Trade

Highlights Structurally overweight US T-bonds versus core European bonds. Our preferred expression is long T-bonds versus Swiss bonds. US yields can fall a lot more than European yields, and European yields can rise a lot more than US yields. Structurally underweight the overvalued dollar versus undervalued European currencies. Our preferred expression is long SEK/USD. Structurally underweight price-sensitive European export sectors. Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. But structurally overweight soft luxuries. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Fractal trade: The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Feature Chart of the WeekLike-For-Like, Structural Inflation Is Lower In the US Than In Europe Like-For-Like, Structural Inflation Is Lower In the US Than In Europe Like-For-Like, Structural Inflation Is Lower In the US Than In Europe A seemingly trivial disagreement between Europeans and Americans on how to measure inflation turns out to be the culprit for three major distortions in the world right now: Deeply divergent monetary policies across the developed economies. Huge valuation anomalies in the foreign exchange markets. President Trump’s threat of a trade war to counter the huge trade surpluses that Europe and China are running against the US. The inflation measurement disagreement wouldn’t really matter if inflation were running in the mid-single digits. But when inflation is near zero, the seemingly trivial difference in inflation measurement methodologies has ended up generating massive distortions. European And American Inflation Are Not The Same European inflation excludes the maintenance and upkeep costs associated with owning your home, whereas US inflation includes these costs at a hefty 25 percent weighting, making owner occupied housing by far the largest single item in the US inflation basket. By omitting the largest item in the US inflation basket, European inflation is subtly yet crucially different to American inflation. The European statisticians argue that unlike all the other items in the inflation basket, there is no independent market price for the ongoing cost of home ownership, and therefore this cost should be excluded. The American statisticians argue that the ongoing cost of home ownership is the single largest expense for most people and, as such, it should be ‘imputed’ from a concept known as ‘owner equivalent rent’ – essentially, asking homeowners how much it would cost to rent their own home. Different definitions of inflation will trigger very different policy responses from central banks. Both the European and American approaches have their merits and drawbacks, and it is not our intention to endorse one approach over the other. Our intention is simply to point out that the two approaches can give very different results for inflation – and therefore trigger very different policy responses from inflation-targeting central banks, with their consequent economic and political repercussions. If Americans used the European definition of inflation, then headline inflation in the US today would be running at the same sub-par rate as in the euro area, 1 percent, and well below the Fed’s 2 percent target (Chart I-2 and Chart I-3). More important, the five year annualised rate of inflation – let’s call it US structural inflation – would have been stuck below 1 percent since 2016 (Chart I-1 and Chart I-4). Under these circumstances, it would have been impossible for the Fed to hike the funds rate eight times, as it did through 2017-18. Chart I-2Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Like-For-Like, Headline Inflation Is Identical In The US And The Euro Area... Chart I-3...And Core Inflation Is ##br##Very Similar ...And Core Inflation Is Very Similar ...And Core Inflation Is Very Similar   Chart I-4Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Using The European Definition Of Inflation, The Fed Couldn't Have Hiked Rates Instead, what if Europeans used the American definition of inflation? European inflation does not include owner equivalent rent, but it does include housing rent for those that do rent their homes. In the US, these two items tend to move in lockstep (Chart I-5). If we assume the same for Europe, we can deduce that a US type weighting for owner equivalent rent would have boosted the headline inflation rate in the euro area by 0.3-0.4 percent through 2014-16, and by a possible 0.5 percent in Sweden through 2013-15 (Chart I-6 and Chart I-7). Under these circumstances, it would have been very difficult for the ECB and Riksbank to take and maintain policy rates deeply in negative territory, as they did through 2015-19. Chart I-5Owner Equivalent Rent Tracks ##br##Housing Rent Owner Equivalent Rent Tracks Housing Rent Owner Equivalent Rent Tracks Housing Rent Chart I-6Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Using The American Definition Of inflation, Euro Area Inflation Would Have Been Higher... Chart I-7...And Swedish Inflation Would Have Been Much Higher ...And Swedish Inflation Would Have Been Much Higher ...And Swedish Inflation Would Have Been Much Higher The Different Definitions Of Inflation Have Created Dangerous Distortions If Europeans and Americans were using the same definition of inflation then, one way or the other, their monetary policies would not be as deeply divergent as they are now. One important implication is that European currencies would not be as undervalued as they are now. If Europeans and Americans were using the same definition of inflation then their monetary policies would not be as deeply divergent as they are now.  Based on the ECB’s own analysis, the euro area is over-competitive versus its top 19 trading partners – meaning the euro is undervalued – by at least 10 percent. Moreover, the ECB admits that this sizable undervaluation only appeared after the ECB and Fed started taking their monetary policies in opposite directions in 2015 (Chart I-8). Chart I-8The Euro Is Undervalued By More Than 10 Percent The Euro Is Undervalued By More Than 10 Percent The Euro Is Undervalued By More Than 10 Percent Put the other way, the dollar would not be as overvalued as it is now. In turn, the stronger dollar has created its own dangerous spill-overs. As we explained last week in The Hidden Sales Recession Of 2015… And Why It Matters Now, the surging dollar in 2015 could not have come at a worse time for China. Given that the Chinese economy was already slowing sharply, and the yuan was pegged to the dollar, the resulting loss of Chinese competitiveness just exacerbated the slump. Forcing China to loosen the dollar peg in August 2015. All of which brings us neatly to the hot topic of 2019, and likely 2020 too – President Trump’s threat of a trade war to counter the huge trade imbalances that Europe and China are running against the US. As it happens, President Trump has a good point. Trade wars almost always stem from trade imbalances; and trade imbalances almost always stem from exchange rate manipulations or, at least, exchange rate distortions that advantage one economy to the detriment of another. The euro's undervaluation only happened after monetary policies diverged in 2015. Most of the euro area’s €150 billion trade surplus with the US appeared after 2015, so it cannot be a structural issue. In fact, the evolution of the trade imbalance has tracked relative monetary policy between the Fed and ECB almost tick for tick (Chart I-9), via the exchange rate channel and the over-competitiveness of the euro which the ECB fully admits. Chart I-9Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Excessively Divergent Monetary Policies Caused The Euro Area's Huge Trade Surplus With The US Of course, neither the ECB nor the Fed are deliberately targeting trade or the exchange rate; they are targeting inflation. But to repeat, they are targeting different definitions of inflation. Crucially, with a backdrop of near zero inflation, small definitional differences in inflation can generate huge economic and financial distortions, with dangerous political consequences. The Compelling Structural Opportunities The definitional difference between European and American inflation explain many of the economic and financial distortions we are witnessing now, as well as the dangerous political consequences. The main counterargument is that the inflation definitions are what they are; neither the ECB nor the Fed are likely to change them anytime soon. Nevertheless, there are compelling structural opportunities. Since 2015, American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices (Chart I-10 and Chart I-11). The historic evidence suggests that such a pace of outperformance is unsustainable structurally and, absent this tailwind, US and European headline inflation rates have to converge, one way or the other. Chart I-10An Unsustainable Surge In US Owner Equivalent Rent... An Unsustainable Surge In US Owner Equivalent Rent... An Unsustainable Surge In US Owner Equivalent Rent... Chart I-11...Has Lifted US Headline ##br##Inflation ...Has Lifted US Headline Inflation ...Has Lifted US Headline Inflation In this inevitable convergence, the asymmetric starting point of bond yields favours a long US T-bonds, short core European bonds structural position. Because, if the inflation convergence is downwards, T-bond yields will fall much further than European yields; whereas if the inflation convergence is upwards, European yields will likely rise more than T-bond yields. Our preferred structural expression is: long US T-bonds, short Swiss bonds. For currencies it is the opposite message. The overvalued dollar is likely to underperform, at least versus other developed market currencies. Given that Swedish inflation has been the most understated by the exclusion of owner equivalent rents, combined with the Riksbank’s intention to exit negative interest rate policy imminently, our preferred structural expression is: long SEK/USD. American inflation has outperformed European inflation for one reason and one reason only: owner equivalent rents have surged by almost 20 percent relative to other prices. Lastly, European export growth – even in Germany – has been heavily reliant on a cheapening euro (Chart I-12). Undervalued European currencies cannot fall much further, and those European exporters that depend on price competitiveness will struggle to outperform. Even those multinationals that sell their products in dollars will lose out in the accounting translation back into a strengthening domestic currency. Hence, structurally underweight price-sensitive European export sectors. Chart I-12Without A Weaker Euro, Most European Exporters Will Struggle To Outperform Without A Weaker Euro, Most European Exporters Will Struggle To Outperform Without A Weaker Euro, Most European Exporters Will Struggle To Outperform The one exception to this is the soft luxuries sector. Despite President Trump’s threat to tariff French products, soft luxuries retain very strong pricing power and sustainable long term demand growth from rising female labour participation rates globally. Stay structurally overweight soft luxuries. Fractal Trading System* The 65-day fractal structure of global equities suggests that they are vulnerable to a near-term countertrend move. Accordingly, this week’s recommended trade is to short the MSCI All Country World versus the global 10-year bond (simple average of US, euro area, and China), setting a profit target and symmetrical stop-loss at 2.5 percent. In other trades, long NZD/JPY and long SEK/JPY both achieved their profit targets of 3 percent and 1.5 percent respectively. Against this, long Poland versus World reached its 4 percent stop-loss. The rolling 1-year win ratio now stands at 65 percent. Chart I-13MSCI All-Country World Vs. Global 10-Year Bond MSCI All-Country World Vs. Global 10-Year Bond MSCI All-Country World Vs. Global 10-Year Bond When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated  December 11, 2014, available at eis.bcaresearch.com.   Dhaval Joshi Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World   Cyclical Recommendations Structural Recommendations How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World How Low Inflation Has Distorted The World Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations Indicators To Watch - Interest Rate Expectations    

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

Highlights The US-China trade talks will continue despite Hong Kong. The UK election will not reintroduce no-deal Brexit risk – either in the short run or the long run. European political risk is set to rise from low levels, but Euro Area break-up risk will not. There is no single thread uniting emerging market social unrest. We remain constructive on Brazil. Feature Chart 1Taiwan Indicator To Rise Despite Ceasefire Taiwan Indicator To Rise Despite Ceasefire Taiwan Indicator To Rise Despite Ceasefire President Trump signed the Hong Kong Human Rights and Democracy Act into law on November 27. The signing was by now expected – Trump was not going to veto the bill and invite the Senate to override him with a 67-vote at a time when he is being impeached. He does not want to familiarize the Senate with voting against him in supermajorities. The Hong Kong bill will not wreck the US-China trade talks, but it is a clear example of our argument that strategic tensions will persist and cast doubt on the durability of the “phase one trade deal” being negotiated. It is better to think of it as a ceasefire, as Trump’s electoral constraint is the clear motivation. Trump is embattled at home and will contend an election in 11 months. He will not impose the tariff rate hike scheduled for December 15. A relapse into trade war would kill the green shoots in US and global growth, which partly stem from the perception of easing trade risk. Only if Trump’s approval rating collapses, or China stops cooperating, will he become insensitive to his electoral constraint. Will China abandon the talks and leave Trump in the lurch? This is not our base case but it is a major global risk. So far China is reciprocating. Xi Jinping’s political and financial crackdown at home, combined with the trade war abroad, has led to an economic slowdown and an explosion in China’s policy uncertainty relative to America’s. A trade ceasefire – on top of fiscal easing – is a way to improve the economy without engaging in another credit splurge. The US and China will continue moving toward a trade ceasefire, despite the Hong Kong bill. The move toward a trade ceasefire will probably keep our China GeoRisk Indicator from rising sharply over the next few months. However, our Taiwan indicator, which we have used as a trade war proxy at times, may diverge as it starts pricing in the heightened political risk surrounding Taiwan’s presidential election on January 11, 2020 (Chart 1). Sanctions, tech controls, Hong Kong, Taiwan, North Korea, Iran, the South China Sea, and Xinjiang are all strategic tensions that can flare up. Yes, uncertainty will fall and sentiment will improve on a ceasefire, but only up to a point. China’s domestic policy decisions are ultimately more important than its handling of the trade war. At the upcoming Central Economic Work Conference authorities