and fiscal impulse preceded the trough in EM stocks and commodity prices in 2015, and again at the top in stocks and commodities in 2017 (Chart 38). However, even if these two indicators bottom today, it could take several months before the sell-off in EM financial markets and commodity prices abates. Chart 38Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Chinese Money And Credit Leads EM And Commodities Finally, if Chinese stimulus comes largely via easier monetary policy rather than fiscal stimulus, then the outcome will be a weaker RMB. We expect the RMB to drift lower in any event, because rate differentials vis-à-vis the U.S. will move against the Chinese currency next year. A weaker RMB would add to the near-term headwinds facing EM assets. The bottom line is that the downside risks remain high enough that you should resist the temptation to bottom-fish until there are concrete signs that the Chinese authorities are getting serious about boosting the economy. We are also watching for signs outside of China that the global growth slowdown is ending. This includes our global leading economic indicator and data that are highly sensitive to global growth, such as German manufacturing foreign orders. Mr. X: Emerging market assets would have to become a lot cheaper for me to consider buying. Debt levels are just too high to be sustained, and stronger Chinese growth would only provide a short-term boost. I’m not sure I would even want to buy developed market risk assets based solely on some Chinese policy stimulus. BCA: Yes, we agree with your assessment that buying EM in 2019 would be a trade rather than a buy-and-hold strategy. Still, the combination of continued solid U.S. growth and a modest upturn in the Chinese economy would alleviate a lot of investors’ global growth concerns. The result could be a meaningful rally in pro-cyclical assets that you should not miss. We are defensively positioned at the moment, but we could see becoming more aggressive in 2019 on signs that China is stimulating more firmly and/or our global leading indicators begin to show some signs of life. Besides upgrading our overall equity allocation back to overweight, we would dip our toes in the EM space again. At the same time, we will likely upgrade the more cyclical DM equity markets, such as the Euro Area and Japan, while downgrading the defensive U.S. equity market to underweight. We are currently defensively positioned in terms of equity sectors, but it would make sense to shift cyclicals to overweight at the same time. Exact timing is always difficult, but we expect to become more aggressive around the middle of 2019. We also think the time is approaching to favor long-suffering value stocks over growth stocks. The relative performance of growth-over-value according to standard measures has become a sector call over the past decade: tech or financials. The sector skew complicates this issue, especially since tech stocks have already cracked. But we have found that stocks that are cheap within equity sectors tend to outperform expensive (or growth) stocks once the fed funds rate moves into restrictive territory. This is likely to occur in the latter half of 2019. Value should then have its day in the sun. Currencies: Mr. X: We don’t usually hedge our international equity exposure, so the direction of the dollar matters a lot to us. As you predicted a year ago, the U.S. dollar reigned supreme in 2018. Your economic views suggest another good year in 2019, but won’t this become a problem for the economy? President Trump’s desire to lower the U.S. trade deficit suggests that the Administration would like the dollar to drop and we could get some anti-dollar rhetoric from the White House. Also, it seems that the consensus is strongly bullish on the dollar which is always a concern. BCA: The outlook for the dollar is much trickier than it was at the end of 2017. As you highlighted, traders are already very long the dollar, implying that the hurdle for the greenback to surprise positively is much higher now. However, a key driver for the dollar is the global growth backdrop. If the latter is poor in the first half of 2019 as we expect, it will keep a bid under the greenback. Interest rates should also remain supportive for the dollar. As we argued earlier, current market expectations – only one more Fed hike after the December meeting – are too sanguine. If the Fed increases rates by more than currently discounted, the dollar’s fair value will rise, especially if global growth continues to lag that of the U.S. Since the dollar’s 2018 rally was largely a correction of its previous undervaluation, the currency has upside potential in the first half of the year (Chart 39). Chart 39U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued U.S. Dollar Not Yet Overvalued A stronger dollar will dampen foreign demand for U.S.-produced goods and will boost U.S. imports. However, do not forget that a rising dollar benefits U.S. consumers via its impact on import prices. Since the consumer sector represents 68% of GDP, and that 69% of household consumption is geared toward the (largely domestic) service sector, a strong dollar will not be as negative for aggregate demand and employment as many commentators fear, unless it were to surge by at least another 10%. In the end, the dollar will be more important for the distribution of U.S. growth than its overall level. Where the strong dollar is likely to cause tremors is in the political arena. You are correct to point out that there is a large inconsistency between the White House’s desires to shore up growth, while simultaneously curtailing the trade deficit, especially if the dollar appreciates further. As long as the Fed focuses on its dual mandate and tries to contain inflationary pressures, the executive branch of the U.S. government can do little to push the dollar down. Currency intervention cannot have a permanent effect unless it is accompanied by shifts in relative macro fundamentals. For example, foreign exchange intervention by the Japanese Ministry of Finance in the late 1990s merely had a temporary impact on the yen. The yen only weakened on a sustained basis once interest rate differentials moved against Japan. This problem underpins our view that the Sino-U.S. relationship is unlikely to improve meaningfully next year. China will remain an easy target to blame for the U.S.’s large trade deficit. What ultimately will signal a top in the dollar is better global growth, which is unlikely until the second half of 2019. At that point, expected returns outside the U.S. will improve, causing money to leave the U.S., pushing the dollar down. Mr. X: While 2017 was a stellar year for the euro, 2018 proved a much more challenging environment. Will 2019 be more like 2017 or 2018? BCA: We often think of the euro as the anti-dollar; buying EUR/USD is the simplest, most liquid vehicle for betting against the dollar, and vice versa. Our bullish dollar stance is therefore synonymous with a negative take on the euro. Also, the activity gap between the U.S. and the Euro Area continues to move in a euro-bearish fashion (Chart 40). Finally, since the Great Financial Crisis, EUR/USD has lagged the differential between European and U.S. core inflation by roughly six months. Today, this inflation spread still points toward a weaker euro. Chart 40Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro Relative LEI's Moving Against Euro It is important to remember that when Chinese economic activity weakens, European growth deteriorates relative to the U.S. Thus, our view that global growth will continue to sputter in the first half of 2019 implies that the monetary policy divergence between the Fed and the ECB has not yet reached a climax. Consequently, we expect EUR/USD to trade below 1.1 in the first half of 2019. By that point, the common currency will be trading at a meaningful discount to its fair value, which will allow it to find a floor (Chart 41). Chart 41Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Euro Heading Below Fair Value Before Bottoming Mr. X: The Bank of Japan has debased the yen, with a balance sheet larger than Japan’s GDP. This cannot end well. I am very bearish on the currency. BCA: The BoJ’s monetary policy is definitely a challenge for the yen. The Japanese central bank rightfully understands that Japan’s inability to generate any meaningful inflation – despite an economy that is at full employment – is the consequence of a well-established deflationary mindset. The BoJ wants to shock inflation expectations upward by keeping real rates at very accommodative levels well after growth has picked up. This means that the BoJ will remain a laggard as global central banks move away from accommodative policies. The yen will continue to depreciate versus the dollar as U.S. yields rise on a cyclical horizon. That being said, the yen still has a place within investors’ portfolios. First, the yen is unlikely to collapse despite the BoJ’s heavy debt monetization. The JPY is one of the cheapest currencies in the world, with its real effective exchange rate hovering at a three-decade low (Chart 42). Additionally, Japan still sports a current account surplus of 3.7% of GDP, hardly the sign of an overstimulated and inflationary economy where demand is running amok. Instead, thanks to decades of current account surpluses, Japan has accumulated a positive net international investment position of 60% of GDP. This means that Japan runs a constant and large positive income balance, a feature historically associated with strong currencies. Chart 42The Yen Is Very Cheap The Yen Is Very Cheap The Yen Is Very Cheap Japan’s large net international investment position also contributes to the yen’s defensive behavior as Japanese investors pull money back to safety at home when global growth deteriorates. Hence, the yen could rebound, especially against the euro, the commodity currencies, and EM currencies if there is a further global growth scare in the near term. Owning some yen can therefore stabilize portfolio returns during tough times. As we discussed earlier, we would avoid the EM asset class, including currency exposure, until global growth firms. Commodities: Ms. X: Once again, you made a good call on the energy price outlook a year ago, with prices moving higher for most of the year. But the recent weakness in oil seemed to come out of nowhere, and I must admit to being confused about where we go next. What are your latest thoughts on oil prices for the coming year? BCA: The fundamentals lined up in a very straightforward way at the end of 2017. The coalition we have dubbed OPEC 2.0 – the OPEC and non-OPEC producer group led by the Kingdom of Saudi Arabia (KSA) and Russia – outlined a clear strategy to reduce the global oil inventory overhang. The producers that had the capacity to increase supply maintained strict production discipline which, to some analysts, was still surprising even after the cohesiveness shown by the group in 2017. Outside that core group output continued to fall, especially in Venezuela, which remains a high-risk producing province. The oil market was balanced and prices were slowly moving higher as we entered the second quarter of this year, when President Trump announced the U.S. would re-impose oil export sanctions against Iran beginning early November. The oft-repeated goal of the sanctions was to reduce Iranian exports to zero. To compensate for the lost Iranian exports, President Trump pressured OPEC, led by KSA, to significantly increase production, which they did. However, as we approached the November deadline, the Trump Administration granted the eight largest importers of Iranian oil 180-day waivers on the sanctions. This restored much of the oil that would have been lost. Suddenly, the market found itself oversupplied and prices fell. As we move toward the December 6 meeting of OPEC 2.0 in Vienna, we are expecting a production cut from the coalition of as much as 1.4mm b/d to offset these waivers. The coalition wishes to keep global oil inventories from once again over-filling and dragging prices even lower in 2019. On the demand side, consumption continues to hold up both in the developed and emerging world, although we have somewhat lowered our expectations for growth next year. We are mindful of persistent concerns over the strength of demand – particularly in EM – in 2019. Thus, on the supply side and the demand side, the level of uncertainty in the oil markets is higher than it was at the start of 2018. Nonetheless, our base-case outlook is on the optimistic side for oil prices in 2019, with Brent crude oil averaging around $82/bbl, and WTI trading $6/bbl below that level (Chart 43). Chart 43Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Oil Prices To Rebound In 2019 Ms. X: I am skeptical that oil prices will rebound as much as you expect. First, oil demand is likely to falter if your view that global growth will continue slowing into early 2019 proves correct. Second, U.S. shale production is rising briskly, with pipeline bottlenecks finally starting to ease. Third, President Trump seems to have gone from taking credit for high equity prices to taking credit for low oil prices. Trump has taken a lot flack for supporting Saudi Arabia following the killing of The Washington Post journalist in Turkey. Would the Saudis really be willing to lose Trump’s support by cutting production at this politically sensitive time? BCA: Faltering demand growth remains a concern. However, note that in our forecasts we do expect global oil consumption growth to slow down to 1.46mm b/d next year, somewhat lower than the 1.6mm b/d growth we expect this year.  