are expected to stay focused on “deepening supply-side structural reform” and avoiding the use of “irrigation-style” stimulus (blowout credit growth). But this does not mean they will not add more stimulus. Since the third quarter, a more broad-based easing of financial controls and industry regulations is apparent, leading our China Investment Strategy to expect a turning point in the Chinese economy in early 2020. This “China view” – on stimulus and trade – is critical to the outlook for the two regions on which we focus for the rest of this report: Europe and emerging markets. Assuming that China stabilizes, these are the regions where risk assets stand to benefit the most. Europe is a political opportunity; the picture in emerging markets is, as always, mixed. United Kingdom: Will Santa Bring A Lump Of Coal? The Brits will hold their first winter election since 1974 on December 12. Prime Minister Boris Johnson’s Conservative Party has seen a tremendous rally in opinion polls, although it has stalled at a level comparable to its peak ahead of the last election in June 2017 (Chart 2). Another hung parliament or weak Tory coalition is possible. Yet the Tories are better positioned this time given that the opposition Labour Party is less popular than two years ago, while the Liberal Democrats are more capable of stealing Labour votes. The Tories stand to lose in Scotland, but the Brexit Party of Nigel Farage is not contesting seats with them and is thus undercutting Labour in certain Brexit-leaning constituencies. Markets would enjoy a brief relief rally on a single-party Tory majority. This would enable Johnson to get his withdrawal deal over the line and take the UK out of the EU in an orderly manner by January 31. The question would then shift to whether Johnson feels overconfident in negotiating the post-Brexit trade agreement with the EU, which is supposed to be done by December 31, 2020. This date will become the new deadline for tariff increases, but it can be extended. Johnson is as unlikely to fly off the cliff edge next year as he was this year, and this year he demurred. Negotiating a trade agreement is easier when the two economies are already integrated, have a clear (yet flexible) deadline, and face exogenous economic risks. Our political risk indicator will rise but it will not revisit the highs of 2018-19 (Chart 3). The pound’s floor is higher than it was prior to September 2019. Chart 2Tories Look To Be Better Positioned For A Single Party Majority Tories Look To Be Better Positioned For A Single Party Majority Tories Look To Be Better Positioned For A Single Party Majority Chart 3UK Risk Will Rise, But Not To Previous Highs UK Risk Will Rise, But Not To Previous Highs UK Risk Will Rise, But Not To Previous Highs Bottom Line: A hung parliament is the only situation where a no-deal Brexit risk reemerges in advance of the new Brexit day of January 31. The market is underestimating this outcome based on our risk indicator. But Johnson himself prefers the deal he negotiated and wishes to avoid the recession that would likely ensue from crashing out of the EU. And a headless parliament can prevent Johnson from forcing a no-deal exit, as investors witnessed this fall. We remain long GBP-JPY. Germany: The Risk Of An Early Election Germany is wading deeper into a period of political risk surrounding Chancellor Angela Merkel’s “lame duck” phase, doubts over her chosen successor, and uncertainty about Germany’s future in the world. The federal election of 2021 already looms large. Our indicator is only beginning to price this trend which can last for the next two years (Chart 4). On October 27 Germany’s main centrist parties suffered a crushing defeat in the state election of Thuringia. For the first time, the Christian Democratic Union (CDU) not only lost its leadership position, but also secured less vote share than both the Left Party and the right-wing Alternative für Deutschland (AfD) (Chart 5, top panel). Chart 4Germany Is Heading Toward A Period Of Greater Political Risk Germany Is Heading Toward A Period Of Greater Political Risk Germany Is Heading Toward A Period Of Greater Political Risk The AfD successfully positioned itself with the right wing of the electorate and managed to capture more undecided voters than any other party (Chart 5, bottom panel). Chart 5The Right-Wing AfD Outperformed In Thuringia … Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 While the rise of the AfD (and its outperformance over its national polling) may seem alarming, Germany is not being taken over by Euroskeptics. Both support for the euro and German feeling of being “European” is near all-time highs (Chart 6). The question is how the centrist parties respond. Merkel’s approval rating is at its lower range. Support for Annegret Kramp-Karrenbauer (AKK), Merkel’s chosen successor, is plummeting (Chart 7). Since AKK was confirmed as party chief, the CDU suffered big losses in the European Parliament election and in state elections. Several of her foreign policy initiatives were not well received in the party.1 In October 2019, the CDU youth wing openly rejected her nomination as Merkel’s successor. At the annual CDU party conference on November 22-23, she only narrowly managed to avoid rebellion. She is walking on thin ice and will need to recover her approval ratings if she wants to secure the chancellorship. Meanwhile the CDU will lose its united front, increasing Germany’s policy uncertainty. Chart 6... But Euroskeptics Will Not Take Over Germany ... But Euroskeptics Will Not Take Over Germany ... But Euroskeptics Will Not Take Over Germany Germany’s other major party – the Social Democratic Party (SPD) – is also going through a leadership struggle. Chart 7The CDU Party Leader Is Walking On Thin Ice The CDU Party Leader Is Walking On Thin Ice The CDU Party Leader Is Walking On Thin Ice Chart 8A Return To The Polls Would Result In A CDU-Green Coalition Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 In the first round of the leadership vote, Finance Minister Olaf Scholz and Klara Geywitz (member of the Brandenburg Landtag) secured a small plurality of votes with 22.7%, just 1.6% more than Bundestag member Saskia Esken and Norbert Walter-Borjans (finance minister of North Rhine-Westphalia from 2010-17). The latest polling, and Scholz’s backing by the establishment, implies that he will win but this is uncertain. The results of the second round will be published on November 30, after we go to press. What does the SPD’s leadership contest mean for the CDU-SPD coalition? More likely than not, the status quo will continue. Scholz is an establishment candidate and supports remaining in the ruling coalition until 2021. Esken is calling for the SPD to leave the coalition, but Walter-Borjans has not explicitly supported this. An SPD exit from the Grand Coalition would likely lead to a snap election, not a favorable outcome for stability-loving Germans. A return to the polls would benefit the Greens and AfD at the expense of the mainstream parties, and would likely see a CDU-Green coalition emerge (Chart 8). Given that a majority of voters want the SPD to remain in government (Chart 9), and that new elections would damage the SPD’s prospects, we believe that the SPD is likely to stay in government until 2021, even if the less established Esken and Walter-Borjans win. The risk is the uncertainty around Merkel’s exit. October 2021 is a long time for Merkel to drag the coalition along, so the odds of an early election are probably higher than expected. Chart 9Germans Prefer The SPD Remains In Government Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 10Climate Spending Closest Germany Gets To Fiscal Stimulus (For Now) Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 11There Is Room For More Fiscal Stimulus In Germany, If Needed There Is Room For More Fiscal Stimulus In Germany, If Needed There Is Room For More Fiscal Stimulus In Germany, If Needed What would a Scholz win mean for the great debate over whether Germany will step up its fiscal policy? If the establishment duo wins the SPD leadership, the Grand Coalition remains in place, and the economy does not relapse, we are unlikely to see additional fiscal stimulus in the near future. Scholz argues that additional stimulus would not be productive, as the slowdown is due to external factors (i.e. trade war).2 The recently released Climate Action Program 2030 is the closest to fiscal stimulus that we will see. This package will deliver additional spending worth 9bn euro in 2020 and 54bn euro until 2023 (Chart 10). We are unlikely to see additional fiscal stimulus from Germany in the near future. Bottom Line: Germany is wading into a period of rising political uncertainty. In the event of a downward surprise in growth, there is room to add more fiscal stimulus (Chart 11). But there is no change in fiscal policy in the meantime, e.g. no positive surprise. France: Macron Takes Center Stage While Merkel exits, President Emmanuel Macron continues to position himself as Europe’s leader – with a vision for European integration, reform, and political centrism. But in the near term he will remain tied down with his ambitious domestic agenda. France is trudging down the path of fiscal consolidation. After exiting the Excessive Deficit Procedure in 2018, and decreasing real government expenditures by 0.3% of GDP, France’s budget deficit is forecasted to decline further (Chart 12). Macron’s government is moving towards balancing its budget primarily by reducing government expenditures to finance tax cuts and decrease the deficit. Macron’s reform efforts following the Great National Debate – tax cuts for the middle class, bonus exemptions from income tax and social security contributions, and adjustment of pensions for inflation – have paid off.3 His approval rating is beginning to recover from the lows hit during the Yellow Vest protests (Chart 13). These reforms will be financed by lower government expenditures and reduced debt burden as a result of accommodative monetary policy. Chart 12Fiscal Consolidation In France Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 13Macron's Reform Efforts Have Paid Off Macron's Reform Efforts Have Paid Off Macron's Reform Efforts Have Paid Off Overall, France has proven to a very resilient country in light of a general economic slowdown (Chart 14, top panel). Business investment and foreign direct investment, propped up by gradual cuts in the corporate income tax rate, have remained steady, and confidence remains strong (Chart 14, bottom panels). France is consumer driven and hence somewhat protected from storms in global trade. Chart 14French Economy Resilient Despite Global Slowdown French Economy Resilient Despite Global Slowdown French Economy Resilient Despite Global Slowdown Chart 15Ongoing Strikes Will Register In French Risk Indicator Ongoing Strikes Will Register In French Risk Indicator Ongoing Strikes Will Register In French Risk Indicator Bottom Line: France stands out for remaining generally stable despite pursuing structural reforms. Strikes and opposition to reforms will continue, and will register in our risk indicator (Chart 15), but it is Germany where global trends threaten the growth model and political trends threaten greater uncertainty. On the fiscal front France is consolidating rather than stimulating.   Italy: Muddling Through This fall’s budget talks caused very little political trouble, as expected. The new Finance Minister Roberto Gualtieri is an establishment Democratic Party figure and will not seek excessive conflict with Brussels over fiscal policy. Italy’s budget deficit is projected to stay flat over 2019 and 2020. The key development since the mid-year budget revision was the repeal of the Value Added Tax hike scheduled for 2020, a repeal financed primarily by lower interest spending.4 Equity markets have celebrated Italy’s avoidance of political crisis this year with a 5.6% increase. Our own measure of geopolitical risk has dropped off sharply (Chart 16). But of course we expect it to rise next year given that Italy remains the weakest link in the Euro Area over the long run. The left-leaning alliance between the established Democratic Party and the anti-establishment Five Star Movement hurt both parties’ approval ratings. In fact, the only parties that have seen an increase in approval in the last month are the League, the far-right Brothers of Italy, and the new centrist party of former Prime Minister Matteo Renzi, Italia Viva (Chart 17). We expect to see cracks form next year, particularly over immigration, but mutual fear of a new election can motivate cooperation for a time. Chart 16Decline In Italian Risk Will Be Short Lived Decline In Italian Risk Will Be Short Lived Decline In Italian Risk Will Be Short Lived Chart 17The M5S-PD Alliance Damaged Their Approval The M5S-PD Alliance Damaged Their Approval The M5S-PD Alliance Damaged Their Approval Bottom Line: Italy’s new government is running orthodox fiscal policy, which means no boost to growth, but no clashing with Brussels either. Spain: Election Post Mortem Chart 18A Gridlocked Parliament In Spain Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 The Spanish election produced another gridlocked parliament, as expected, with no party gaining a majority and no clear coalition options. The Spanish Socialist Workers’ Party (PSOE) emerged as the clear leader but still lost three seats. The People’s Party recovered somewhat from its April 2019 defeat, gaining 23 seats. The biggest loser of the election was Ciudadanos, which lost 47 seats after its highly criticized shift to the right, forcing its leader Alberto Rivera to resign. The party’s seats were largely captured by the far-right Vox party, which won 15.1% of the popular vote and more than doubled its seats (Chart 18). Socialist leader Pedro Sanchez has arranged a preliminary governing agreement with Podemos leader Pablo Iglesias, but it is unstable. Even with Podemos, Sanchez falls far short of the 176 seats he needs to govern. In fact, there are only three possible scenarios in which the Socialists can reach the required 176 seats and none of these scenarios are easy to negotiate (Chart 19). The first – a coalition with the People’s Party – can already be ruled out. The other two require the support of the smaller pro-independence party, which will be difficult for Sanchez to secure, given that he hardened his stance on Catalonia in the days leading up to the election. Chart 19No Simple Way To A Majority Government Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 The next step for Sanchez is to be confirmed as prime minister in an “investiture” vote, likely on December 16.5 He would need 176 votes in the first round (or a simple majority in the second round) to gain the confidence of Congress. He looks to fall short (Chart 20).6 If he fails to be confirmed, Sanchez will have another two months to form a government or face the possibility of yet another election. Chart 20Sanchez Set To Fall Short In Investiture Vote Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Spain’s indecision is leading to small conflicts with Brussels. Last week, the European Commission placed Spain under the preventative arm of the Stability and Growth Pact, stating that the country had not done enough to reach its medium-term budget objective.7 The European Commission’s outlook on Spain is slightly more pessimistic than that of the Spanish government (Chart 21). Deficit projections could worsen if a left-wing government takes power that includes the anti-austerity Podemos – which means that Spain is the only candidate for a substantial fiscal policy surprise. Chart 21A Fiscal Policy Surprise In Spain? Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 22Spanish Risk Will Keep Rising Spanish Risk Will Keep Rising Spanish Risk Will Keep Rising We expect our Spanish risk indicator to keep rising (Chart 22). The silver lining is that Spain’s turmoil – like Germany’s – poses no systemic risk to the Euro Area. Spain could also see an increase in fiscal thrust. Stay long Italian government bonds and short Spanish bonos. Bottom Line: We remain tactically long Italian government bonds and short Spanish bonos. Italian bonds will sell off less in a risk-on phase and rally more in a risk-off phase, and relative political trends reinforce this trade. Emerging Markets: Global Unrest Civil unrest is unfolding across the world, grabbing the attention of the global news media (Chart 23). The proximate causes vary – ranging from corruption, inequality, governance, and austerity – but the fear of contagion is gaining ground. Chart 23Pickup In Civil Unrest Raising Fear Of Contagion Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 A country’s vulnerability to unrest can be gauged by two main factors: political voice and underlying economic conditions. • Political Voice: The Worldwide Governance Indicators, specifically voice and accountability, corruption, and rule of law, provide proxies for political participation (Chart 24). The aim is to assess whether there is a legitimate channel for discontent to lead to change. Countries with low rankings are especially at risk of experiencing unrest when the economy is unable to deliver. Chart 24Greater Risk Of Unrest Where Political Voice Is Absent Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 • Economic Conditions: Last year’s tightening monetary conditions, the manufacturing and trade slowdown, the US-China trade war, and a strong US dollar have weighed on global growth this year. This is challenging, especially for economies struggling to pick up the pace of growth (Chart 25). It translates to increased job insecurity, in some cases where insecurity is already rife (Chart 26). The likelihood that economic deterioration spurs widespread unrest depends on both the level and change in these variables. The former political factor is a structural condition that becomes more relevant when economic conditions deteriorate. Chart 25The Global Slowdown Weighed On Growth In Regions Already Struggling … Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 26… And Raise Job Insecurity Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 27Brazilian Risk Unlikely To Reach Previous Highs Brazilian Risk Unlikely To Reach Previous Highs Brazilian Risk Unlikely To Reach Previous Highs BCA Research is optimistic on global growth as we enter the end game of this business cycle. Nevertheless risks to this view are elevated and emerging market economies are still reeling from the past year’s slowdown. This makes them especially sensitive to failures on the part of policymakers. As a result, policymakers will be more inclined to ease monetary and fiscal policy and less inclined to execute structural reforms. Brazil is a case in point. Our indicator is flagging a sharp rise in political risk (Chart 27). This reflects the recent breakdown in the real – which can go further as the finance ministry has signaled it is willing to depreciate to revive growth. Meanwhile the administration has postponed its proposals to overhaul the country’s public sector, including measures to freeze wages and reduce public sectors jobs. On the political front, President Jair Bolsonaro’s recent break from the Social Liberal Party and launch of a new party, the Alliance for Brazil, threatens to reduce his ability to get things done. This move comes at a time when Brazil’s political landscape is being shaken up by former president Luiz Inacio Lula da Silva’s release from jail, pending an appeal against his corruption conviction. The former leader of the Worker’s Party lost no time in vowing to revive Brazil’s left. Our risk indicator might overshoot due to currency policy, but we doubt that underlying domestic political instability will reach late-2015 and mid-2018 levels. Brazil has emerged from a deep recession, an epic corruption scandal, and an impeachment that led to the removal of former president Dilma Rousseff. It is not likely to see a crisis of similar stature so soon. Bolsonaro’s approval rating is the lowest of Brazil’s recent leaders, save Michel Temer, but it has not yet collapsed (Chart 28). An opinion poll held in October – prior to Lula’s release – indicates that Bolsonaro is favored to win in a scenario in which he goes head to head against Lula (Chart 29). Justice Minister Sergio Moro, who oversaw the corruption investigation, is the only candidate that would gain more votes when pitted against Bolsonaro. He is working with Bolsonaro at present and is an important pillar of the administration. So it is premature to pronounce Bolsonaro’s presidency finished. Chart 28Bolsonaro’s Approval, While Relatively Low, Has Not Collapsed Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Chart 29Bolsonaro Not Yet Finished Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 The problem, as illustrated in Charts 25 and 26, is that Brazil still suffers from slow growth and an uninspiring job market – longstanding economic grievances. This will induce the administration to take a precautionary stance and slow the reform process. The result should be reflationary in the short run but negative for Brazil’s sustainability over the long run. There is still a positive path forward. Unlike the recently passed pension cuts and the public sector cuts that were just postponed – both of which zap entitlements from Brazilians – the other items on the reform agenda are less controversial. Privatization and tax reform are less politically onerous and will keep the government and economy on a positive trajectory. Meanwhile the pension cuts are unlikely to be a source of discontent as they will be phased in over 12-14 years. Thus, while the recent political events justify a higher level of risk, speculation regarding the likelihood of mass unrest in Brazil – apart from the mobilization of Worker’s Party supporters ahead of the municipal elections next fall – is overdone. Bottom Line: The growth environment in emerging markets is set to improve in 2020. US-China trade risk is falling and China will do at least enough stimulus to be stable. Moreover emerging markets will use monetary and fiscal tools to mitigate social unrest. This will not prevent unrest from continuing to flare. But not every country that has unrest is globally significant. Brazil is a major market that has recently emerged from extreme political turmoil, so a relapse is not our base case. Otherwise one should monitor Hong Kong’s impact on the trade deal, Russia’s internal stability, and the danger that Iranian and Iraqi unrest could cause oil supply disruptions. In the event that the global growth rebound does not materialize we expect Mexico and Thailand – which have better fundamentals – to outperform. Our long Thai equity relative trade is a strategic defensive trade.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Roukaya Ibrahim Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Footnotes 1 Please see “Merkel’s Successor Splits German Coalition With Rogue Syria Plan,” dated October 22, 2019 and “Merkel's Own Party Wants Outright Huawei Ban From 5G Networks,” dated November 15, 2019, available at bloomberg.com. 2 Please see “Scholz Says No Need for German Stimulus After Dodging Recession,” dated November 14, 2019, available at bloomberg.com. 3 Please see “France: Draft Budgetary Plan For 2020,” dated October 15, 2019, available at ec.europa.eu. 4 Please see “Analysis of the Draft Budgetary Plan of Italy,” dated November 20, 2019, available at ec.europa.eu. 5 Please see “Investiture calendar | Can a government be formed before Christmas?” dated November 14, 2019, available at elpais.com. 6 If Sanchez convinces PNV, BNG, and Teruel Exists to vote in his favor for both rounds of the vote, he would need ERC and Eh Bildu to abstain in order to win. However, given that the PSOE has stated that it will not even negotiate with Eh Bildu, it is likely that this party will vote against Sanchez, giving the opposition 168 votes. In this case, Sanchez would not only need PNV, BNG, and Teruel in his favor, but also the support of either CC or ERC, both unlikely scenarios. 7 Please see “Commission Opinion on the Draft Budgetary Plan of Spain,” dated November 20, 2019, available at ec.europa.eu. Appendix Germany: GeoRisk Indicator Germany: GeoRisk Indicator Germany: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator France: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator Spain: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator UK: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator Canada: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator China: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Taiwan: GeoRisk Indicator Korea: GeoRisk Indicator  Korea: GeoRisk Indicator Korea: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Russia: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Brazil: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator Turkey: GeoRisk Indicator What's On The Geopolitical Radar? Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Global Unrest And A Christmas Election – GeoRisk Update: November 29, 2019 Section III: Geopolitical Calendar

An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities bca.ems_wr_2019_11_28_s1_c1 bca.ems_wr_2019_11_28_s1_c1 I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies bca.ems_wr_2019_11_28_s1_c3 bca.ems_wr_2019_11_28_s1_c3   Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle bca.ems_wr_2019_11_28_s1_c4 bca.ems_wr_2019_11_28_s1_c4 Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect China: A Weak Multiplier Effect China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession China Construction Is In Recession China Construction Is In Recession   It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak EM/China Capex Is Very Weak EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers No Recovery For Chinese Consumers No Recovery For Chinese Consumers     In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over?   European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence European Manufacturing And Business Confidence European Manufacturing And Business Confidence   In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices EM Profits And Share Prices EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US   In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies bca.ems_wr_2019_11_28_s1_c15 bca.ems_wr_2019_11_28_s1_c15 In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks High-Beta Stocks High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture European Equities: At A Critical Juncture European Equities: At A Critical Juncture   That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market bca.ems_wr_2019_11_28_s1_c17 bca.ems_wr_2019_11_28_s1_c17 Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen   Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable   The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Brazil: The Economy Is Weak Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining   The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices BRL And Commodities Prices BRL And Commodities Prices Chart II-6Widening Current Account Deficit Widening Current Account Deficit Widening Current Account Deficit   Chart II-7The BRL Is Not Cheap The BRL Is Not Cheap The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    Processing trade includes imports of goods that undergo further processing before being re-exported.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Duration: A survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Credit Cycle: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. IG Valuation: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk. Feature Chart 1Recession Risk Getting Priced Out Recession Risk Getting Priced Out Recession Risk Getting Priced Out The bond sell-off continued last week, driven by positive developments in US/China trade negotiations and tentative signs of stabilization in some global growth indicators. The renewed sense of economic optimism has reduced the recessionary risk priced into bond markets. The 2/10 Treasury slope has steepened 30 bps since it briefly inverted in late August. During that same period, the 2-year Treasury yield is up 15 bps, the 10-year yield is up 45 bps and the Bloomberg Barclays Treasury index has underperformed a position in cash by 2.7% (Chart 1). These recent developments raise two important questions. First, should investors chase or fade the back-up in Treasury yields? And second, if the sell-off does continue, how high can yields go? To answer these questions we turn to the five macro factors that drive trends in US bond yields. These factors were outlined in our “Bond Kitchen” report from last April, and are listed right here:1 Global growth Policy uncertainty The US dollar The output gap Sentiment Back In The Kitchen Global Growth Chart 2CRB Index Needs To Rebound CRB Index Needs To Rebound CRB Index Needs To Rebound Three global growth indicators are particularly relevant for US Treasury yields. They are the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index. The latter is especially useful because it updates on a daily basis. Considering the CRB index, we notice that, while it is no longer in a steep downtrend, it has also not rebounded alongside the jump in bond yields (Chart 2). This should give us pause. Continued low readings from the CRB index make it more likely that bond yields will fall back in the coming weeks. We should also note that the ratio between the CRB index and Gold is more highly correlated with the 10-year Treasury yield than the CRB index itself.2 This ratio has bounced off its lows (Chart 2, top panel), but only because Gold has come under downward pressure. With the Fed committed to maintaining an accommodative policy stance until inflation expectations are re-anchored, we expect the Gold price to remain well bid. This means that raw industrials prices must rebound to keep the ratio trending higher. The CRB/Gold ratio has bounced off its lows, but only because Gold has come under downward pressure. More encouraging than the CRB index is the Global Manufacturing PMI, which has moved off its lows during the past three months (Chart 3). The increase has been partially driven by stronger US readings (Chart 3, panel 2), but principally by a significant jump in China’s PMI (Chart 3, bottom panel). Chart 3China Pulling The Global Manufacturing PMI Higher China Pulling The Global Manufacturing PMI Higher China Pulling The Global Manufacturing PMI