In terms of the U.S. shale sector, production levels over the short term can be somewhat insensitive to changes in spot and forward prices, given the hedging activity of producers. Over the medium to longer term, however, lower spot and forward prices will disincentivize drilling by all but the most efficient producers with the best, lowest-cost acreage. If another price collapse were to occur – and were to persist, as the earlier price collapse did – we would expect a production loss of between 5% and 10% from the U.S. shales.  Regarding KSA, the Kingdom needs close to $83/bbl to balance its budget this year and next, according to the IMF’s most recent estimates. If prices remain lower for longer, KSA’s official reserves will continue to fall, as its sovereign wealth fund continues to be tapped to fill budget gaps. President Trump’s insistence on higher production from KSA and the rest of OPEC is a non-starter – it would doom those economies to recession, and stifle further investment going forward. The U.S. would also suffer down the road, as the lack of investment significantly tightens global supply. So, net, if production cuts are not forthcoming from OPEC at its Vienna meeting we – and the market – will be downgrading our oil forecast. Ms. X: Does your optimism regarding energy extend to other commodities? The combination of a strong dollar and a China slowdown did a lot of damage to industrial commodities in 2018. Given your view that China’s economy should stabilize in 2019, are we close to a bottom in base metals? BCA: It is too soon to begin building positions in base metals because the trade war is going to get worse before it gets better. Exposure to base metals should be near benchmark at best entering 2019, although we will be looking to upgrade along with other risk assets if Chinese policy stimulus ramps up. Over the medium term, the outlook for base metals hinges on how successfully China pulls off its pivot toward consumer- and services-led growth, away from heavy industrial-led development. China accounts for roughly half of global demand for these base metals. Commodity demand from businesses providing consumer goods and services is lower than that of heavy industrial export-oriented firms. But demand for commodities used in consumer products – e.g., copper, zinc and nickel, which go into stainless-steel consumer appliances such as washers and dryers – will remain steady, and could increase if the transition away from heavy industrial-led growth is successful. Gasoline and jet fuel demand will also benefit, as EM consumers’ demand for leisure activities such as tourism increases with rising incomes. China is also going to be a large producer and consumer of electric vehicles, as it attempts to reduce its dependence on imported oil. Although timing the production ramp-up is difficult, in the long term these trends will be supportive for nickel and copper. Mr. X: You know I can’t let you get away without asking about gold. The price of bullion is down about 5% since the end of 2017, but that is no worse than the global equity market and it did provide a hedge against economic, financial or political shocks. The world seems just as risky as it did a year ago, so I am inclined to hold on to our gold positions, currently close to 10% of our portfolio. That is above your recommended level, but keeping a solid position in gold is one area where my daughter and I have close agreement regarding investment strategy. BCA: Gold did perform well during the risk asset corrections we had in 2018, and during the political crises as well. The price is not too far away from where we recommended going long gold as a portfolio hedge at the end of 2017 ($1230.3/oz). We continue to expect gold to perform well as a hedge. When other risk assets are trading lower, gold holds value relative to equities and tends to outperform bonds (Chart 44). Likewise, when other risk assets are rising, gold participates, but does not do as well as equities. It is this convexity – outperforming on the downside but participating on the upside with other risk assets – that continues to support our belief that gold has a role as a portfolio hedge. However, having 10% of your portfolio in gold is more than we would recommend – we favor an allocation of around 5%. Chart 44Hold Some Gold As A Hedge OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Geopolitics Ms. X: I’m glad that the three of us agree at least on one thing – hold some gold! Let’s return to the geopolitical situation for a moment. Last year, you correctly forecast that divergent domestic policies in the U.S. and China – stimulus in the former and lack thereof in the latter – would be the most investment-relevant geopolitical issue. At the time, I found this an odd thing to highlight, given the risks of protectionism, populism, and North Korea. Do you still think that domestic policies will dominate in 2019? BCA: Yes, policy divergence between the U.S. and China will also dominate in 2019, especially if it continues to buoy the U.S. economy at the expense of the rest of the world. Of course, Beijing may decide to do more stimulus to offset its weakening economy and the impact of the trade tariffs. A headline rate cut, cuts to bank reserve requirements, and a boost to local government infrastructure spending are all in play. In the context of faltering housing and capex figures in the U.S., the narrative over the next quarter or two could be that the policy divergence is over, that Chinese policymakers have “blinked.” We are pushing back against this narrative on a structural basis. We have already broadly outlined our view that China will not be pressing hard to boost demand growth. Many of its recent policy efforts have focused on rebalancing the economy away from debt-driven investment (Chart 45). The problem for the rest of the world is that raw materials and capital goods comprise 85% of Chinese imports. As such, efforts to boost domestic consumption will have limited impact on the rest of the world, especially as emerging markets are highly leveraged to “old China.” Chart 45Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Rebalancing Of The Chinese Economy Meanwhile, the Trump-Democrat gridlock could yield surprising results in 2019. President Trump is becoming singularly focused on winning re-election in 2020. As such, he fears the “stimulus cliff” looming over the election year. Democrats, eager to show that they are not merely the party of “the Resistance,” have already signaled that an infrastructure deal is their top priority. With fiscal conservatives in the House all but neutered by the midterm elections, a coalition between Trump and likely House Speaker Nancy Pelosi could emerge by late 2019, ushering in even more fiscal stimulus. While the net new federal spending will not be as grandiose as the headline figures, it will be something. There will also be regular spending increases in the wake of this year’s bipartisan removal of spending caps. We place solid odds that the current policy divergence narrative continues well into 2019, with bullish consequences for the U.S. dollar and bearish outcomes for EM assets, at least in the first half of the year. Mr. X: Your geopolitical team has consistently been alarmist on the U.S.-China trade war, a view that bore out throughout 2018. You already stated that you think trade tensions will persist in 2019. Where is this heading? BCA: Nowhere good. Rising geopolitical tensions in the Sino-American relationship has been our premier geopolitical risk since 2012. The Trump administration has begun tying geopolitical and strategic matters in with the trade talks. No longer is the White House merely asking for a narrowing of the trade deficit, improved intellectual property protections, and the removal of non-tariff barriers to trade. Now, everything from surface-to-air missiles in the South China Sea to Beijing’s “Belt and Road” project are on the list of U.S. demands. Trade negotiations are a “two-level game,” whereby policymakers negotiate in parallel with their foreign counterparts and domestic constituents. While Chinese economic agents may accept U.S. economic demands, it is not clear to us that its military and intelligence apparatus will accept U.S. geopolitical demands. And Xi Jinping himself is highly attuned to China’s geopolitical position, calling for national rejuvenation above all. We would therefore downplay any optimistic news from the G20 summit between Presidents Trump and Xi. President Trump could freeze tariffs at current rates and allow for a more serious negotiating round throughout 2019. But unless China is willing to kowtow to America, a fundamental deal will remain elusive in the end. For Trump, a failure to agree is still a win domestically, as the median American voter is not asking for a resolution of the trade war with China (Chart 46). Chart 46Americans Favor Being Tough On China OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Could trade tensions spill into rising military friction? BCA: Absolutely. Minor military skirmishes will likely continue and could even escalate. We believe that there is a structural bull market in “war.” Investors should position themselves by being long global defense stocks. Mr. X: That is not encouraging. What about North Korea and Iran? Could they become geopolitical risks in 2019? BCA: Our answer to the North Korea question remains the same as 12 months ago: we have seen the peak in the U.S.’ display of a “credible military threat.” But Iran could re-emerge as a risk mid-year. We argued in last year’s discussion that President Trump was more interested in playing domestic politics than actually ratcheting up tensions with Iran. However, in early 2018 we raised our alarm level, particularly when staffing decisions in the White House involved several noted Iran hawks joining the foreign policy team. This was a mistake. Our initial call was correct, as President Trump ultimately offered six-month exemptions to eight importers of Iranian crude. That said, those exemptions will expire in the spring. The White House may, at that point, ratchet up tensions with Iran. This time, we will believe it when we see it. Intensifying tensions with Iran ahead of the U.S. summer vacation season, and at a time when crude oil markets are likely to be finely balanced, seems like folly, especially with primary elections a mere 6-to-8 months away. What does President Trump want more: to win re-election or to punish Iran? We think the answer is obvious, especially given that very few voters seem to view Iran as the country’s greatest threat (Chart 47). Chart 47Americans Don’t See Iran As A Major Threat OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Ms. X: Let’s turn to Europe. You have tended to dismiss Euroskeptics as a minor threat, which has largely been correct. But don’t you think that, with Brexit upon us and Chancellor Angela Merkel in the twilight, populism in continental Europe will finally have its day? BCA: Let’s first wait to see how Brexit turns out! The next few months will be critical. Uncertainty is high, with considerable risks remaining. We do not think that Prime Minister May has the votes in the House of Commons to push through any version of soft Brexit that she has envisioned thus far. If the vote on the U.K.-EU exit deal falls through, a new election could be possible. This will require an extension of the exit process under Article 50 and a prolonged period of uncertainty. The probability of a no-deal Brexit is lower than 10%. It is simply not in the interest of anyone involved, save for a smattering of the hardest of hard Brexit adherents in the U.K. Conservative Party. Put simply, if the EU-U.K. deal falls through in the House of Commons, or even if PM May is replaced by a hard-Brexit Tory, the most likely outcome is an extension of the negotiation process. This can be easily done and we suspect that all EU member states would be in favor of such an extension given the cost to business sentiment and trade that would result from a no-deal Brexit. It is not clear that Brexit has emboldened Euroskeptics. In fact, most populist parties in the EU have chosen to tone down their Euroskepticism and emphasize their anti-immigrant agenda since the Brexit referendum. In part, this decision has to do with how messy the Brexit process has become. If the U.K. is struggling to unravel the sinews that tie it to Europe, how is any other country going to fare any better? The problem for Euroskeptic populists is that establishment parties are wise to the preferences of the European median voter. For example, we now have Friedrich Merz, a German candidate for the head of the Christian Democratic Union – essentially Merkel’s successor – who is both an ardent Europhile and a hardliner on immigration. This is not revolutionary. Merz simply read the polls correctly and realized that, with 83% of Germans supporting the euro, the rise of the anti-establishment Alternative for Germany (AfD) is more about immigration than about the EU. As such, we continue to stress that populism in Europe is overstated. In fact, we expect that Germany and France will redouble their efforts to reform European institutions in 2019. The European parliamentary elections in May will elicit much handwringing by the media due to a likely solid showing by Euroskeptics, even though the election is meaningless. Afterwards, we expect to see significant efforts to complete the banking union, reform the European Stability Mechanism, and even introduce a nascent Euro Area budget. But these reforms will not be for everyone. Euroskeptics in Central and Eastern Europe will be left on the outside looking in. Brussels may also be emboldened to take a hard line on Italy if institutional reforms convince the markets that the core Euro Area is sheltered from contagion. In other words, the fruits of integration will be reserved for those who play by the Franco-German rules. And that could, ironically, set the stage for the unraveling of the European Union as we know it. Over the long haul, a much tighter, more integrated, core could emerge centered on the Euro Area, with the rest of the EU becoming stillborn. The year 2019 will be a vital one for Europe. We are sensing an urgency in Berlin and Paris that has not existed throughout the crisis, largely due to Merkel’s own failings as a leader. We remain optimistic that the Euro Area will survive. However, there will be fireworks. Finally, a word about Japan. The coming year will see the peak of Prime Minister Shinzo Abe’s career. He is promoting the first-ever revision to Japan’s post-war constitution in order to countenance the armed forces. If he succeeds, he will have a big national security success to couple with his largely effective “Abenomics” economic agenda – after that, it will all be downhill. If he fails, he will become a lame duck. This means that political uncertainty will rise in 2019, after six years of unusual tranquility. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground and your views have reinforced my belief that 2019 could be even more turbulent for financial markets than the past has been. I accept your opinion that a major global economic downturn is not around the corner, but with valuations still stretched, I feel that it makes good sense to focus on capital preservation. I may lose out on the proverbial “blow-off” rally, but so be it – I have been in this business long enough to know that it is much better to leave the party while the music is still playing! Ms. X: I agree with my father that the risks surrounding the outlook have risen as we have entered the late stages of this business-cycle expansion. Yet, if global growth does temporarily stabilize and corporate earnings continue to expand, I fear that being out of the market will be very painful. The era of hyper-easy money may be ending, but interest rates globally are still nowhere near restrictive territory. This tells me that the final stages of this bull market could be very rewarding. A turbulent market is not only one where prices go down – they can also go up a lot! BCA: The debate you are having is one we ourselves have had on numerous occasions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term returns. While most assets have cheapened over the past year, prices are still fairly elevated. Table 4 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.9% over the next ten years, or 2.8% after adjusting for inflation. That is an improvement over our inflation-adjusted estimate of 1.3% from last year, but still well below the 6.6% real return that a balanced portfolio earned between 1982 and 2018. Table 410-Year Asset Return Projections OUTLOOK 2019: Late-Cycle Turbulence OUTLOOK 2019: Late-Cycle Turbulence Our return calculations for equities assume that profit margins decline modestly over the period and that multiples mean revert to their historical average. These assumptions may turn out to be too pessimistic if underlying changes in the economy keep corporate profits elevated as a share of GDP. Structurally lower real interest rates may also justify higher P/E multiples, although this would be largely offset by the prospect of slower economic growth, which will translate into slower earnings growth. In terms of the outlook for the coming year, a lot hinges on our view that monetary policy in the main economies stays accommodative. This seems like a safe assumption in the Euro Area and Japan, where rates are near historic lows, as well as in China, where the government is actively loosening monetary conditions. It is not such a straightforward conclusion for the U.S., where the Fed is on track to keep raising rates. If it turns out that the neutral interest rate is not far above where rates are already, we could see a broad-based slowdown of the U.S. economy that ripples through to the rest of the world. And even if U.S. monetary policy does remain accommodative, many things could still upset the apple cart, including a full-out trade war, debt crises in Italy or China, or a debilitating spike in oil prices. As the title of our outlook implies, 2019 is likely to be a year of increased turbulence. Ms. X: As always, you have left us with much to think about. My father has looked forward to these discussions every year and now that I am able to join him, I understand why. Before we conclude, it would be helpful to have a recap of your key views. BCA: That would be our pleasure. The key points are as follows: The collision between policy and markets that we discussed last year finally came to a head in October. Rather than falling as they normally do when stocks plunge, U.S. bond yields rose as investors reassessed the willingness of the Fed to pause hiking rates even in the face of softer growth. Likewise, hopes that China would move swiftly to stimulate its economy were dashed as it became increasingly clear that the authorities were placing a high emphasis on their reform agenda of deleveraging and capacity reduction. The ongoing Brexit saga and the stalemate between the populist Italian government and the EU have increased uncertainty in Europe at a time when the region was already beginning to slow. We expect the tensions between policy and markets to be an ongoing theme in 2019. With the U.S. unemployment rate at a 48-year low, it will take a significant slowdown for the Fed to stop hiking rates. Despite the deterioration in economic data over the past month, real final domestic demand is still tracking to expand by 3% in the fourth quarter, well above estimates of the sustainable pace of economic growth. Ultimately, the Fed will deliver more hikes next year than discounted in the markets. This will push up the dollar and keep the upward trend in Treasury yields intact. The dollar should peak midway next year. China will also become more aggressive in stimulating its economy, which will boost global growth. However, until both of these things happen, emerging markets will remain under pressure. For the time being, we continue to favor developed market equities over their EM peers. We also prefer defensive equity sectors such as health care and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the U.S. will outperform Europe and Japan for the next few quarters, especially in dollar terms. A stabilization in global growth could ignite a blow-off rally in global equities. If the Fed is raising rates in response to falling unemployment, this is unlikely to derail the stock market. However, once supply-side constraints begin to fully bite in early 2020 and inflation rises well above the Fed’s target of 2%, stocks will begin to buckle. This means that a window exists next year where stocks will outperform bonds. We would maintain a benchmark allocation to stocks for now, but increase exposure if global bourses were to fall significantly from current levels without a corresponding deteriorating in the economic outlook. Corporate credit will underperform stocks as government bond yields rise. A major increase in spreads is unlikely as long as the economy is still expanding, but spreads could still widen modestly given their low starting point. U.S. shale companies have been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices are unlikely to rise much from current levels over the long term. However, over the next 12 months, we expect production cuts in Saudi Arabia will push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio is likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 26, 2018 ​​​​​​

Highlights Gold's performance during the "Red October" equities sell-off, coupled with that of the most widely followed gold ratios (copper- and oil-to-gold), indicates investors and commodity traders are not pricing in a sharp contraction in global growth. These ratios are, however, picking up divergent trends in EM and DM growth (Chart of the Week). Chart of the WeekGold Ratios Lead Divergence Of Global Bond Yields Gold Ratios Lead Divergence Of Global Bond Yields Gold Ratios Lead Divergence Of Global Bond Yields In the oil markets, the Trump Administration appears to have blinked on its Iran oil-export sanctions. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days (Chart 2).1 The higher-than-expected number of waivers indicates the Trump Administration is aligned with our view that the global oil market is extremely tight, despite the recent production increases from OPEC 2.0 and the U.S.2 The U.S. State Department, in particular, apparently did not want to test the ability of OPEC spare capacity - mostly held by the Kingdom of Saudi Arabia (KSA) - to cover the combined losses of Iranian exports, Venezuela's collapse, and unplanned random production outages. No detail of volumes that will be allowed under these waivers was available as we went to press. Chart 2Waivers Will Restore Iranian Exports For 180 Days Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Energy: Overweight. Iran's exports are reportedly down ~ 1mm b/d from April's pre-sanction levels of ~ 2.5mm b/d. We assume Iran's exports will fall 1.25mm b/d. Base Metals: Neutral. Close to 45k MT of copper was delivered to LME warehouses last week, according to Metal Bulletin's Fastmarkets. This was the largest delivery into LME-approved warehouses since April 7, 1989. Precious Metals: Neutral. Gold is trading close to fair value, while the most widely followed gold ratios - copper- and oil-to-gold - indicate global demand is holding up. Ags/Softs: Underweight. The USDA's crop report shows the corn harvest accelerated at the start of November, reaching 76% vs. 68% a year ago. Feature Gold Ratios Suggest Continued Growth Gold is trading mostly in line with our fair-value model, based on estimates using the broad trade-weighted USD and U.S. real rates (Chart 3).3 Safe-haven demand - e.g., buying prompted by the fear of a global slowdown or a deepening of the global equity rout dubbed "Red October" in the press - does not appear to be driving gold's price away from fair value. Neither is rising volatility in the equity markets. Chart 3Gold Trading Close To Fair Value Gold Trading Close To Fair Value Gold Trading Close To Fair Value This assessment also is supported by the behavior of the widely followed gold ratios - copper-to-gold and oil-to-gold - which have become useful leading indicators of global bond yields and DM equity levels following the Global Financial Crisis (GFC). From 1995 up to the GFC, the gold ratios tracked changes in the nominal yields of 10-year U.S. Treasury bonds fairly closely. During this period, bond yields led the ratios as they expanded and contracted with global growth, as seen in Chart 4. Post-GFC, this relationship has reversed, and the gold ratios now lead global bond yields. Chart 4Gold Ratios Followed Global 10-Year Yields Pre-GFC Gold Ratios Followed Global 10-Year Yields Pre-GFC Gold Ratios Followed Global 10-Year Yields Pre-GFC To understand this better, we construct two variables to isolate the common growth-related and idiosyncratic factors driving these ratios over the long term, particularly following the GFC.4 The common factor is labeled growth vs. safe-haven in the accompanying charts. It consistently tracks changes in global bond yields and DM equities, which also follow global GDP growth closely. If investors were fleeing economically sensitive assets and buying the safe haven of gold, the correlation between these variables would fall. As it happens, the strong correlation held up well following the "Red October" equities rout, indicating investors have not become overly risk-averse or fearful global growth is taking a downturn. When regressing our proxy for global 10-year yields and the U.S. 10-year yields on the growth vs. safe-haven factor, we found this factor explains a significantly larger part of the variation in global yields than U.S. bond yields alone (Chart 5).5 This common factor also is highly correlated with DM equity variability (Chart 6). Chart 5Gold Ratios' Common Factor Correlates With 10-Year Global Yields ... Gold Ratios" Common Factor Correlates With 10-Year Global Yields... Gold Ratios" Common Factor Correlates With 10-Year Global Yields... Chart 6... And DM Equities ... And DM Equities ... And DM Equities The second, or idiosyncratic, factor we constructed, captures the fundamental drivers that impact each of the gold ratios through supply-demand fundamentals in the copper and oil markets, and EM vs. DM economic performance. The latter is proxied using EM equity returns relative to DM returns.6 This analysis shows oil outperforms copper in periods of rising DM and slowing EM economic growth (Chart 7). Our analysis also indicates this idiosyncratic factor explains the divergence of the gold ratios