Higher Somewhat stronger China PMI readings should be expected, given the rebound in our China Investment Strategy’s Li Keqiang Leading Indicator – a composite measure of monetary conditions, money and credit growth (Chart 4).3 We should also expect further modest policy stimulus from China, as long as the labor market remains under pressure (Chart 4, bottom panel). Turning to the US, we have seen three very positive developments in the economic data during the past month. First, the ISM Services PMI jumped from 52.6 to 54.7 in October (Chart 5). A drop in this index to 50 or below would be consistent with a US recession, while the combination of a strong service sector and a depressed manufacturing sector is consistent with our baseline 2015/16 roadmap. This roadmap leads to an eventual rebound in the manufacturing index. Second, the ISM Manufacturing PMI rose a tad in October, but the New Export Orders component jumped significantly from 41 to 50.4 (Chart 5, panel 2). Since the global slowdown began as a non-US phenomenon, a rebound in this export component sends a strong signal that we are at an inflection point. Finally, consumer confidence rose in October following a sharp decline in September. A year-over-year decline in the consumer confidence index is a reasonably strong recession signal, but recent data suggest that this signal is fading (Chart 5, bottom panel). Chart 4Modest Stimulus In China Modest Stimulus In China Modest Stimulus In China Chart 5Three Positive Developments Three Positive Developments Three Positive Developments All in all, the global growth data have turned more positive during the past month. US indicators, in particular, are no longer sending strong recessionary signals. A rebound in the CRB Raw Industrials index would give us more confidence in the durability of the recent rise in Treasury yields. Policy Uncertainty Uncertainty about the US/China trade conflict has eased considerably during the past few weeks, as the two sides appear to be working toward a “phase 1” deal that would prevent the imposition of new tariffs and roll back some that are already in place. Heightened uncertainty about the trade war played a large role in dragging bond yields lower in 2019. This becomes apparent when you notice that survey and sentiment (aka “soft”) data about the economic outlook have been significantly worse than the actual “hard” data on US economic activity.4 It is clear that negative sentiment about the trade war has held survey data and bond yields down, even as underlying US economic activity has been solid. Less bullish dollar sentiment supports a continued uptrend in Treasury yields.  We see a continued easing of trade tensions as we head into the first half of next year. President Trump has an incentive to support the economy in an election year, given the historical record of incumbent presidents being re-elected when the economy is strong. However, if this strategy doesn’t work and Trump finds himself behind in the polls by the end of next summer, then he could decide that ramping up the trade war again is the best course of action. In other words, another spike in policy uncertainty in the second half of 2020 is possible if President Trump is trailing in the polls. The US Dollar Chart 6Dollar Sentiment Points To Higher Yields Dollar Sentiment Points To Higher Yields Dollar Sentiment Points To Higher Yields The US dollar is important for the path of US Treasury yields because it signals whether US yields are decoupling from yields in the rest of the world. In other words, if the dollar appreciates significantly alongside rising Treasury yields, then we should view those yields as increasingly out of step with the rest of the world, and thus more likely to fall back down. So far, the dollar has been relatively flat as yields have risen and bullish sentiment toward the US dollar has declined significantly (Chart 6). Less bullish dollar sentiment supports a continued uptrend in Treasury yields. But if yields do in fact continue to rise, it will be important to watch the dollar’s reaction. The Output Gap Chart 7Wage Gains Hurting Margins, Not Raising Prices Wage Gains Hurting Margins, Not Raising Prices Wage Gains Hurting Margins, Not Raising Prices Some sense of the output gap is important for forecasting bond yields. This is because the same amount of global growth will lead to more inflationary pressure and higher bond yields when the output gap is small than when it is large. The fact that the output gap is smaller now than it was in 2016 is probably the reason why the 10-year Treasury yield bottomed 10 bps above its 2016 trough this year, and why the average Treasury index yield bottomed 47 bps above its 2016 trough. We have found wage growth to be an excellent indicator of the output gap, and noted in a recent report that wage growth should continue to accelerate.5 In this vein, another crucial variable to monitor is labor compensation as a percent of national income (Chart 7). The rise in this series indicates that wage gains during the past few years have come at the expense of corporate profit margins, and have not been passed through to higher consumer prices. If this series proves to have a lot more cyclical upside, then it could be some time before wage acceleration translates to higher inflation. Sentiment Chart 8Surprise Index Says Sentiment Is Neutral Surprise Index Says Sentiment Is Neutral Surprise Index Says Sentiment Is Neutral The final factor we consider when forecasting US Treasury yields is sentiment. We have found that the Economic Surprise Index is the single best measure of aggregate market sentiment. That is, when the Surprise index reaches a positive or negative extreme, it usually means that sentiment is too positive or too negative, and will mean-revert in the months ahead. Also, we have observed a strong correlation between the Surprise index and changes in Treasury yields (Chart 8). At present, the Surprise index is roughly neutral, and therefore does not send a strong signal about where sentiment might push bond yields during the next few months. Investment Conclusions To summarize, the outlook from our five macro factors suggests that Treasury yields will rise further in the coming months. Global growth indicators are showing tentative signs of bottoming, and should rise to levels more consistent with the “hard” economic data as policy uncertainty continues to wane. The fact that the US economic data look less recessionary than they did one month ago makes us more confident that our global indicators will rebound. Chart 9A Clear Path To 2.5% A Clear Path To 2.5% A Clear Path To 2.5% We would become concerned about a renewed downtick in yields if the CRB Raw Industrials index fails to rebound, or if the dollar strengthens significantly in the coming weeks. At the beginning of this report, we asked how high Treasury yields can go if the global growth rebound proves durable. To answer that question we refer to current estimates of the long-run neutral fed funds rate. The FOMC’s median estimate of the long-run neutral fed funds rate is 2.5% and the median estimate from the New York Fed’s Survey of Market Participants is 2.48%, with an interquartile range of 2.25% - 2.5%. If recessionary fears move to the back burner, it would be logical for long-dated yields to converge toward those levels. That is in fact what happened in recent years, with the 5-year/5-year forward Treasury yield peaking several times at levels close to the Fed’s median neutral rate estimate (Chart 9). With this in mind, we see a clear path to 2.5% on the 5-year/5-year forward Treasury yield, with the 10-year yield reaching similar levels since the 5/10 Treasury slope is likely to remain flat (Chart 9, bottom panel). For yields to eventually move above 2.5%, the market would have to re-consider its outlook for the long-run neutral fed funds rate. We discussed what factors to monitor in this regard in a recent report.6 Bottom Line: Treasury yields have moved significantly higher in recent weeks, but a survey of the five factors that determine the path for Treasury yields suggests that further upside is likely. We see a clear path to 2.5% for long-maturity Treasury yields as recessionary risk moves to the back burner in the coming months. Checking In On The Credit Cycle In previous reports, we mentioned that three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health Monetary conditions Valuation We last presented a detailed examination of these factors in a report from mid-September, concluding that accommodative monetary conditions will support corporate bond excess returns, despite deteriorating balance sheet health.7 Three factors drive our view of corporate bond spreads and the credit cycle: Balance sheet health, monetary conditions,and valuation. But since then, C&I lending standards – an important indicator of monetary conditions – moved into “net tightening” territory for the third quarter of 2019 (Chart 10). Tightening C&I lending standards, if they persist, would put significant upward pressure on corporate defaults and credit spreads. Chart 10Credit Cycle Checklist: Monetary Conditions Credit Cycle Checklist: Monetary Conditions Credit Cycle Checklist: Monetary Conditions While the recent move in lending standards is concerning, we expect it to reverse in the near future. The yield curve, another indicator of monetary conditions, has steepened in recent months, suggesting that conditions are becoming more accommodative. Also, loan officers reported that the terms on C&I loans continued to ease in Q3, even as overall standards tightened (Chart 10, panel 3). Most importantly, inflation expectations remain extremely low (Chart 10, bottom panel). This gives the Fed every incentive to maintain accommodative monetary conditions. This should give lenders the confidence to ease lending standards, leading to tight credit spreads and a low corporate default rate. Bottom Line: C&I lending standards tightened on net in the third quarter of 2019. But other indicators of monetary conditions point to continued accommodation. We expect lending standards will soon move back into “net easing” territory. Remain overweight Spread Product versus Treasuries. Downgrade Investment Grade Corporates To Neutral Last week, we downgraded our recommended allocation to investment grade corporate bonds from overweight to neutral.8 We maintain a positive view of the credit cycle, and expect that corporate bonds will continue to outperform Treasuries. However, investment grade corporate spreads no longer provide adequate compensation for their level of risk. We maintain an overweight allocation to high-yield corporates, where spreads remain attractive. Chart 11 shows that investment grade corporate spreads have tightened somewhat in recent months, but that they remain well above the tights seen in early 2018. However, the chart also shows that average index duration has increased considerably this year. All else equal, higher index duration justifies a wider spread. In contrast, notice that high-yield index duration fell this year (Chart 11, bottom panel). This is because high-yield bonds usually carry embedded call options, making them negatively convex. All else equal, lower index duration makes the spread offered by the high-yield index more attractive. Because changes in spread and duration are both important, we prefer to use the 12-month breakeven spread as our main valuation tool. This measure is the spread widening required on a 12-month investment horizon to underperform a duration-matched position in Treasuries. It can be approximated by dividing the option-adjusted spread by duration. Chart 12 shows investment grade 12-month breakeven spreads as a percentile rank since 1995. The overall message is that spreads have rarely been lower. Chart 11Higher Durations Makes IG Spreads Look Too Tight Higher Durations Makes IG Spreads Look Too Tight Higher Durations Makes IG Spreads Look Too Tight Chart 12Investment Grade Corporate Spreads Have Rarely Been Lower Investment Grade Corporate Spreads Have Rarely Been Lower Investment Grade Corporate Spreads Have Rarely Been Lower Finally, we can also recognize that spreads tend to be tight in the middle and late stages of the credit cycle. In the current environment, that means we should expect spreads to be near the bottom of their historical ranges. To control for this fact, we re-calculate our breakeven spread percentile ranks using only mid-cycle periods when the slope of the yield curve is between 0 bps and 50 bps. We can then back-out spread targets for each credit tier based on the median 12-month breakeven spreads seen in similar macro environments. Chart 13 shows that spreads for all investment grade credit tiers have moved below our targets. High-yield spreads are not shown, but they remain well above target levels.9 Chart 13Spreads For All IG Credit Tiers Are Below Target Spreads For All IG Credit Tiers Are Below Target Spreads For All IG Credit Tiers Are Below Target In place of investment grade corporates, which have become expensive, we recommend upgrading Agency MBS. MBS now offer expected returns that are comparable with corporate bonds rated A or higher, with considerably less risk.10 Bottom Line: Investment grade corporate bond spreads for all credit tiers are now below our fair value targets. We recommend only a neutral allocation to the sector. Investors should prefer high-yield bonds, where spreads are more attractive, and Agency MBS, which offer competitive expected returns and much less risk.