seen in 2018: Copper demand is heavily influenced by EM demand, particularly China, which accounts for ~ 50% of global copper demand, but less than 15% of global oil demand. Oil demand - some 100mm b/d - is much more affected by the evolution of global GDP. Chart 7Relative DM Outperformance Drives Idiosyncratic Factors Relative DM Outperformance Drives Idiosyncratic Factors Relative DM Outperformance Drives Idiosyncratic Factors At the moment, this idiosyncratic factor is driving both ratios apart because of: Relative economic underperformance of EM vs. DM, which favors oil over copper; and Persistent fears of escalating Sino-U.S. trade tensions, which are weighing on copper. Price-supportive supply-shocks in the oil market (sanctions on Iranian oil exports, falling Venezuelan production) and still-strong demand continue to drive oil prices. These dynamics likely will remain in place for the foreseeable future (1H19), which will favor oil over copper. Gold Ratios As Leading Indicators To round out our analysis, we looked at causal relationships between the performance of financial assets - EM and DM stocks and bonds - and the gold ratios.7 From 1995 to 2008, the causality ran from stocks and bond yields to our growth vs. safe-haven factor for the gold ratios. However, since 2009, causality has gone from the common factor to bond yields (Table 1). Table 1Granger-Causality Results Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market In our view, this suggests that the widely traded industrial commodities - copper and oil being the premier examples of such commodities - convey important economic information on the state of the global economy, as a result of their respective price-formation processes.8 It also suggests that in the post-GFC world, commodity markets assumed a larger role in discounting the impacts on the real economy of the numerous monetary experiments of central banks in the post-GFC era. Bottom Line: Our analysis of the factors driving the copper- and oil-to-gold ratios supports our view that demand for cyclical commodities - mainly oil and metals - is still strong. The behavior of our idiosyncratic factor leads us to favor oil over copper due to the rising EM vs. DM divergence, and the price-supportive supply dynamics in the oil market.   Waivers On U.S. Sanctions Roil Oil Markets A week ago, we cautioned clients to "expect more volatility" on the back of news leaks the Trump administration was considering granting waivers to importers of Iranian crude oil, just before the sanctions kicked in this week. We certainly got it. Since hitting $86.1/bbl in early October, Brent crude oil prices have fallen $15.4/bbl (18%), as markets attempt to price in how much Iranian oil is covered by the sanctions and when importers can expect to see it arrive. On Monday, the U.S. granted waivers to eight "jurisdictions" - China, India, Japan, South Korea, Turkey, Italy, Greece and Taiwan - allowing them to continue to import Iranian oil for 180 days. This was a higher-than-expected number of waivers than we - and, given the volatility in prices - the market was expecting. This pushed down the elevated risk premium, which had been supporting prices over the past few months.9 The combined imports of these eight states is ~1.4mm b/d, according to Bloomberg estimates. The loss of these volumes in a market that was progressively tightening as OPEC 2.0 brought more of its spare capacity on line - while the USD continued to strengthen - likely would have driven the local-currency cost of fuel steadily higher (Chart 8). Because they are a de facto supply increase - albeit temporary, based on Trump Administration statements - they also will restrain price hikes in EM generally, barring an unplanned outage in 1H19 (Chart 9). Chart 8Waivers Will Contain Oil Price Rises In Local-Currency Terms Waivers Will Contain Oil Price Rises In Local-Currency Terms Waivers Will Contain Oil Price Rises In Local-Currency Terms \ Chart 9Oil Prices Rises In EM Economies Oil Prices Rises In EM Economies Oil Prices Rises In EM Economies No detail of volumes that will be allowed under these waivers was available as we went to press. Although it is obvious Iranian sales will recover some of the ~ 1mm b/d of exports lost in the run-up to the re-imposition of sanctions, it is not clear how much will be recovered. We believe the 180-day effective period for the waivers most likely was sought by KSA and Russia to give them time to bring on additional capacity to cover Iranian export losses. Markets will find out just how much spare capacity these states have in 1H19. By 2H19, additional production out of the U.S. from the Permian Basin will hit the market, as transportation bottlenecks are alleviated. This will allow U.S. exports to increase as well. However, it's not clear how much of this can get to export markets, given most of the dredging work needed to accommodate very large crude carriers (VLCCs) in the U.S. Gulf Coast has yet to be done. This could explain why the WTI - Cushing vs. WTI - Midland differentials are narrowing, while WTI spreads vs. Brent remain wide (Chart 10). Chart 10WTI Spreads Diverge WTI Spreads Diverge WTI Spreads Diverge It is important to note the market still is exposed to greater-than-expected declines in Venezuela's production, and to any unplanned outage anywhere in the world. OPEC spare capacity is 1.3mm b/d, according to the EIA and IEA, and most of that is in KSA. Russia probably has another 200k b/d or so it can bring on line. These production increases both are undertaking are cutting deeply into spare capacity, as the Paris-based International Energy Agency noted in its October 2018 Oil Market Report: Looking ahead, more supply might be forthcoming. Saudi Arabia has stated it already raised output to 10.7 mb/d in October, although at the cost of reducing spare capacity to 1.3 mb/d. Russia has also signaled it could increase production further if the market needs more oil. Their anticipated response, along with continued growth from the US, might be enough to meet demand in the fourth quarter. However, spare capacity would fall to extremely low levels as a percentage of global demand, leaving the oil market vulnerable to major disruptions elsewhere (p. 17). Bottom Line: We expected continued crude-oil price volatility, as markets sort out the U.S. waivers on Iranian oil imports. The supply side of the market remains tight, and spare capacity is being eroded by production increases. We believe OPEC 2.0 will use the 180 days contained in the waivers to mobilize additional production. How much of this becomes available is yet to be determined. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com 1 Please see "As U.S. starts oil sanctions against Iran, major buyers get waivers," published by reuters.com November 5, 2018. 2 OPEC 2.0 is a name we coined for the producer coalition led by KSA and Russia. Please see "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity" for our most recent supply-demand balances and price assessments, published October 25 by Commodity & Energy Strategy, and is available at ces.bcaresearch.com. 3 We use the USD broad trade-weighted index (TWIB) and U.S. inflation-adjusted real rates as explanatory variables in these models. As Chart 3 indicates, actual gold prices are in line with these variables. 4 The first factor accounts for ~ 80% of the variation in the gold ratios. The second idiosyncratic factor, which captures (1) supply-demand fundamentals in the oil and copper markets, and (2) divergences in global growth using EM vs. DM equities as proxies, accounts for the remaining ~ 20% of the variation. 5 Throughout this report, we proxy global yield by summing the yield on the 10-year German Bunds, Japanese Government Bonds and U.S. Treasurys. Please see BCA Research European Investment Strategy Weekly Report titled "The 'Rule Of 4' For Equities And Bonds," dated August 2, 2018. Available at eis.bcaresearch.com. The adjusted R2 in the global yield model is 0.94 compared to 0.88 for the U.S. Treasury model. 6 Using MSCI Emerging Market Index and MSCI Word Index price index. 7 To conduct this analysis, we use a statistical technique developed by the 2003 Nobel laureate, Clive Granger. The eponymous Granger-causality test is used to see whether one variable (i.e., time series) can be said to precede the other in terms of occurrence in time. This test measures information in the variables, particularly the effect of information from the preceding variable on the following variable. Please see Granger, C.W.J. (1980). "Testing for Causality, Personal Viewpoint,"Journal of Economic Dynamics and Control, 2 (pp. 329 - 352). 8 This assessment is consistent with the Efficient Market Hypothesis, the literature on which is countably infinite at this point. Sewell notes: "A market is said to be efficient with respect to an information set if the price 'fully reflects' that information set (Fama, 1970), i.e. if the price would be unaffected by revealing the information set to all market participants (Malkiel, 1992). The efficient market hypothesis (EMH) asserts that financial markets are efficient." The EMH has been debated and tested for decades. Please see Sewell, Martin (2011). "History of the Efficient Market Hypothesis," Research Note RN/11/04, published by University College London (UCL) Department of Computer Science. 9 Please see BCA Research Commodity & Energy Strategy Weekly Report "Risk Premium In Oil Prices Rising; KSA Lifts West Coast Export Capacity," published October 25, 2018. It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Trades Closed in 2018 Summary of Trades Closed in 2017 Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market Gold Ratios Wave Off "Red October" ... Iran Export Waivers Highlight Tight Market

Highlights Five risks to our bullish dollar stance need to be monitored: further weakness in the S&P 500; rebounding gold prices; stabilizing EM exchange rates and bond prices; Spanish bank stocks at multi-decade lows; and large, long-exposure by speculators to the greenback. However, China's lackluster response to stimulus and the U.S.'s domestic strength still favor the dollar. In fact, the key force likely to cause U.S. growth to converge toward weaker global growth will be a stronger U.S. dollar. Feature BCA has a positive bias toward the dollar for the coming six to nine months. Admittedly, the dollar is expensive, but cyclical determinants still favor a rally. The Federal Reserve is hiking rates as the U.S. economy is at full capacity and goosed up by fiscal injections. Yet global growth is very wobbly. This combination is a potent cocktail for USD strength. Despite these key sources of support, we cannot be dogmatic, especially as financial markets are anticipatory mechanisms, and therefore the dollar could have already priced in some of these developments. As such, this week we explore the key risks to our dollar view. While serious threats for the dollar exist over the upcoming two to three quarters, the key macro and financial drivers remain dollar bullish. The Threats 1) The S&P Sells Off Further The MSCI EAFE index, expressed in USD terms, is down nearly 20% since its January 2018 highs. Meanwhile, the S&P 500 has fallen 9% since its recent all-time high, or 7% vis-Ã -vis where it stood in late January. The risk is that as the global economic slowdown deepens, investors end up selling their good assets along with their bad ones. This means the S&P 500 could fall more. In fact, our colleague Peter Berezin writes in BCA's Global Investment Strategy that U.S. equities could fall an additional 6% from current levels before finding a durable support.1 The problem for the dollar is not whether stock prices fall. It is about what it means for the Fed. Until earlier this week, equity weakness had no impact at all on bonds. However, now, weak stock prices are dragging down U.S. bond yields. Moreover, while the U.S. yield curve slope steepened between August 24 and October 5, it is flattening anew (Chart I-1). All these market moves suggest investors are beginning to price out anticipated interest rate hikes. If U.S. stocks were to fall further, these dynamics would most likely deepen. However, since there is little monetary tightening to price out of the European or Japanese interest rate curves, such a move would likely lead to a dollar-bearish narrowing of interest rate differentials. Chart I-1It Took A Stock Market Rout For Investors To Reconsider The Fed's Path It Took A Stock Market Rout For Investors To Reconsider The Fed's Path It Took A Stock Market Rout For Investors To Reconsider The Fed's Path 2) Gold Is Rebounding Keynes might have called gold a barbarous relic of a bygone era, but as an extremely long-duration asset with no cash flow, the yellow metal remains an important gauge of global monetary and liquidity conditions. As the stock of dollar foreign-currency debt is large, a strong dollar is synonymous with tightening global liquidity conditions. Unsurprisingly, since 2017, gold and the dollar have been tightly negatively correlated (Chart I-2). However, since October, this correlation has been breaking down. Both the dollar and gold are moving up. This suggests that the recent increase in U.S. interest rates and in the dollar might not be as deleterious for the world as markets are currently anticipating. Chart I-2Is Gold Not Hating A Strong Dollar Anymore? Is Gold Not Hating A Strong Dollar Anymore? Is Gold Not Hating A Strong Dollar Anymore? Moreover, gold prices often lead EM asset prices. Since gold prices are highly sensitive to global liquidity, this makes sense. When the yellow metal sniffs out whiffs of reflation, it is only a matter of time before EM assets do as well. Since a rally in EM assets would lead to an easing in EM financial conditions, this easing would improve the global growth outlook (Chart I-3). Hence, rising gold prices might be a sign that while investors are increasingly negative on global industrial activity, the light at the end of the tunnel could be around the corner. The dollar would suffer if the outlook for global growth were to improve. Chart I-3EM Financial Conditions Hold The Key To Global Growth EM Financial Conditions Hold The Key To Global Growth EM Financial Conditions Hold The Key To Global Growth 3) EM Currencies And EM High-Yield Bonds Stabilizing Something strange is happening. While EM equity prices are still falling, EM high-yield bonds and currencies are not. In fact, EM FX and EM debt prices bottomed at the beginning of September, despite rising U.S. interest rates. However, since then, EM stock prices denominated in USD terms have fallen nearly 10% (Chart I-4). EM exchange rates and yields are the most important determinants of EM financial conditions. This suggests that despite EM stock prices falling fast, EM financial conditions may not be deteriorating as quickly as assumed. Chart I-4Are EM Financial Conditions Easing? Are EM Financial Conditions Easing? Are EM Financial Conditions Easing? This market action is in fact consistent with the development we highlighted in the gold market. We must therefore maintain a watchful eye on EM bonds and EM FX. Further meaningful improvement in these assets, while not BCA's base-case, would dangerously challenge our view that global industrial activity slows further, undermining our dollar-bullish view. 4) Spanish Banks Near Post-2008 Lows As we highlighted in August, Spanish banks are the most exposed major banks in the world to EM woes (Chart I-5).2 The exposure of the Spanish banking sector to the weakest EM economies represents 170% of capital and reserves, which is driving the entire euro area's exposure to these markets to 32% of Eurozone banks' capital and reserves. Chart I-5Who Has More Exposure To EM? Risks To The Dollar View Risks To The Dollar View The weakening in EM expected growth and the fall in EM currencies is a risk for Spanish banks. However, Spanish banks also maintain a large chunk of their EM exposure in wholly or partly owned subsidiaries. This means that while an EM crisis will definitely have an important impact on Spanish bank earnings, the impact on the balance sheet of Spanish banks is likely to be more limited. However, Spanish banks now trade in line with the levels that prevailed in Q1 2009, Q3 2012 and Q1 2016 (Chart I-6). In other words, Spanish banks are already pricing in a crisis, especially after the Spanish Supreme Court ruled that banks - not customers - must pay mortgage duties. Chart I-6Spanish Banks Are Discounting Plenty Of Bad News Spanish Banks Are Discounting Plenty Of Bad News Spanish Banks Are Discounting Plenty Of Bad News While markets may not be the most efficient mechanism when it comes to pricing future shocks, markets are very efficient at lateral pricing - i.e. the pricing of an event in one market, even if wrong, will be equally reflected in other markets. If the impact of an EM crisis is fully priced into Spanish banks, the impact of such a crisis is likely to also be reflected in the expectations of what the European Central Bank will do over the coming quarters, and thus it is also priced into the euro. The pessimism already present in Spanish banks and euro area financial equities may explain why the euro has not cracked below its August 17 lows, while global stock prices have. The bad news could simply already be baked into the cake! If Spanish bank stocks rebound, the dollar is likely to suffer; if they break down, the dollar will likely rally more. 5) Speculators Are Already Long The Dollar For the dollar to rise further, someone needs to buy it. The problem is that speculators have already been buying the greenback, and they are now aggressively long the dollar (Chart I-7). This means that it may become more difficult to find new buyers for U.S. dollars, especially as investors may be in the process of unloading their U.S. equities. To be fair, while it is true that the net speculative positions are elevated, they also can remain so for extended periods. Chart I-7Investors Are Long The Dollar Investors Are Long The Dollar Investors Are Long The Dollar Bottom Line: There are important risks to our dollar-bullish view that we need to closely monitor. They are: the global stock selloff migrating to the U.S., which could prompt investors to price out Fed rate hikes; gold rebounding, which might indicate marginal improvement in global liquidity conditions; EM exchange rates and high-yield bonds not weakening anymore, which could result in an easing in financial conditions, ending the deterioration in global growth; Spanish banks potentially already pricing in a dire outcome in EM; and speculators being already long the dollar. Despite these Risks, Why Do We Still Like The Dollar? The first reason relates to global growth. Ultimately, the dollar is a counter-cyclical currency. When global growth weakens, the dollar strengthens. China continues to generate potent headwinds for the world economy. Beijing has been stimulating the Chinese economy, but this stimulus is having a muted impact. As Arthur Budaghyan writes in the week's Emerging Market Strategy report, China's monetary stimulus is falling flat.3 Not only are excess reserves in the banking sector rather meager, Chinese banks are not showing a deep propensity to lend. It is not just about the behavior of Chinese banks: Chinese firms are also not displaying a high propensity to spend and borrow, which is weighing on the velocity of money in China (Chart I-8). As a result, this means that liquidity injections are not generating much impact in terms of loan growth and economic activity. Chart I-8Chinese Stimulus Is Falling Flat Because Economic Agents Are Cautious bca.fes_wr_2018_10_26_s1_c8 bca.fes_wr_2018_10_26_s1_c8 This is evident when looking at two variables. China's Li-Keqiang Index, our preferred measure of Chinese industrial activity, has stopped rebounding. In fact, it is currently weakening anew, which suggests that Chinese growth, despite all the supposed easing in monetary conditions, is not responding (Chart I-9, top panel). Moreover, Chinese infrastructure spending is also contracting at its fastest pace in 14 years (Chart I-9, bottom panel). Further, the slowing in Chinese real estate sales suggests that construction will not come to the rescue, especially as vacancy rates in Chinese major cities currently stand at elevated levels. Chart I-9Chinese Growth Outlook Is Deteriorating Anew Chinese Growth Outlook Is Deteriorating Anew Chinese Growth Outlook Is Deteriorating Anew We continue to monitor our China Play index (Chart I-10) to see if China is showing any underlying improvement, but the rally evident from June to October is now dissipating. The impact of stimulus thus looks like it is leaving investors wanting for more. Yet, as Matt Gertken and Roukaya Ibrahim argue in this week's Geopolitical Strategy service, additional stimulus will be limited as Xi Jinping is not yet abandoning his three battles against indebtedness, pollution and poverty.4 Hence, we expect China to remain a significant drag on global growth over the coming two to three quarters. Chart I-10China-Related Plays Are Losing Momentum China-Related Plays Are Losing Momentum China-Related Plays Are Losing Momentum The second issue that supports our bullish-dollar stance is the mechanism required for U.S. and global growth to converge. As Ryan Swift argues in BCA's U.S. Bond Strategy service, U.S. growth will not be able to avoid the gravitational pull of a weaker global economy.5 The type of divergence currently on display between the global and U.S. Leading Economic Indicators (LEIs) is generally followed by a deteriorating U.S. growth outlook (Chart I-11). Chart I-11U.S. Growth Ultimately Converges With The Rest Of The World U.S. Growth Ultimately Converges With The Rest Of The World U.S. Growth Ultimately Converges With The Rest Of The World However, this weakening in U.S. growth won't happen out of nowhere. Either there will be domestic vulnerabilities that prompt the U.S. to become more sensitive to foreign shocks, or the dollar will force this adjustment. Today, unlike in 2015 and 2016, the sales-to-inventory ratio does not point to any imminent decline in U.S. industrial activity; to the contrary, it suggests further improvements in the coming months (Chart I-12). This leaves the dollar as the main culprit to put the brakes on U.S. growth. Chart I-12U.S. Domestic Fundamentals Are Fine U.S. Domestic Fundamentals Are Fine U.S. Domestic Fundamentals Are Fine Since 2009, the greenback has been very responsive to the relative growth outlook between the U.S. and the rest of the world. The accumulated gap between the U.S. and global LEIs shows the total impact of growth divergences. This indicator has done a good job at foretelling how the dollar will trade (Chart I-13). The dollar tends to respond to U.S. growth outperformance. Only once the dollar has rallied enough to meaningfully tighten U.S. financial conditions does the U.S. growth outlook deteriorate vis-Ã -vis the rest of the world. Currently, this chart suggests we are nowhere near having reached a chokepoint for U.S. growth. Chart I-13A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World A Higher Dollar Needed For U.S. Growth To Resist The Gravitational Pull From The Rest Of The World Since the Fed remains quite unconcerned by the weakness in global growth and global stock prices, we expect that world financial markets will have to plunge deeper, the dollar to rally higher and U.S. financial conditions to tighten further before the FOMC shows enough concern to hurt the dollar. We are not there yet. Bottom Line: The absence of a meaningful response by the Chinese economy to stimulus suggests that China may have hit a debt wall. This implies that Chinese growth remains fragile and therefore a drag on global growth. Hence, international economic activity and trade will continue to provide an important tailwind for the U.S. dollar. Meanwhile, the U.S. economy is not displaying enough domestic vulnerabilities to be overly sensitive to the softness in global growth. Instead, more rounds of dollar strength will be required to force U.S. growth to converge lower toward global economic activity. As such, these two forces remain powerful enough to overweight currency exposure to the USD within global portfolios. That said, the five risks described in the previous section must be kept in mind. At the current juncture, they only warrant buying a few hedges, such as our long NZD/USD recommendation, but they do not warrant underweighting the greenback. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com 1 Please see Global Investment Strategy Special Report, "Chinese Stimulus: Not so Stimulating", dated October 26, 2018, available at gis.bcaresearch.com 2 Please see Foreign Exchange Strategy Special Report, "The Bear And The Two Travelers", dated August 17, 2018, available at fes.bcaresearch.com 3 Please see Emerging Markets Strategy Weekly Report, "China: Stimulus, Deleveraging And Growth", dated October 25, 2018, available at ems.bcaresearch.com 4 Please see Geopolitical Strategy Special Report, "China Sticks To The "Three Battles", dated October 24, 2018, available at gps.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, "Waiting For Peak Divergence", dated October 23, 2018, available at usbs.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. has been mixed: Markit Services PMI outperformed expectations, coming in at 54.7. This measure also increased from the previous month's reading of 53.5. However, durable good ex-defense month-on-month growth underperformed expectations, coming in at -0.6%. Finally, monthly new homes sales underperformed expectations, coming in at an annualized pace of 553 thousand. DXY has appreciated by 0.8% this week. We are bullish on the U.S. dollar on a cyclical basis. Furthermore, momentum, one of the strongest predictive factors for the dollar continues to be positive. Finally, global growth should continue to slowdown, as the monetary tightening by Chinese authorities starts to weigh on the global industrial cycle. Report Links: In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 The Dollar And Risk Assets Are Beholden To China's Stimulus - August 3, 2018 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 has been negative: Markit Manufacturing PMI surprised to the downside, coming in at 52.1. Moreover, Markit Services PMI also underperformed expectations, coming in at 53.3. Finally, private loan yearly growth surprised negatively, coming in at 3.1%. EUR/USD has fallen by 0.8% this week. We are bearish on the euro on a cyclical basis, as inflationary pressures continue to be too weak in the euro area for the ECB to start raising rates. Moreover, the fact that the euro area's economy is highly dependent on exports, makes it very sensitive to global growth and emerging markets. This means that the tightening by Chinese authorities should impact the euro area economy negatively, and consequently, put downward pressure on EUR/USD. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 Time To Pause And Breathe - July 6, 2018 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 has been mixed: The leading economic Index outperformed expectations, coming in at 104.5. However, the coincident index surprised to the downside, coming in at 116.7. USD/JPY has been flat this week. We are neutral on the yen on a tactical basis, given that the current risk-off environment should continue to help safe havens like the yen. However, we are bearish on the yen on a cyclical basis, as inflation expectations are not well anchored in Japan. This means that the BoJ will continue to conduct ultra-dovish monetary policy for the foreseeable future, putting a cap on how high the yen can rise. Report Links: Will Rising Wages Cause An Imminent Change In Policy Direction In Europe And Japan? - October 5, 2018 Rhetoric Is Not Always Policy - July 27, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 GBP/USD has decreased by 1.5% this week. Given the lack of a geopolitical risk premium embedded into the pound, we expect GBP volatility to remain elevated. This means that any hiccups in Brexit negotiations could bring about some downside for the pound. Furthermore, inflation should remain contained, even amid a tight labour market. This is mainly because inflation dynamics in the U.K. are much more driven by the external sector, as imports represent a very large portion of British final demand. Given that the pound has remained stable this year, inflation will remain subdued. We are currently short GBP/NZD in our portfolio, to take advantage of the dynamics mentioned above. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 AUD/USD has been flat this week. We are most bearish on this currency within the G10, given that the AUD is highly sensitive to the Chinese industrial cycle, which will continue to slow down, as Chinese authorities keep cleaning credit excesses in the economy. Moreover, policy tightening by the Fed will provide a further headwind to cyclical plays like the AUD. We are short AUD/CAD within our portfolio, as we believe that the oil currencies should fare better than other commodity currencies, given that OPEC supply cuts, as long as Iranian sanction in oil will keep upward pressure on oil prices. Report Links: Policy Divergences Are Still The Name Of The Game - August 14, 2018 What Is Good For China Doesn't Always Help The World - June 29, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 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 NZD/USD has been flat this week. We are positive on the New Zealand dollar, particularly against the GBP, as there is very little room for kiwi rate expectations to fall. Moreover, this currency should also outperform the Australian dollar, given that New Zealand is less exposed to the Chinese industrial cycle than Australia. Nevertheless, we remain bearish on the NZD on a long-term basis, given that the new government proposals to reduce immigration and add an unemployment mandate to the RBNZ will lower the neutral rate in New Zealand, which will limit the central bank's ability to tighten monetary policy. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 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 has been negative: Core inflation underperformed expectations, coming in at 1.5%. This measure also decreased form 1.7% last month. Headline inflation also surprised to the downside, coming in at 2.2%. This measure decreased significantly, coming down from 2.8% the previous month. The Bank of Canada increased rates to tk% on Wednesday, and highlighted the potential for additional rate hikes over the coming 12 months. USD/CAD has been mostly flat this week. The upside in the CAD versus the USD is likely to be limited as the policy tightening by the BoC now seems well anticipated by market participants. To take advantage of this reality, we went short CAD/NOK in our portfolio. This cross also serves as a hedge to our long dollar view, given its positive correlation to the DXY. Despite some headwinds, the CAD should outperform the AUD, as we expect that oil will do better than base metals within the commodity complex. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Inflation Is In The Price - June 15, 2018 Swiss Franc Chart II-15CHF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 EUR/CHF has fallen by 0.5% this week, as investors have grown worried with the recent sell off in equities. We are bearish on the franc on a cyclical basis, given that inflation in Switzerland is still too weak for the SNB to move away from their ultra-dovish monetary policy. Moreover, Helvetic real estate prices should continue to fall, as the restrictions on immigration put forth by the Swiss government since 2014 should continue to weigh on housing demand. This will further hamper the ability of the SNB to tighten its extraodinarly accommodative monetary policy. That being said, EUR/CHF could continue to fall in the near term, as money flows into safe heaven assets amid the current sell off in equities. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 USD/NOK has risen by 0.9% this week. As expected, yesterday the Norges Bank left rates unchanged at 0.75%. In its report, the Norwegian central bank highlighted that although economic growth has been a little lower than anticipated, inflation has been somewhat higher than expectations. We are bullish on the krona against the Canadian dollar, given that rate hike expectation in Canada are much more fully priced in than in Norway even though the inflationary backdrop is very similar. Moreover, we are positive on the krone relatively to other commodity currencies like the AUD or the NZD, as we expect oil to outperform other commodities thanks to supply cuts by OPEC and sanctions against Iran. Report Links: Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 USD/SEK has rallied by 1% this week. We are positive on USD/SEK on a short-term basis, given that the SEK is the currency which is most negatively affected by the strength of the U.S. dollar. Furthermore, tightening by Chinese authorities should also weigh on the krona, given that the Swedish economy is very levered to the global industrial cycle, as many of its exports are intermediate goods that are then re-exported to emerging markets. That being said, we are bullish on the krona on a longer-term basis, as the Riksbank is on the verge of beginning a tightening cycle as imbalances in the Swedish economy are only growing more dangerous. Report Links: Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Value Strategies In FX Markets: Putting PPP To The Test - May 11, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Macro outlook: Global growth will continue to decelerate into early next year on the back of brewing EM stresses and an underwhelming policy response from China. Equities: Stay neutral for now, while underweighting EM relative to DM stocks. Within DM, overweight the U.S. in dollar terms. Bonds: Global bond yields may dip in the near term, but the longer-term path is firmly higher. Currencies: The dollar is working off overbought conditions, but will rebound into year-end. EM currencies will suffer the most. Commodities: Favor oil over industrial metals. Precious metals will also remain under pressure until the dollar peaks next year, before beginning a major bull run as inflation accelerates. Feature I. Economic Outlook The Fed Can Hike A Lot More If 2017 was the year of a synchronized global growth recovery, 2018 is turning out to be a year where desynchronization is once again the name of the game. The U.S. economy continues to fire on all cylinders, while much of the rest of the world is struggling to stay afloat. The divergence in economic outcomes has been mirrored in central bank policy. The Fed is now hiking rates once per quarter whereas most other major central banks are still sitting on their hands. How high can U.S. rates go? The answer is a lot higher than investors anticipate. Market participants currently expect the Fed funds rate to rise to 2.37% by the end of this year and 2.84% by the end of 2019. No rate hikes are priced in for 2020 and beyond. The Fed dots are somewhat higher than market expectations (Chart 1). The median dot rises to about 3.4% in 2020-21, but then falls back to 3% over the Fed's longer-run horizon. Both investors and the Fed have apparently bought into Larry Summers' secular stagnation thesis. They seem convinced that rates will not be able to rise above 3% without triggering a recession. While we have a lot of sympathy for Summers' thesis, it must be acknowledged that it is a theory about the long-term determinants of the neutral rate of interest. Over a shorter-term cyclical horizon, many factors can influence the neutral rate. Critically, as discussed last week, most of these factors are pushing it higher: Fiscal policy is extremely stimulative. The IMF estimates that the U.S. cyclically-adjusted budget deficit will reach 6.8% of GDP in 2019. In contrast, the euro area is projected to run a deficit of only 0.8% of GDP (Chart 2). The relatively more expansionary nature of U.S. fiscal policy is one key reason why the Fed can raise rates while the ECB cannot. Chart 1Markets Expect No Fed ##br##Hikes Beyond Next Year 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Chart 2Fiscal Policy Is More Expansionary ##br##In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Fiscal Policy Is More Expansionary In The U.S. Than In The Euro Area Credit growth has picked up. After a prolonged deleveraging cycle, private-sector nonfinancial debt is increasing faster than GDP (Chart 3). The recent easing in The Conference Board's Leading Credit Index suggests that this trend will continue (Chart 4). Chart 3U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend U.S. Private-Sector Nonfinancial Debt Is Rising At Close To Its Historic Trend Chart 4U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong U.S. Credit Growth Will Remain Strong Wage growth is accelerating. Average hourly earnings surprised on the upside in August, with the year-over-year change rising to a cycle high of 2.9%. This followed a stronger reading in the Employment Cost Index in the second quarter. A simple correlation with the quits rate suggests that there is plenty of upside for wage growth (Chart 5). Faster wage growth will put more money into workers' pockets who will then spend it. The savings rate has scope to fall. The personal savings rate currently stands at 6.7%, more than two percentage points higher than what one would expect based on the current level of household net worth (Chart 6). If the savings rate were to fall by two points over the next two years, it would add 1.5% of GDP to aggregate demand. Chart 5The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth The Quits Rate Is Signaling Upside For Wage Growth Chart 6The Personal Savings Rate Has Room To Fall 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back A back-of-the-envelope calculation suggests that these cyclical factors will permit the Fed to raise rates to 5% by 2020, almost double what the market is discounting.1 An Absence Of Major Financial Imbalances Will Allow The Fed To Keep Raising Rates The past three recessions were all caused by financial market overheating rather than economic overheating. The 1991 recession was mainly the consequence of the Savings and Loan crisis, compounded by the spike in oil prices leading up to the Gulf War. The 2001 recession stemmed from the dotcom bust. The Great Recession was triggered by the housing bust. Today, it is difficult to point to any clear imbalances in the economy. True, housing activity has been weak for much of the year. However, unlike in 2006, the home vacancy rate stands near record-low levels (Chart 7). Tight supply will limit downside risks to both construction and home prices. On the demand side, low unemployment, high consumer confidence, and a rebound in the rate of new household formation should help the sector. Despite elevated home prices in some markets, the average monthly payment that homeowners must make to service their mortgage is quite low by historic standards (Chart 8). The quality of mortgage lending has also been very high over the past decade, which reduces the risk of a sudden credit crunch (Chart 9). Chart 7Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Low Housing Inventories Will Support Home Prices And Construction Chart 8Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Housing Affordabiity Is Not Yet Stretched Chart 9Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Mortgage Lenders Are Being Prudent Unlike housing debt, there are more reasons to be concerned about corporate debt. The ratio of corporate debt-to-GDP has risen to record-high levels. So-called "covenant-lite" loans now make up the bulk of corporate leveraged loan issuance. While there is no doubt that the corporate debt market is the weakest link in the U.S. financial sector, some perspective is in order. U.S. corporate debt levels are quite low by global standards. Corporate debt in the euro area is more than 30 points higher as a percent of GDP than in the United States (Chart 10). Moreover, the interest coverage ratio - EBIT divided by interest expense - for U.S. corporates is still above its historic average (Chart 11). While this ratio will fall