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 For details on why the ratio between the CRB Raw Industrials index and Gold tracks the 10-year Treasury yield please see US Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com 3 Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com 4 For more details on the divergence between “soft” and “hard” data please see US Bond Strategy Weekly Report, “Crisis Of Confidence”, dated October 22, 2019, available at usbs.bcaresearch.com 5 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 6 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com 7 Please see US Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 8 Please see US Bond Strategy Portfolio Allocation Summary, “The Fed Will Stay Supportive”, dated November 5, 2019, available at usbs.bcaresearch.com 9 For details on how we calculate our spread targets please see US Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 10 For more details on the positive outlook for MBS please see US Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The slowdown in global industrial activity appears to have bottomed. This, along with an apparent shared desire for a ceasefire in the Sino-US trade war, points toward a measured recovery in manufacturing and global trade, which will contribute to higher iron-ore and steel demand beginning in 1H20. A trade-war ceasefire, should it endure, will reduce global economic uncertainty. Along with continued monetary accommodation from systematically important central banks, reduced economic uncertainty will boost global growth and industrial-commodity demand generally by allowing the USD to weaken. We expect Beijing policymakers to remain focused on keeping GDP growth above 6.0% p.a. To that end, we believe a boost in infrastructure spending next year is likely, which also will be bullish for steel demand. Given China’s growing share of global steel production, we expect price differentials for high-grade iron ore – most of which comes from Brazil – to widen as steel demand increases next year. Given this view, we are initiating a strategic iron-ore spread trade at tonight’s close: Getting long December 2020 high-grade (65% Fe) futures traded on the Singapore Exchange vs. short the benchmark-grade (62% Fe) December 2020 futures traded on the CME. We recommend a 20% stop-loss on this recommendation. Feature Iron ore and steel demand will get a lift from the rebound our proprietary Global Industrial Activity (GIA) index has been forecasting for the past few months (Chart of the Week). The GIA index is designed to pick up changes in Chinese industrial activity, given its outsized influence on world industrial output, and also makes use of trade data, FX rates, and global manufacturing data. The rebound we are expecting will get a fillip from an apparent shared desire for a ceasefire in the Sino-US trade war, which, based on media reports, is close to being agreed. Should this ceasefire prove to be durable, it would contribute to a lowering of global economic policy uncertainty (GEPU), which, as we have shown recently, has kept the USD well bid to the detriment of industrial-commodity demand.1 Chart of the WeekBCA GIA Index Pick-Up Points To Higher Global Steel Demand BCA GIA Index Pick-Up Points To Higher Global Steel Demand BCA GIA Index Pick-Up Points To Higher Global Steel Demand While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. As global economic uncertainty fades, the USD broad trade-weighted index for goods (TWIBG) will fall, which will bolster EM GDP growth, and a recovery in global trade next year (Chart 2). If, as media reports suggest, this so-called “phase-one” agreement includes a relaxation – or complete removal – of tariffs by the US on Chinese imports, we would expect manufacturing activity to pick up as Chinese manufacturers spin-up capacity to meet demand. A reduction in tariffs also will lessen the deadweight loss they imposed on US households, which will support higher consumption.2 Chart 2Reduced Global Economic Uncertainty Bolsters Global Trade Volumes, EM GDP Iron Ore, Steel Prices Set To Lift Iron Ore, Steel Prices Set To Lift That said, economic uncertainty still remains high. This uncertainty is destructive of demand and will remain a key risk factor in 2020. While we do expect economic uncertainty to decline next year, it will remain elevated due to continued Sino-US trade tensions – even if a “phase-one” deal is agreed – ongoing hostilities in the Persian Gulf, and popular discontent with the political status quo globally. China’s Steel Demand Holds Up In Trade War China accounts for more than half of global steel production and consumption, and the lion’s share of seaborne iron-ore consumption (Chart 3). This makes its steel industry critically important to the global economy, and a key barometer of industrial activity worldwide. With global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises. China’s apparent steel demand held up fairly well during the slowdown observed in manufacturing and in commodity demand growth globally, averaging 8% y/y growth ytd (Chart of the Week, bottom panel). It now appears to be stalling in the wake of the global manufacturing slowdown. In addition, Chinese credit stimulus remains weak, contrary to expectations. However, with global industrial activity bottoming and moving higher, and the USD expected to weaken, we expect iron ore demand and steel production in China to move higher next year as domestic and global demand for steel rises.3 Chart 3China Dominates Global Steel Production and Consumption China Dominates Global Steel Production and Consumption China Dominates Global Steel Production and Consumption Chart 4Construction, Real Estate Strength Offset Lower Chinese Auto Production Construction, Real Estate Strength Offset Lower Chinese Auto Production Construction, Real Estate Strength Offset Lower Chinese Auto Production Greater demand for steel by the construction and real estate sectors offset lower consumption by the automobile industry in China this year, as manufacturing and trade slowed globally (Chart 4). Overall, apparent demand is still growing (Chart 5), which will continue to support iron ore imports, even though domestic production of low-grade ore picked up as steelmakers’ margins tightened earlier in the year (Chart 6). Chart 5China"s Apparent Steel Demand Growth Holds Up During Industrial Slowdown China"s Apparent Steel Demand Growth Holds Up During Industrial Slowdown China"s Apparent Steel Demand Growth Holds Up During Industrial Slowdown Chart 6China Iron Ore Imports Remain Stout China Iron Ore Imports Remain Stout China Iron Ore Imports Remain Stout Chinese imports from Brazil have rebounded following the Brumadinho tailings dam collapse in January at Vale’s Córrego do Feijão iron ore mine, which killed close to 300 people. The collapse in margins from steel mills combined with outages to Brazil and Australia high-grade ore exports led to a rise in imports and domestic production of low-grade iron ore. High-Grade Iron Ore Favored; Policy Uncertainty Persists Our overall view for industrial commodities – iron ore, steel, base metals and crude oil – is constructive but not wildly bullish going into next year. Our oil view, for example, calls for a rally in the average price of crude oil next year of ~ 10% from current levels for Brent crude oil, the world benchmark. While we expect global monetary stimulus to offset much of the tightening of financial conditions brought on by the Fed’s rate hikes last year, and China’s de-leveraging campaign of 2017-18, elevated economic uncertainty will keep the USD better bid that it otherwise would be absent the Sino-US trade war and global economic policy uncertainty. This translates into weaker commodity demand, generally, as a strong USD raises local-currency costs for consumers and lowers local-currency production costs for producers. At the margin, both push commodity prices lower. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. For iron ore and steel in particular, environmental considerations also are important, given the Chinese government's “Blue Skies Policy” aimed at reducing the country’s high levels of air pollution.4 This policy has led to the forced retirement of older, highly polluting steelmaking capacity, which has been replaced with newer, less-polluting technology that favors high-grade iron ore. However, the application of regulations designed to reduce pollution has been uneven, and still relies on local compliance, which has been spotty. We expect demand for high-grade ore will increase as global manufacturing and trade also recovers. On a relative basis, we expect the more efficient, less-polluting technology likely will be called on to meet higher steel demand – in China and globally – next year, which means higher-grade iron ore will be favored by Chinese steel mills as profitability improves. The restoration of high-grade exports from Brazil means this ore will be available. It is worthwhile noting that these steelmakers account for an increasing share of global capacity. For this reason, we expect demand for high-grade ore will increase as global manufacturing and trade also recovers (Chart 7). Given our view, at tonight’s close we will get long December 2020 high-grade iron-ore futures (65% Fe) traded on the Singapore Exchange vs. short benchmark-grade iron-ore futures (62% Fe) traded on the CME. Both are quoted in USD/MT and settle basis Chinese port-delivery (CFR) indexes in cash. Given the uncertain nature of the durability and depth of the ceasefire currently being negotiated by the US and China, we will keep a stop-loss on this position of 20%. Bottom Line: China’s steel demand has held up relatively well despite the global slowdown in manufacturing and trade. Given our expectation for a pick-up in global growth – in response to global monetary and fiscal stimulus and lower economic uncertainty in the wake of a ceasefire in the Sino-US trade war – we expect Chinese steel demand to resume growing. This will support iron ore prices, particularly for high-grade ores. On the back of this expectation, we are recommending an iron-ore spread trade, going long high-grade futures vs. short benchmark-grade iron ore futures. Chart 7High-Grade Iron Ore Should Outperform Strategically High-Grade Iron Ore Should Outperform Strategically High-Grade Iron Ore Should Outperform Strategically   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Market Round-Up Energy: Overweight. Bloomberg reported China is looking to invest between $5-$10 billion in the Saudi Aramco IPO through various vehicles. Such an investment would give China a deeper stake in the Kingdom’s oil industry, and a hedge to price shocks. In addition, it could open the way for deeper investment in the Saudi oil and petchems industries. For KSA, as we have argued in the past, a deepening of China’s investment and involvement in the Kingdom’s economy would diversify the states that have a vested interest in ensuring its safety.5 We will be updating our analysis of China’s pivot to the Middle East, and KSA’s pivot to Asia next week. Separately, we the last of our Brent backwardation trades – i.e., long December 2019 Brent vs. short December 2020 Brent – was closed last week with a gain of 110.8%. Base Metals: Neutral. Copper prices are up 6% vs. last month, supported by supply-side worries in Chile and, more recently, easing trade tensions. Cyclically, we believe copper prices are turning up – spurred by easy monetary conditions and fiscal stimulus directed at infrastructure and construction spending. Most of our key commodity-demand indicators have bottomed and are suggesting EM demand growth will move up. This supports a year-end base metal rally. Precious Metals: Neutral. A risk-on sentiment fueled by expectation the U.S. and China will sign a trade deal weighs on gold’s safe-haven demand. Prices fell 2% since last week. Additionally, U.S. 10-year bond yields shot higher – pushing gold prices lower – on Tuesday following a stronger-than-expect ISM services PMI data release. Gold-backed ETF holdings reached a new record in September at 2,855 MT (up 377 MT ytd), surpassing the December 2012 peak. A reversal in investors’ sentiment towards gold could send prices down. Ags/Softs: Underweight. The USDA reported that 52% of the U.S. corn has been harvested, a 13 percentage point increase relative to last week, yet the figure came shy of analysts’ expectation and far below the 2014-2018 average of 75%. On a weekly basis, corn prices are still down 2% due to drier weather forecast. Soybean harvest did better reaching 75%, and meeting expectations. Soybean price is almost unchanged on a weekly basis, despite having edged higher earlier in the week on the back of rising expectations the US and China will agree on a ceasefire in the ongoing trade war.   Footnotes 1     We measure this uncertainty using the Baker-Bloom-Davis Global Economic Policy Uncertainty (GEPU) index. This is a GDP-weighted index of newspaper headlines containing a list of words related economic uncertainty. Newspapers from 20 countries representing almost 80% of global GDP are scoured for reports reflecting economic uncertainty. Please see our October 17 and October 31, 2019, reports Policy Uncertainty Lifts USD, Stifles Global Oil Demand Growth and Global Financial Conditions Support Higher Commodity Demand for the original research on this topic. Both are available at ces.bcaresearch.com. 2    We discuss deadweight losses to US households arising from the tariffs in Waiting To Get Long Copper, In China’s Steel Slipstream, published August 29, 2019. It is available at ces.bcaresearch.com. 3    BCA Research’s China Investment Strategy expects China’s business cycle likely will bottom in 1Q20 of next year, rather than in 4Q19. This aligns with our expectation. Please see China Macro And Market Review, published November 6, 2019. It is available at cis.bcaresearch.com. 4    We examined the implications of China’s “Blue Skies” policy in China's Anti-Pollution Resolve Critical To Iron Ore Markets, published April 4, 2019. It is available at ces.bcaresearch.com. 5    We discuss these issues in our Special Report entitled ضد الواسطة published November 16, 2018. The Arabic title of the report translates as "Against Wasta." Wasta means reciprocity in formal and informal dealings. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q3 Iron Ore, Steel Prices Set To Lift Iron Ore, Steel Prices Set To Lift Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Iron Ore, Steel Prices Set To Lift Iron Ore, Steel Prices Set To Lift

Martin Barnes and I spent last week visiting clients in Hong Kong and Singapore in celebration of BCA’s 70th anniversary. Martin has been with BCA Research for 32 years and has been a keen observer of market trends for much longer than that. It is always fascinating to hear his thoughts on the state of world affairs. I have spent this week visiting clients in Sydney and Melbourne. I made the case that global growth will accelerate next year. Stronger growth will pull down the U.S. dollar, while pushing up bond yields, equities, and commodity prices. EM and European stocks will begin to outperform their global benchmark. Cyclical equity sectors (including financials) will outperform defensives. What follows are my answers to some of the most common questions I have been receiving. Best regards, Peter Berezin, Chief Global Strategist Feature Q: What makes you confident that global growth will rebound? A: Three things. First, global financial conditions have eased significantly thanks largely to the dovish pivot of most central banks. Reflecting this development, credit growth has picked up. This should support economic activity in the months ahead (Chart 1). Second, the manufacturing downturn seems to be running its course, as excess inventories continue to be liquidated (Box 1). As we have noted before, manufacturing cycles tend to last about three years, with 18 months of weaker growth followed by 18 months of stronger growth (Chart 2). Given that the current downturn began in the first half of 2018, we are probably approaching a bottom in growth. Chart 1Lower Rates Should Help Spur Growth Lower Rates Should Help Spur Growth Lower Rates Should Help Spur Growth Chart 2A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle A Fairly Regular Three-Year Manufacturing Cycle Third, while there will be plenty of bumps along the road, trade tensions are likely to continue easing. As a self-described master negotiator, President Trump has to produce a “tremendous” deal for the American people. Had he negotiated an agreement with China a year or two ago, he would currently be on the hook for showing that it resulted in a smaller trade deficit. But with the presidential election only a year away, he can semi-credibly claim that the trade balance will only improve after he is re-elected. For their part, the Chinese would rather grapple with Trump now than risk either having to negotiate with him during