as interest rates rise, this will not happen very quickly. Most U.S. corporate debt is at fixed rates and average maturities have been rising. This reduces both rollover risk and the sensitivity of debt-servicing costs to higher short-term rates. An increasing share of U.S. corporate debt is held by non-leveraged investors. Bank loans account for only 18% of nonfinancial corporate sector debt, down from 40% in 1980 (Chart 12). This is important, because what makes a spike in corporate defaults so damaging is not the direct impact this has on the economy, but the second-round effects rising defaults have on financial sector stability. Chart 10U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards U.S. Corporate Debt Not That High By Global Standards Chart 11Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Interest Coverage Ratio Is Above Its Historic Average Chart 12Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector Banks Have Been Reducing Their Exposure To The Corporate Sector In any case, we already had a dress rehearsal for what a corporate debt scare might look like. Credit spreads spiked in 2015. Default rates rose, but the knock-on effects to the financial system were minimal. This suggests that corporate America could handle a fair bit of monetary tightening without buckling under the pressure. The Fed And The Dollar If the Fed is able to raise rates substantially more than the market is discounting while most central banks cannot, the short-term interest rate spread between the U.S. and its trading partners is likely to widen. History suggests that this will produce a stronger dollar (Chart 13). Chart 13Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Historically, The Dollar Has Moved In Line With Interest Rate Differentials Some have speculated that the Trump administration will intervene in the foreign-exchange market in order to drive down the value of the greenback. We doubt this will happen, but even if such interventions were to occur, they would not be successful. Presumably, currency interventions would take the form of purchases of foreign exchange, financed through the issuance of Treasurys. The purchase of foreign currency would release U.S. dollars into the financial system, but the sale of Treasury securities would suck those dollars back out of the system. The net result would be no change in the volume of U.S. dollars in circulation - what economists call a "sterilized" intervention. Both economic theory and years of history show that sterilized interventions do not have lasting effects on currency values. The Fed could, of course, provide funding for the Treasury's purchases of foreign exchange, leading to an increase in the monetary base. This would be tantamount to an unsterilized intervention. However, such a deliberate attempt to weaken the dollar by expanding the money supply would fly in the face of the Fed's efforts to cool growth by tightening financial conditions. We highly doubt the Fed's current leadership would go along with this. Emerging Markets In The Crosshairs The combination of rising U.S. rates and a stronger dollar is bad news for emerging markets. Eighty percent of EM foreign-currency debt is denominated in dollars. Outside of China, EM dollar debt is now back to late-1990s levels, both as a share of GDP and exports (Chart 14). The wave of EM local-currency debt issued in recent years only complicates matters. If EM central banks raise rates to defend their currencies, this could imperil economic growth and make it difficult for local-currency borrowers to pay back their loans. Rather than hiking rates, some EM central banks may simply choose to inflate away debt. Consider the case of Brazil. The fiscal deficit stands at nearly 8% of GDP and government debt has soared from 60% of GDP in 2013 to 84% of GDP at present (Chart 15). Ninety percent of Brazilian sovereign debt is denominated in reais. The Brazilian government won't default on its debt per se. However, if push comes to shove, Brazil's central bank can always step in to buy government bonds, effectively monetizing the fiscal deficit. This could cause the real to weaken much more than it already has. Chart 14EM Dollar Debt Is High EM Dollar Debt Is High EM Dollar Debt Is High Chart 15Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Brazil's Perilous Fiscal Position Chinese Stimulus To The Rescue? When emerging markets last succumbed to pressure in 2015, China saved the day by stepping in with massive stimulus. Fiscal spending and credit growth accelerated to over 15% year-over-year. The government's actions boosted demand for all sorts of industrial commodities. The stimulus measures in 2015 followed an even greater wave of stimulus in 2009. While these stimulus measures invigorated China's economy and helped put a floor under global growth, they came at a price: China's debt-to-GDP ratio has swollen from 140% in 2008 to over 250% at present, which has endangered financial stability (Chart 16). Excess capacity has also increased. This can be seen in the dramatic rise in the capital-to-output ratio. It can also be seen in the fact that the rate of return on assets within the Chinese state-owned enterprise sector, which has been the main source of rising corporate leverage, has fallen below borrowing costs (Chart 17). Chart 16China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand China: Debt And Capital Accumulation Went Hand In Hand Chart 17China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs China: Rate Of Return On Assets Below Borrowing Costs For SOEs Chinese banks are being told that they must lend more money to support the economy, while ensuring that their loans do not turn sour. Unfortunately, that is becoming an impossible feat. The Chinese economy produces too much and spends too little. The result is excess savings, epitomized most clearly in a national savings rate of 46% (Chart 18). As a matter of arithmetic, national savings must be transformed either into domestic investment or exported abroad via a current account surplus. Now that the former strategy has run into diminishing returns, the Chinese authorities will need to concentrate on the latter. This will require a larger current account surplus which, in turn, will necessitate a relatively cheap currency. Above-average productivity growth has pushed up the fair value of China's real exchange rate over time. However, the currency still looks expensive relative to its long-term trend line (Chart 19). Pushing down the value of the yuan against the dollar will not be that difficult. Chart 20 shows that USD/CNY has moved broadly in line with the one-year swap spread between the U.S. and China. The spread was about 3% earlier this year. Today, it stands at only 0.6%. As the Fed continues to raise rates, the spread will narrow further, taking the yuan down with it. Chart 18China Saves A Lot China Saves A Lot China Saves A Lot Chart 19The RMB Is Still Quite Strong The RMB Is Still Quite Strong The RMB Is Still Quite Strong Chart 20USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials USD/CNY Has Tracked China-U.S. Interest Rate Differentials Unlike standard Chinese fiscal/credit easing, a stimulus strategy focused on weakening the yuan would hurt other emerging markets by undermining their competitiveness in relation to China. A weaker yuan would also make it more expensive for Chinese companies to import natural resources, thus putting downward pressure on commodity prices. The Euro Area: Back In The Slow Lane After putting in a strong performance in 2017, the economy in the euro area has struggled to maintain momentum this year. Growth is still above trend, but the overall tone of the data has been lackluster at best, with the risks to growth increasingly tilted to the downside. Weaker growth in China and other emerging markets certainly has not helped. However, much of the problem lies closer to home. Bank credit remains the lifeblood of the euro area economy. The 12-month credit impulse - defined as the change in credit growth from one 12-month period to the next - tends to track GDP growth (Chart 21).2 Euro area credit growth accelerated over the course of 2017, but has been broadly stable this year. As a result, the credit impulse has fallen, taking GDP growth down with it. It will be difficult for euro area GDP growth to increase unless credit growth starts rising again. So far, there is little sign that this is about to happen. According to the latest euro area bank lending survey, while banks continue to ease standards for business loans, they are doing so at a slower pace than in the past. A net 3% of banks eased lending standards in the second quarter, compared to 8% in the first quarter. Loan demand growth has been fairly stable. This suggests that loan growth will remain positive, but is unlikely to increase much from current levels. Worries about the health of European banks will further constrain credit growth. European banks in general, and Spanish banks in particular, have significant exposure to the most vulnerable emerging markets (Chart 22). Chart 21Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Euro Area Credit Growth Has Flatlined Chart 22Spain Most Exposed To Vulnerable EMs 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Concerns about the ability of the Italian government to service its debt obligations will also restrain bank lending. Investors breathed a sigh of relief last month when the Italian government signaled a greater willingness to pare back next year's proposed budget deficit, in accordance with the dictates of the European Commission. Tensions remain, however, as evidenced by the fact that the ten-year spread between BTPs and German bunds is still 120 basis points higher than in April (Chart 23). The European political establishment is terrified of the rise in populism across the region and would love nothing more than to see Italy's populist parties implode. This means that any help from the ECB and the European Commission will only arrive once a full-fledged crisis is underway. Anyway, it is far from clear that a smaller budget deficit would actually translate into a lower government debt-to-GDP ratio. Like China, Italy also has a private sector that saves too much and spends too little. A shrinking population has reduced the need for firms to invest in new capacity. The prior government's pension cuts have also incentivized people to save more for their retirement. The result is a private sector savings-investment surplus that stood at 5% of GDP in 2017 compared to close to breakeven a decade ago (Chart 24). Chart 23Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Italian/Bund Spreads Signal Lingering Fiscal Strain Chart 24Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Italy: Private Sector Saves Too Much And Spends Too Little Unlike Germany, Italy cannot export its excess production because it does not have a hypercompetitive economy. Nor does it have the ability to devalue its currency to gain a quick competitiveness boost. This means that the Italian government has to absorb excess private-sector savings with its own dissavings - a fancy way of saying that it has to run a large budget deficit. This has effectively been Japan's strategy for over two decades. However, unlike Japan, Italy does not have a lender of last resort that can unconditionally buy government debt. This raises the risk that Italy's debt woes will resurface, either because the government abandons austerity measures, or because the lack of fiscal support causes nominal GDP to stagnate, making it all but impossible for the country to outgrow its debt burden. Receding Policy Puts The discussion above suggests that many of the "policy puts" that investors have relied on are in the process of having their strike price marked down to deeper out-of-the-money levels. Yes, the Fed will ease off on rate hikes if U.S. growth is at risk of stalling out completely. However, now that the labor market has reached full employment, the Fed will welcome modestly slower growth. Remember that there has never been a case in the post-war era where the three-month average of the unemployment rate has risen by more than a third of a percentage point without a recession taking place (Chart 25). The further the unemployment rate falls below NAIRU, the more difficult it will be for the Fed to achieve the proverbial soft landing. Chart 25Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Even A Small Uptick In The Unemployment Rate Is Bad News For The Business Cycle Likewise, the "China stimulus put" - the presumption that most investors have that the Chinese authorities will launch a barrage of fiscal and credit easing at the first sign of slower growth - has become less reliable in light of the government's competing objectives namely reducing debt growth and excess capacity. The same goes for the "ECB put." Yes, the ECB will bail out Italy if the entire European project appears at risk. But spreads may need to blow out before the cavalry arrives. Meanwhile, just as the aforementioned policy puts are receding, new policy risks are rising to the fore, chief among them protectionism. We expect the trade war to heat up, with the Trump administration increasingly directing its ire at China. Trump's macroeconomic policies are completely at odds with his trade agenda. Fiscal stimulus will boost aggregate demand, which will suck in more imports. An overheated economy will prompt the Fed to raise rates more aggressively than it otherwise would, leading to a stronger dollar. All this will result in a wider trade deficit. What will Trump tell voters two years from now when he is campaigning in Michigan and Ohio about why the trade deficit has widened rather than narrowed under his watch? Will he blame himself or Beijing? No trophy for getting that answer right. II. Financial Markets Global Equities The combination of slower global growth, rising economic vulnerabilities outside the U.S., and a more challenging policy environment caused us to downgrade our view on global equities from overweight to neutral in June,3 while reiterating our preference for developed market equities relative to EM stocks. For now, we are comfortable with our bearish view towards emerging market stocks. While EM equities have cheapened, they are not yet at washed out levels (Chart 26). Bottom fishers still abound, as evidenced by the fact that the number of shares outstanding in the MSCI iShares Turkish ETF has almost tripled since early April (Chart 27). Chart 26EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels EM Assets: Valuations Not Yet At Washed Out Levels Chart 27EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound EM Bottom Fishers Still Abound At some point - probably in the first half of next year - investors will liquidate their remaining bullish EM bets. At that point, EM stocks will rebound. European and Japanese equities should also start to outperform the U.S., given their more cyclical nature. As far as the absolute direction of the S&P 500 is concerned, the next few months could be challenging. U.S. stocks have been able to decouple from those in the rest of the world, but this state of affairs may not last. Recall that the S&P 500 fell by 22% peak-to-trough between July 20 and October 8, 1998, in what otherwise was a massive bull market. We do not know if there is another Long-Term Capital Management lurking around the corner, but if there is, a temporary selloff in U.S. stocks may be hard to avoid. Such a selloff would present a buying opportunity over a horizon of 12-to-18 months. If we are correct that cyclical forces have lifted the neutral rate of interest, it will take a while for monetary policy to reach restrictive territory. This means that both fiscal and monetary policy will stay accommodative at least for the next 18 months. As such, the S&P 500 may not peak until 2020. Appendix A - Chart I presents a stylized diagram of where we think global equities are going. It incapsulates three phases: 1) a challenging period over the next six months, driven by EM weakness; 2) a blow-off rally in equities starting in the middle of next year; 3) and finally, a recession-induced bear market beginning in late-2020. Appendix B also presents our valuation charts, which highlight that long-term return prospects are better outside the United States. Fixed Income After advocating for a long duration strategy for much of the post-crisis recovery, BCA declared "The End Of The 35-Year Bond Bull Market" on July 5, 2016, the very same day that the 10-year U.S. Treasury yield hit a record closing low of 1.37%. Cyclically and structurally, we continue to expect U.S. bond yields to rise more than the market is discounting. As noted above, the Fed is underestimating how high rates will need to go before they reach restrictive territory. This means that the Fed will end up behind the curve in normalizing monetary policy, causing the economy to overheat and inflation to rise above the Fed's comfort zone. Chart 28Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Bond Sentiment Is Extremely Bearish Granted, the Fed is willing to tolerate a modest inflation overshoot. However, a core PCE reading above 2.3%, which is at the top end of the range of the Fed's own forecast, would prompt the Fed to expedite the pace of rate hikes. A bear flattening of the yield curve - a situation where long-term yields rise, but short-term rates go up even more - would be highly likely in that environment. Over a shorter-term horizon spanning the next six months, the outlook for yields is more benign. The combination of a stronger dollar, slower global growth, and flight-to-quality flows into the Treasury market from vulnerable emerging markets can cap yields. Add to this the fact that sentiment towards bonds is currently extremely bearish (Chart 28), and a temporary countertrend decline in yields becomes quite probable. Developed market bond yields in general are likely to follow the direction of U.S. yields, both on the upside and the downside, but in a more muted manner. Outside the periphery, euro area yields have less scope to fall in the near term given that they are already so low. European yields also have less room to rise once global growth bottoms next year because the neutral rate of interest is much lower in the euro area than in the United States. Ironically, a more dovish ECB would help reduce Italian bond yields, as higher inflation is critical for increasing Italian nominal GDP. Since labor market slack is still elevated in Italy, continued monetary stimulus would also lift wages in core Europe more than in Italy, helping to boost Italy's competitiveness relative to the rest of the euro area. Japanese yields have plenty of scope to rise over the long haul. An aging population is pushing more people into retirement, which will cause the national savings rate to fall further. A decline in the savings pool will increase the neutral rate of interest in Japan. Instead of raising the policy rate, the Japanese authorities will let the economy overheat, generating inflation in the process. This will cause the yield curve to steepen, particularly at the very long end (e.g., beyond 10 years) which is the part of the yield curve that is the least susceptible to the BoJ's yield curve control regime. We are positioned for this outcome through our short 20-year JGB/long 5-year JGB trade recommendation. Appendix A - Chart II shows our expectations for the major government bond markets over the coming years. Turning to credit markets, high-yield credit typically underperforms in the latter innings of business-cycle expansions, a period when the Fed is raising rates. Thus, while we do not think that U.S. corporate debt levels will be a major source of systemic financial risk for the broader economy, this is hardly a reason to be overweight spread-product. A more cautious stance towards credit outside the U.S. is also warranted. Currencies And Commodities The dollar is working off overbought conditions, but will rebound into year-end, as EM tensions intensify and hopes of a massive credit/fiscal-fueled Chinese stimulus package fizzle. EM currencies will weaken the most against the dollar over the next three-to-six months, but the euro and, to a lesser extent, the yen, will also come under pressure. Granted, the dollar is no longer a cheap currency, but if long-term interest rate differentials stay anywhere close to current levels, the greenback will remain well supported. Consider the dollar's value against the euro. Thirty-year U.S. Treasurys currently yield 3.20% while 30-year German bunds yield 1.12%, a difference of 208 basis points. Even if one allows for the fact that investors expect euro area inflation to be lower than in the U.S. over the next 30 years, EUR/USD would need to trade at a measly 82 cents today in order to compensate German bund holders for the inferior yield they will receive.4 We do not expect EUR/USD to get down to that level, but a descent into the $1.10-to-$1.12 range over the next six months is probable. Sterling will remain hostage to Brexit negotiations. It is impossible to know how talks will evolve, but our bias is to take a somewhat pound-positive view. The main reason is that support for Brexit has faded (Chart 29). Opinion polls suggest that if a referendum were held again, the "bremain" side would almost certainly prevail. Lacking public support for leaving the EU, it is unlikely that British negotiators could simply walk away from the table. This reduces the odds of a "hard Brexit" outcome. Indeed, a second referendum that leads to a "no-Brexit" verdict remains a distinct possibility. The combination of slower global growth and a resurgent dollar is likely to hurt commodity prices. Industrial metals are more vulnerable than oil. China consumes around half of all the copper, nickel, aluminum, zinc, and iron ore produced around the world (Chart 30). In contrast, China represents less than 15% of global oil demand. Chart 29When Bremorse Sets In When Bremorse Sets In When Bremorse Sets In Chart 30China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil China Is A More Dominant Consumer Of Metals Than Oil The supply backdrop for oil is also more favorable than for metals. Not only are Saudi Arabia and Russia maintaining production discipline, but U.S. sanctions against Iran threaten to weigh on global crude supply. Further reduction in Venezuela's oil output, as well as potential disruptions to Libyan or Iraqi exports, could also boost oil prices. The superior outlook for oil over metals means we prefer the Canadian dollar relative to the Aussie dollar. While AUD/CAD has weakened in recent months, the Aussie dollar is still somewhat expensive against the loonie based on our long-term valuation model (Chart 31). We also see an increasing chance that Canada will negotiate a revamped trade deal with the U.S., as Trump focuses his attention more on China. Should this happen, it will remove the NAFTA break-up risk discount embedded in the Canadian dollar. Finally, a few words on precious metals. Precious metals typically struggle during periods when the dollar is appreciating (Chart 32). Consequently, we would not be eager buyers of gold or other precious metals until the dollar peaks, most likely around the middle of next year. As inflation starts to accelerate in late-2019 and in 2020, gold will finally move decisively higher. Chart 31Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Canadian Dollar Still Somewhat Cheap Versus The Aussie Dollar Chart 32Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Gold Won't Shine Until The Dollar Peaks Appendix A - Chart III and Chart IV present an illustration of where the major currencies and commodities are heading. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com 1 Depending on which specification of the Taylor rule one uses, a one percent of GDP increase in aggregate demand will increase the neutral rate of interest by half a point (John Taylor's original specification) or by a full point (Janet Yellen's preferred specification). Fiscal policy is currently about 3% of GDP too stimulative compared to a baseline where government debt-to-GDP is stable over time. Assuming a fiscal multiplier of 0.5, fiscal policy is thus boosting aggregate demand by 1.5% of GDP. Nonfinancial private credit has increased by an average of 1.5 percentage points of GDP per year since 2016. Assuming that every additional one dollar of credit increases aggregate demand by 50 cents, the revival in credit growth is raising aggregate demand by 0.75% of GDP, compared to a baseline where credit-to-GDP is flat. The labor share of income has increased by 1.25% of GDP from its lows in 2015. Assuming that every one dollar shift in income from capital to labor boosts overall spending on net by 20 cents, this would have raised aggregate demand by 0.25% of GDP. Lastly, if the personal savings rate falls by two points over the next two years, this would raise aggregate demand by 1.5% of GDP. Taken together, these factors are boosting the neutral rate by anywhere from 2% (Taylor's specification) to 4% (Yellen's specification). This is obviously a lot, and easily overwhelms other factors such as a stronger dollar that may be weighing on the neutral rate. 2 Recall that GDP is a flow variable (how much production takes place every period), whereas credit is a stock variable (how much debt there is outstanding). By definition, a flow is a change in a stock. Thus, credit growth affects GDP and the change in credit growth affects GDP growth. Euro area private-sector credit growth accelerated from -2.6% in May 2014 to 3.1% in March 2017, but has been broadly flat ever since. Hence, the credit impulse has dropped. 3 Please see Global Investment Strategy Special Report, "Three Policy Puts Go Kaput: Downgrade Global Equities To Neutral," dated June 20, 2018. 4 For this calculation, we assume that the fair value for EUR/USD is 1.32, which is close to the IMF's Purchasing Power Parity (PPP) estimate. The annual inflation differential of 0.47% is based on 30-year CPI swaps. This implies that the fair value for EUR/USD will rise to 1.52 after 30 years. If one assumes that the euro reaches that level by then, the common currency would need to trade at 1.52/(1.0208)^30=0.82 today. Appendix A Appendix A Chart IMarket Outlook: Equities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIMarket Outlook: Bonds 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IIIMarket Outlook: Currencies 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix A Chart IVMarket Outlook: Commodities 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Appendix B Chart 1Long-Term Return Prospects Are Slightly Better Outside The U.S. 2018 Q4 Strategy Outlook: Desynchronization Is Back 2018 Q4 Strategy Outlook: Desynchronization Is Back Strategy & Market Trends Tactical Trades Strategic Recommendations Closed Trades