his second term (when he will be unconstrained by re-election pressures) or having to negotiate with Elizabeth Warren (who may insist on including stringent environmental and human rights provisions in any trade deal). Better the devil you know than the devil you don’t, as they say. Q: Will a ceasefire between the U.S. and China really be enough to boost business confidence? Don’t we need to see an outright rollback of tariffs? A: We do not know if any tariffs will be rolled back as part of the “phase 1” deal that is currently being negotiated. Right now, the U.S. has only agreed to cancel the previously announced October 15th tariff hike on $250 billion of Chinese imports. A Reuters news story earlier this week indicated that China is also asking the U.S. scrap its plan to levy tariffs on $156 billion of Chinese imports on December 15th and to abolish the 15% tariffs on $125 billion in imports which were imposed on September 1st.1 Chart 3China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was China Is No Longer As Dependent On Trade With The U.S. As It Once Was While the removal of some tariffs would be a positive development, it is not a necessary condition for a global growth revival. Remember that U.S. exports to China account for only 0.5% of GDP while Chinese exports to the U.S. account for 3.4% of GDP (Chart 3). The numbers are even smaller when measured in value-added terms. That does not mean that the trade war is irrelevant. An out-of-control trade war could cause the global supply chain to break down, leading to significant economic disruptions. To the extent that a détente greatly reduces the odds of such an outcome, it justifies a meaningful upgrade to the probability-weighted economic outlook. Q: What’s your read on the Chinese economy right now? A: China’s growth data have been mixed. The Caixin manufacturing purchasing managers’ index rose to 51.7 in October, the best reading since December 2016. The new orders subcomponent reached the highest level since September 2013. Export orders rose back above 50, registering the largest month-on-month increase of any of the subcomponents. In contrast, the “official” National Bureau of Statistics (NBS) manufacturing PMI, which mainly samples larger, state-owned companies, remained below 50 and sank to the lowest level since February. The NBS nonmanufacturing PMI also weakened. It is worth noting that unlike most of the industries tracked by the NBS, the construction sector PMI moved back above 60 in October. This is consistent with industry data showing that sales of reinforced steel bars, a good proxy for property construction, have accelerated. Electricity consumption has also picked up, which often bodes well for industrial output (Chart 4). Policy has generally remained supportive: Bank reserve requirements have been cut. Benchmark interest rates should come down over the coming months. Credit growth surprised on the upside in September. While the acceleration in credit formation has been more muted this past year than in 2015-16, the credit impulse has nevertheless moved off its late-2018 lows. The Chinese credit impulse leads global growth by about nine months (Chart 5). Chart 4A Positive Sign For Chinese Growth Momentum A Positive Sign For Chinese Growth Momentum A Positive Sign For Chinese Growth Momentum Chart 5The Chinese Credit Cycle Should Support Global Growth The Chinese Credit Cycle Should Support Global Growth The Chinese Credit Cycle Should Support Global Growth   Chart 6China Stepped Up Fiscal Stimulus In 2019 China Stepped Up Fiscal Stimulus In 2019 China Stepped Up Fiscal Stimulus In 2019 Less noticed is the fact that fiscal policy has been eased significantly. According to the IMF, the augmented budget deficit – which includes spending through local government financing vehicles and other off-balance sheet expenditures – is on track to reach nearly 13% of GDP in 2019, a bigger deficit than during the depth of the Great Recession (Chart 6).  Looking out, we expect Chinese growth to rebound next year as the global manufacturing downturn ends and trade war tensions subside. Q: How much of a growth rebound can we expect in Europe? A: The slowdown in the euro area has been concentrated in Italy and Germany. In contrast, growth in Spain and France has held up relatively well (Chart 7). Looking out, Italian growth should rebound thanks to the 270 bps decline in 10-year bond yields that has taken place since October 2018 (Chart 8). German growth should also recover on an improvement in world trade and a stabilization in global auto production and demand. Chart 7Euro Area Growth: The Good, The Bad, And The Ugly Euro Area Growth: The Good, The Bad, And The Ugly Euro Area Growth: The Good, The Bad, And The Ugly Chart 8Lower Yields Should Lift Italian Growth Lower Yields Should Lift Italian Growth Lower Yields Should Lift Italian Growth     Q: Will we see fiscal stimulus in Europe? A: Yes. Fiscal policy remains quite tight in the euro area, but it is starting to loosen at the margin. The fiscal thrust should reach 0.4% of GDP this year, the highest level since 2010 (Chart 9). We expect further modest fiscal easing in 2020, even against a backdrop of stronger domestic economic growth.   Chart 9Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Euro Area Fiscal Stimulus Will Also Boost Growth Chart 10Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating Germany's Competitive Advantage Against The Rest Of The Euro Area Is Deteriorating       Germany has been reluctant to increase its own budget deficit in the past. However, there are at least two reasons why this attitude may slowly change. First, there are growing calls within Germany for more spending on public infrastructure, including on ”green” measures to mitigate climate change. The fact that Germany can issue debt at negative rates only incentivizes fiscal easing. If you can get paid to issue debt, why not do it? Second, relatively fast wage growth has caused Germany to become less competitive against its neighbors over the past eight years. As a result, Germany’s trade surplus with the rest of the euro area has fallen in half (Chart 10). A shrinking trade surplus will require a bigger budget deficit to compensate for the loss of aggregate demand.   Q: Is A “No Deal” Brexit still a risk? A: No. Westminster and the British Supreme Court have both rebuked Prime Minister Boris Johnson’s threat of a “no deal” Brexit. This means that the only outcome that would unsettle markets – a disorderly U.K. exit from the EU – is practically off the table. Two options remain: An orderly Brexit in which an eventual trade deal minimizes tariffs, or another referendum. There is no appetite for a no-deal exit. Furthermore, if another referendum on EU membership were held today, the remain side would probably win (Chart 11). Chart 11Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Brexit Angst: A Case Of Bremorse Q: Is the Fed done cutting rates? A: Yes. The FOMC statement removed the promise to “act as appropriate to sustain the expansion” and replaced it with a more neutral pledge to “monitor the implications of incoming information for the economic outlook”. If there were any ambiguity left about what this meant, Chair Powell squelched it by noting in his press conference that “monetary policy is in a good place” and “the current stance of policy [is] likely to remain appropriate.” This week’s “insurance cut” brings the total for this year to 75 bps. This is exactly the same amount of easing the Fed delivered in 1995/96 and 1998 — two episodes that are widely seen as successful mid-cycle course corrections. Today’s strong employment report and uptick in the ISM manufacturing index provide further evidence that the U.S. economy is on the right track. If U.S. and global growth continue to pick up as we expect, there will not be any need to cut rates further. Q: When can we expect the Fed to start hiking rates again? Chart 12Inflation Expectations Are Too Low Inflation Expectations Are Too Low Inflation Expectations Are Too Low A: Probably not until December 2020 at the earliest. This is partly because the Fed will want to stay out of the political fray leading up to the presidential election (perhaps wishful thinking). Arguably more important, the Fed, along with most market participants, has convinced itself that the neutral rate of interest is very low. If that is truly the case, raising rates is a risky strategy because it could cause growth to weaken at a time when inflation expectations are still below the Fed’s comfort zone (Chart 12). In his recent press conference, Powell seemed to go out of his way to stress that he would not make the same mistake he did last October when he said rates were “a long way from neutral”. Most notably, he said this week that the FOMC “would need to see a really significant move up in inflation that is persistent before we even consider raising rates to address inflation concerns.” Q: How worried should equity investors be about the prospect of President Warren? A: While Elizabeth Warren would not be a welcome treat for shareholders, she probably would not be a disaster either. Right now she is trying to elbow Bernie Sanders out of the race in order to lock up the “progressive” vote. Thus, it is not surprising that she has dialed up the far-left rhetoric. If Warren succeeds in securing the Democratic Party nomination, she will pivot to the centre. Remember this is the same person who said last year she was “a capitalist” and “I love what markets can do… They are what make us rich, they are what create opportunity.”2 Considering that financial sector reform has been the focus of Warren’s academic and legislative career, bank shareholders are understandably worried about what a Warren presidency would entail. They probably shouldn’t be. Banks today operate more like staid utilities than the reckless casinos they were prior to the financial crisis. A lot of the rules and regulations that Warren champions have already been implemented in one guise or another. In fact, it would not be a stretch to say that had these rules been in place 15 years ago, the share prices of many financial institutions would be a lot higher today (especially the ones that went under!). Lastly, one should keep in mind that the U.S. political system has numerous checks and balances. Even if Elizabeth Warren did want to pursue a radical agenda, she would be stymied by moderate Democrats and a Senate which, more likely than not, will remain in Republican control. Q: Taking everything you said on board, how should investors position themselves over the next 12 months? A: Despite the risks facing the global economy, investors should continue to overweight stocks relative to bonds in a balanced portfolio. A rebound in global growth next year will give corporate earnings a lift. As a countercyclical currency, the U.S. dollar is likely to weaken in an environment of improving global growth (Chart 13). The combination of stronger growth and a weaker dollar will boost commodity prices (Chart 14). Chart 13The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 14Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Dollar Weakness Is A Boon For Commodities Cyclical equity sectors normally outperform defensive sectors when the global economy is strengthening and the dollar is weakening (Chart 15).     Chart15ACyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens Cyclical Stocks Will Outperform If The Dollar Weakens Chart 15BCyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives Cyclical Stocks Are More Attractive Than Defensives       We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank net interest margins, flattering profits and share prices (Chart 16). Emerging market and European stocks have more exposure to cyclical sectors than U.S. stocks. Thus, it stands to reason that EM and European equities will outperform their U.S. peers over the next 12 months (Chart 17). Chart 16Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Steeper Yield Curves Will Benefit Financials Chart 17EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves EM And Euro Area Equities Usually Outperform When Global Growth Improves   Non-U.S. stocks also have the advantage of being cheaper, even if adjusted for differences in sector weights. U.S. equities currently trade at a forward PE ratio of 18, compared to 13 for non-U.S. stocks. Since interest rates are generally lower outside the U.S., the equity risk premium is especially wide for non-U.S. stocks (Chart 18). Chart 18Equity Risk Premia Remain Quite High Equity Risk Premia Remain Quite High Equity Risk Premia Remain Quite High Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector   U.S. (October 2019): “Finally, despite a renewed rise in input buying, the stronger increase in new business meant firms increasingly dipped into stocks to ensure new orders were fulfilled in a timely manner. Therefore, pre-production inventories fell at the quickest rate for three months and stocks of finished goods decreased slightly.” Markit “The [inventory] index contracted for the fifth straight month, but at a slower rate. Improvements in new orders and stocking for the fourth quarter both contributed positively to the index compared to September” ISM (Institute for Supply Management) Germany (October 2019): “However, weighing on the index were faster decreases in employment and stocks of purchases, alongside a more marked improvement in supplier delivery times.” Markit U.K. (October 2019): “A number of firms revisited their Brexit preparations during October, leading to higher levels of input purchasing and a build-up of safety stocks. Growth in inventories of finished goods and purchases were at six-month highs, but remained below the survey-record rates reached during the first quarter.” Markit Japan (October 2019): “A reluctance to hold items in stocks was also signalled by simultaneous draw-downs to pre- and post-production inventories during the latest survey period. In fact, rates of depletion in both cases accelerated during the month, with stocks of finished goods falling at the fastest rate since survey data were first collected 18 years ago.” Markit Canada (October 2019): “Latest data signalled a marginal accumulation of preproduction inventories across the manufacturing sector. In contrast, stocks of finished goods were depleted for the first time in three months. A number of survey respondents commented on efforts to boost cash flow by streamlining their post-production inventories.” Markit China (October 2019): “Improved client demand led firms to expand their purchasing activity, with the rate of growth the quickest since February 2018. This contributed to a further rise in stocks of inputs, albeit marginal. Inventories of finished goods meanwhile declined amid reports of the greater use of stocks to fulfil orders.” Markit Taiwan (October 2019): “Stocks of both pre- and postproduction goods contracted at accelerated rates, with the latter falling solidly overall.” Markit Korea (October 2019): “Elsewhere, latest survey data highlighted a strong drive towards cost cutting, with firms clearing their existing stocks of both inputs and finished goods at accelerated rates.” Markit India (October 2019): “Both pre- and post-production inventories decreased in October. The fall in the latter was sharper and the quickest in 16 months.” Markit Russia (October 2019): “Finally, firms reduced their purchasing activity further as they supplemented production through the use of preproduction inventories. Stocks of finished goods also fell amid lower client demand and efforts to run down stores.” Markit Turkey (October 2019): “A muted easing of purchasing activity was recorded in October, while stocks of both purchases and finished goods were scaled back.” Markit Brazil (October 2019): “As a result, stocks of purchases fell at the quickest rate in 16 months. Post-production inventories likewise decreased to the greatest extent since mid-2018 during October. According to panel members, the fall was due to sales growth.” Markit   Peter Berezin Chief Global Strategist peterb@bcaresearch.com Footnotes 1Please see David Lawder, and Andrea Shalal, “U.S., China say they are 'close to finalizing' part of a Phase One trade deal,” Reuters (October 25, 2019); and Alexandra Alper, and Doina Chiacu,"Trump: 'ahead of schedule' on China trade deal," Reuters (October 28, 2019). 2Please see John Harwood, “Democratic Sen. Elizabeth Warren: ‘I am a capitalist’ – but markets need to work for more than just the rich,” CNBC (July 24, 2018).   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Questions From The Road: The Pacific Rim Edition Questions From The Road: The Pacific Rim Edition   Strategic Recommendations Closed Trades

Highlights The Cold War is a limited analogy for the U.S.-China conflict; In a multipolar world, complete bifurcation of trade is difficult if not impossible; History suggests that trade between rivals will continue, with minimal impediments; On a secular horizon, buy defense stocks, Europe, capex, and non-aligned countries. Feature There is a growing consensus that China and the U.S. are hurtling towards a Cold War. BCA Research played some part in this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012.1 For much of this decade, Geopolitical Strategy focused on the thesis that geopolitical risk was rotating out of the Middle East, where it was increasingly irrelevant, to East Asia, where it would become increasingly relevant. This thesis remains cogent, but it does not mean that a “Silicon Curtain” will necessarily divide the world into two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the U.S. will continue and may even grow. But the risk of conflict, including a military one, will not decline. In this report, we first review the geopolitical logic that underpins Sino-American tensions. We then survey the academic literature for clues on how that relationship will develop vis-à-vis trade and economic relations. The evidence from political theory is surprising and highly investment relevant. We then look back at history for clues as to what this means for investors. Our conclusion is that it is highly likely that the U.S. and China will continue to be geopolitical rivals. However, due to the geopolitical context of multipolarity, it is unlikely that the result will be “Bifurcated Capitalism.” Rather, we expect an exciting and volatile environment for investors where geopolitics takes its historical place alongside valuation, momentum, fundamentals, and macroeconomics in the pantheon of factors that determine investment opportunities and risks. The Thucydides Trap Is Real … Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed that it was time for Germany to demand “its own place in the sun.”2 The occasion was a debate on Germany’s policy towards East Asia. Bülow soon ascended to the Chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Realpolitik was characterized by Germany’s cautious balancing of global powers under Chancellor Otto von Bismarck, Weltpolitik saw Bülow and Wilhelm II seek to redraw the status quo through aggressive foreign and trade policy. Imperial Germany joined a long list of antagonists, from Athens to today’s People’s Republic of China, in the tragic play of human history dubbed the “Thucydides Trap.”3 Chart II-1Imperial Overstretch Imperial Overstretch Imperial Overstretch The underlying concept is well known to all students of world history. It takes its name from the Greek historian Thucydides and his seminal History of the Peloponnesian War. Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he dispassionately describes how the conflict between a revisionist Athens and established Sparta became inevitable due to a cycle of mistrust. Graham Allison, one of America’s preeminent scholars of international relations, has argued that the interplay between a status quo power and a challenger has almost always led to conflict. In 12 out of the 16 cases he surveyed, actual military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and a respect for the prevailing institutions.4 In those cases, the transition was a case of new management running largely the same organizational structure. And one of the four non-war outcomes was nothing less than the Cold War between the Soviet Union and the U.S. The fundamental problem for a status quo power is that its empire or “sphere of influence” remains the same size as when it stood at the zenith of power. However, its decline in a relative sense leads to a classic problem of “imperial overstretch.” The hegemonic or imperial power erroneously doubles down on maintaining a status quo that it can no longer afford (Chart II-1). The challenger power is not blameless. It senses weakness in the hegemon and begins to develop a regional sphere of influence. The problem is that regional hegemony is a perfect jumping off point towards global hegemony. And while the challenger’s intentions may be limited and restrained (though they often are ambitious and overweening), the status quo power must react to capabilities, not intentions. The former are material and real, whereas the latter are perceived and ephemeral. The challenging power always has an internal logic justifying its ambitions. In China’s case today, there is a sense among the elite that the country is merely mean-reverting to the way things were for many centuries in China’s and Asia’s long history (Chart II-2). In other words, China is a “challenger” power only if one describes the status quo as the past three hundred years. It is the “established” power if one goes back to an earlier state of affairs. As such, the consensus in China is that it should not have to pay deference to the prevailing status quo given that the contemporary context is merely the result of western imperialist “challenges” to the established Chinese and regional order. Chart II-2China’s Mean Reverting Narrative November 2019 November 2019 In addition, China has a legitimate claim that it is at least as relevant to the global economy as the U.S. and therefore deserves a greater say in global governance. While the U.S. still takes a larger share of the global economy, China has contributed 23% to incremental global GDP over the past two decades, compared to 13% for the U.S. (Chart II-3). Chart II-3The Beijing Consensus November 2019 November 2019 Bottom Line: The emerging tensions between China and the U.S. fit neatly into the theoretical and empirical outlines of the Thucydides Trap. We do not see any way for the two countries to avoid struggle and conflict on a secular or forecastable horizon. What does this mean for investors? For one, the secular tailwinds behind defense stocks will persist. But what beyond that? Is the global economy destined to witness complete bifurcation into two armed camps separated by a Silicon Curtain? Will the Alibaba and Amazon Pacts suspiciously glare at each other the way that NATO and Warsaw Pacts did amidst the Cold War? The answer, tentatively, is no. … But It Will Not Lead To Economic Bifurcation President Trump’s aggressive trade policy also fits neatly into political theory, to a point. Realism in political science focuses on relative gains over absolute gains in all relationships, including trade. This is because trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. Two states that care only about relative gains due to rivalry produce a zero-sum game with no room for cooperation. It is a “Prisoner’s Dilemma” that can lead to sub-optimal economic outcomes in which both actors chose not to cooperate. Diagram II-1 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3-Q0) due to the inability of domestic production (Q0) to meet it. Diagram II-1Trade War In A Bipolar World November 2019 November 2019 However, geopolitical externality – a rivalry with another state – raises the marginal social cost of imports – i.e. trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1, while shrinking demand to Q2, thus reducing imports to merely Q2-Q1, a fraction of where they would be in a world where geopolitics do not matter. The dynamic of relative gains can also have a powerful pull on the hegemon as it begins to weaken and rethink its originally magnanimous trade relations. As political scientist Duncan Snidal argued in a 1991 paper, When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state’s concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.5 The reason small states are initially more concerned with relative gains is because they are far more concerned with national security than the hegemon. The hegemon has a preponderance of power and is therefore more relaxed about its security needs. This explains why Presidents George Bush Sr., Bill Clinton, and George Bush Jr. all made “bad deals” with China. Writing nearly thirty years ago, Snidal cogently described the current U.S.-China trade war. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over, it was just beginning! As such, the dynamic Snidal described took thirty years to come to fruition. When thinking about the transition away from U.S. hegemony, most investors anchor themselves to the Cold War as it is the only world they have known that was not unipolar. Moreover the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. If this is the world we are about to inhabit, with the U.S. and China dividing the whole planet into spheres like the U.S. and Soviet Union, then the paragraph we lifted from Snidal’s paper would be the end of it. America would abandon globalization in totality, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. But most of recent human history has been defined by a multipolar distribution of power between states, not a bipolar one. The term “cold war” is applicable to the U.S. and China in the sense that comparable military power may prevent them from fighting a full-blown “hot war.” But ultimately the U.S.-Soviet Cold War is a poor analogy for today’s world. In a multipolar world, Snidal concludes, “states that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world.” Snidal shows via formal modeling that as the number of players increases from two, relative-gains sensitivity drops sharply.6 The U.S.-China relationship does not occur in a vacuum — it is moderated by the global context. Today’s global context is one of multipolarity. Multipolarity refers to the distribution of geopolitical power, which is no longer dominated by one or two great powers (Chart II-4). Europe and Japan, for instance, have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Chart II-4The World Is No Longer Bipolar The World Is No Longer Bipolar The World Is No Longer Bipolar A multipolar world is the least “ordered” and the most unstable of world systems (Chart II-5). This is for three reasons: Chart II-5Multipolarity Is Messy Multipolarity Is Messy Multipolarity Is Messy Math: Multipolarity engenders more potential “conflict dyads” that can lead to conflict. In a unipolar world, there is only one country that determines norms and rules of behavior. Conflict is possible, but only if the hegemon wishes it. In a bipolar world, conflict is possible, but it must align along the axis of the two dominant powers. In a multipolar world, alliances are constantly shifting and producing novel conflict dyads. Lack of coordination: Global coordination suffers in periods of multipolarity as there are more “veto players.” This is particularly problematic during times of stress, such as when an aggressive revisionist power uses force or when the world is faced with an economic crisis. Charles Kindleberger has argued that it was exactly such hegemonic instability that caused the Great Depression to descend into the Second World War in his seminal The World In Depression.7 Mistakes: In a unipolar and bipolar world, there are a very limited number of dice being rolled at once. As such, the odds of tragic mistakes are low and can be mitigated with complex formal relationships (such as U.S.-Soviet Mutually Assured Destruction, grounded in formal modeling of game theory). But in a multipolar world, something as random as an assassination of a dignitary can set in motion a global war. The multipolar system is far more dynamic and thus unpredictable. Diagram II-2 is modified for a multipolar world. Everything is the same, except that we highlight the trade lost to other great powers. The state considering using tariffs to lower the marginal social cost of trading with a rival must account for this “lost trade.” In the context of today’s trade war with China, this would be the sum of all European Airbuses and Brazilian soybeans sold to China in the place of American exports. For China, it would be the sum of all the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. Diagram II-2Trade War In A Multipolar World November 2019 November 2019 Could Washington ask its allies – Europe, Japan, South Korea, Taiwan, etc. – not to take advantage of the lucrative trade (Q3-Q0)-(Q2-Q1) lost due to its trade tiff with China? Sure, but empirical research shows that they would likely ignore such pleas for unity. Alliances produced by a bipolar system produce a statistically significant and large impact on bilateral trade flows, a relationship that weakens in a multipolar context. This is the conclusion of a 1993 paper by Joanne Gowa and Edward D. Mansfield.8 The authors draw their conclusion from an 80-year period beginning in 1905, which captures several decades of global multipolarity. Unless the U.S. produces a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – something hardly foreseeable under the current administration – the self-interest of U.S. allies will drive them to continue trading with China. The U.S. will not be able to exclude China from the global system; nor will China be able to achieve Xi Jinping’s vaunted “self-sufficiency.” A risk to our view is that we have misjudged the global system, just as political scientists writing in the early 1990s did. To that effect, we accept that Charts II-1 and II-4 do not really support a view that the world is in a balanced multipolar state. The U.S. clearly remains the most powerful country in the world. The problem is that it is also clearly in a relative decline and that its sphere of influence is global – and thus very expensive – whereas its rivals have merely regional ambitions (for the time being). As such, we concede that American hegemony could be reasserted relatively quickly, but it would require a significant calamity in one of the other poles of power. For instance, a breakdown in China’s internal stability alongside the recovery of U.S. political stability. Bottom Line: The trade war between the U.S. and China is geopolitically unsustainable. The only way it could continue is if the two states existed in a bipolar world where the rest of the states closely aligned themselves behind the two superpowers. We have a high conviction view that today’s world is – for the time being – multipolar. American allies will cheat and skirt around Washington’s demands that China be isolated. This is because the U.S. no longer has the preponderance of power that it enjoyed in the last decade of the twentieth and the first decade of the twenty-first century. Insights presented thus far come from formal theory in political science. What does history teach us? Trading With The Enemy In 1896, a bestselling pamphlet in the U.K., “Made in Germany,” painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”9 Look around your own houses, author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”10 By the late 1890s, it was clear to the U.K. that Germany was its greatest national security threat. The Germany Navy Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the First Lord of the Royal Navy pointed out that “the great new German navy is being carefully built up from the point of view of a war with us.”11 There is absolutely no doubt that Germany was the U.K.’s gravest national security threat. As a result, London signed in April 1904 a set of agreements with France that came to be known as Entente Cordiale. The entente was immediately tested by Germany in the 1905 First Moroccan Crisis, which only served to strengthen the alliance. Russia was brought into the pact in 1907, creating the Triple Entente. In hindsight, the alliance structure was obvious given Germany’s meteoric rise from unification in 1871. However, one should not underestimate the magnitude of these geopolitical events. For the U.K. and France to resolve centuries of differences and formalize an alliance in 1904 was a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.12 Political scientists and historians have noted that geopolitical enmity rarely produces bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling shows that trade occurs even amongst rivals and during wartime.13 This was certainly the case between the U.K. and Germany, whose trade steadily increased right up until the outbreak of World War One (Chart II-6). Could this be written off due to the U.K.’s ideological commitment to laissez-faire economics? Or perhaps London feared a move against its lightly defended colonies in case it became protectionist? These are fair arguments. However, they do not explain why Russia and France both saw ever-rising total trade with the German Empire during the same period (Chart II-7). Either all three states were led by incompetent policymakers who somehow did not see the war coming – unlikely given the empirical record – or they simply could not afford to lose out on the gains of trade with Germany to each other. Chart II-6The Allies Traded With Germany ... November 2019 November 2019 Chart II-7… Right Up To WWI November 2019 November 2019   Chart II-8Japan And U.S. Never Downshifted Trade November 2019 November 2019 A similar dynamic was afoot ahead of World War Two. Relations between the U.S. and Japan soured in the 1930s, with the Japanese invasion of Manchuria in 1931. In 1935, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite a clear and present danger, the U.S. continued to trade with Japan right up until July 26, 1941, few days after Japan invaded southern Indochina (Chart II-8). On December 7, Japan attacked the U.S. A skeptic may argue that precisely because policymakers sleepwalked into war in the First and Second World Wars, they will not (or should not) make the same mistake this time around. First, we do not make policy prescriptions and therefore care not what should happen. Second, we are highly skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today’s enlightened leaders). Our constraints-based framework urges us to seek systemic reasons for the behavior of leaders. Political science provides a clear theoretical explanation for why London and Washington continued to trade with the enemy despite the clarity of the threat. The answer lies in the systemic nature of the constraint: a multipolar world reduces the sensitivity of policymakers to relative gains by introducing a collective action problem thanks to changing alliances and the difficulty of disciplining allies’ behavior. In the case of U.S. and China, this is further accentuated by President Trump’s strategy of skirting multilateral diplomacy and intense focus on mercantilist measures of power (i.e. obsession with the trade deficit). An anti-China trade policy that was accompanied by a magnanimous approach to trade relations with allies could have produced a “coalition of the willing” against Beijing. But after two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision. There are two outcomes that we can see emerging over the course of the next decade. First, U.S. leadership will become aware of the systemic constraints under which they operate, and trade with China will continue – albeit with limitations and variations. However, such trade will not reduce the geopolitical tensions, nor will it prevent a military conflict. In facts, the probability of military conflict may increase even as trade between China and the U.S. remains steady. Second, U.S. leadership will fail to correctly assess that they operate in a multipolar world and will give up the highlighted trade gains from Diagram II-2 to economic rivals such as Europe and Japan. Given our methodological adherence to constraint-based forecasting, we highly doubt that the latter scenario is likely. Bottom Line: The China-U.S. conflict is not a replay of the Cold War. Systemic pressures from global multipolarity will force the U.S. to continue to trade with China, with limitations on exchanges in emergent, dual-use technologies that China will nonetheless source from other technologically advanced countries. This will create a complicated but exciting world where geopolitics will cease to be seen as exogenous to investing. A risk to the sanguine conclusion is that the historical record is applicable to today, but that the hour is late, not early. It is already July 26, 1941 – when U.S. abrogated all trade with Japan – not 1930. As such, we do not have another decade of trade between U.S. and China remaining, we are at the end of the cycle. While this is a risk, it is unlikely. American policymakers would essentially have to be willing to risk a military conflict with China in order to take the trade war to the same level they did with Japan. It is an objective fact that China has meaningfully stepped up aggressive foreign policy in the region. But unlike Japan in 1941, China has not outright invaded any countries over the past decade. As such, the willingness of the public to support such a conflict is unclear, with only 21% of Americans considering China a top threat to the U.S. Investment Implications This analysis is not meant to be optimistic. First, the U.S. and China will continue to be rivals even if the economic relationship between them does not lead to global bifurcation. For one, China continues to be – much like Germany in the early twentieth century – concerned with access to external markets on which 19.5% of its economy still depend. China is therefore developing a modern navy and military not because it wants to dominate the rest of the world but because it wants to dominate its near abroad, much as the U.S. wanted to, beginning with the Monroe Doctrine. This will continue to lead to Chinese aggression in the South and East China Seas, raising the odds of a conflict with the U.S. Navy. Given that the Thucydides Trap narrative remains cogent, investors should look to overweight S&P 500 aerospace and defense stocks relative to global equity markets. An alternative way that one could play this thesis is by developing a basket of global defense stocks. Multipolarity may create constraints to trade protectionism, but it engenders geopolitical volatility and thus buoys defense spending. Second, we would not expect another uptick in globalization. Multipolarity may make it difficult for countries to completely close off trade with a rival, but globalization is built on more than just trade between rivals. Globalization requires a high level of coordination among great powers that is only possible under hegemonic conditions. Chart II-9 shows that the hegemony of the British and later American empires created a powerful tailwind for trade over the past two hundred years. Chart II-9The Apex Of Globalization Is Behind Us The Apex Of Globalization Is Behind Us The Apex Of Globalization Is Behind Us The Apex of Globalization has come and gone – it is all downhill from here. But this is not a binary view. Foreign trade will not go to zero. The U.S. and China will not completely seal each other’s sphere of influence behind a Silicon Curtain. Instead, we focus on five investment themes that flow from a world that is characterized by the three trends of multipolarity, Sino-U.S. geopolitical rivalry, and apex of globalization: Europe will profit: As the U.S. and China deepen their enmity, we expect some European companies to profit. There is some evidence that the investment community has already caught wind of this trend, with European equities modestly outperforming their U.S. counterparts whenever trade tensions flared up in 2019 (Chart II-10). Given our thesis, however, it is unlikely that the U.S. would completely lose market share in China to Europe. As such, we specifically focus on tech, where we expect the U.S. and China to ramp up non-tariff barriers to trade regardless of systemic pressures to continue to trade. A strategic long in the secularly beleaguered European tech companies relative to their U.S. counterparts may therefore make sense (Chart II-11). Chart II-10Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Chart II-11Is Europe Really This Incompetent? Is Europe Really This Incompetent? Is Europe Really This Incompetent? USD bull market will end: A trade war is a very disruptive way to adjust one’s trade relationship. It opens one to retaliation and thus the kind of relative losses described in this analysis. As such, we expect that U.S. to eventually depreciate the USD, either by aggressively reversing 2018 tightening or by coercing its trade rivals to strengthen their currencies. Such a move will be yet another tailwind behind the diversification away from the USD as a reserve currency, a move that should benefit the euro. Bull market in capex: The re-wiring of global manufacturing chains will still take place. The bad news is that multinational corporations will have to dip into their profit margins to move their supply chains to adjust to the new geopolitical reality. The good news is that they will have to invest in manufacturing capex to accomplish the task. One way to articulate this theme is to buy an index of semiconductor capital companies (AMAT, LRCX, KLAC, MKSI, AEIS, BRIKS, and TER). Given the highly cyclical nature of capital companies, we would recommend an entry point once trade tensions subside and green shoots of global growth appear. “Non-aligned” markets will benefit: The last time the world was multipolar, great powers competed through imperialism. This time around, a same dynamic will develop as countries seek to replicate China’s “Belt and Road Initiative.” This is positive for frontier markets. A rush to provide them with exports and services will increase supply and thus lower costs, providing otherwise forgotten markets with a boon of investments. India, and Asia-ex-China more broadly, stand as intriguing alternatives to China, especially with the current administration aggressively reforming to take advantage of the rewiring of global manufacturing chains. Capital markets will remain globalized: With interest rates near zero in much of the developed world and the demographic burden putting an ever-greater pressure on pension plans to generate returns, the search for yield will continue to be a powerful drive that keeps capital markets globalized. Limitations are likely to grow, especially when it comes to cross-border private investments in dual-use technologies. But a completely bifurcation of capital markets is unlikely. The world we are describing is one where geopolitics will play an increasingly prominent role for global investors. It would be convenient if the world simply divided into two warring camps, leaving investors with neatly separated compartments that enabled them to go back to ignoring geopolitics. This is unlikely. Rather, the world will resemble the dynamic years at the end of the nineteenth century, a rough-and-tumble era that required a multi-disciplinary approach to investing. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group Footnotes 1   Please see BCA Research Geopolitical Strategy, “Power And Politics In East Asia: Cold War 2.0?,” September 25, 2012, “Sino-American Conflict: More Likely Than You Think,” October 4, 2013, “The Great Risk Rotation,” December 11, 2013, and “Strategic Outlook 2014 – Stay The Course: EM Risk – DM Reward,” January 23, 2014, “Underestimating Sino-American Tensions,” November 6, 2015, “The Geopolitics Of Trump,” December 2, 2016, “How To Play The Proxy Battles In Asia,” March 1, 2017, and others available at gps.bcaresearch.com or upon request. 2   Please see German Historical Institute, “Bernhard von Bulow on Germany’s ‘Place in the Sun’” (1897), available at http://germanhistorydocs.ghi-dc.org/ 3   See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017).  4  The three cases are Spain taking over from Portugal in the sixteenth century, the U.S. taking over from the U.K. in the twentieth century, and Germany rising to regional hegemony in Europe in the twenty-first century. 5   Duncan Snidal, “Relative Gains and the Pattern of International Cooperation,” The American Political Science Review, 85:3 (September 1991), pp. 701-726. 6   We do not review Snidal’s excellent game theory formal modeling in this paper as it is complex and detailed. However, we highly encourage the intrigued reader to pursue the study on their own.  7   See Charles P. Kindleberger, The World In Depression, 1929-1939 (Berkeley: University of California Press, 2013). 8   Joanne Gowa and Edward D. Mansfield, “Power Politics and International Trade,” The American Political Science Review, 87:2 (June 1993), pp. 408-420. 9   See Ernest Edwin Williams, Made in Germany (reprint, Ithaca: Cornell University Press), available at https://archive.org/details/cu31924031247830. 10   Quoted in Margaret MacMillan, The War That Ended Peace (Toronto: Allen Lane, 2014). 11   Peter Liberman, “Trading with the Enemy: Security and Relative Economic Gains,” international Security, 21:1 (Summer 1996), pp. 147-175. 12  Although France and Russia overcame even greater bitterness due to the ideological differences between a republic founded on a violent uprising against its aristocracy – France – and an aristocratic authoritarian regime – Russia.  13  See James Morrow, “When Do ‘Relative Gains’ Impede Trade?” The Journal of Conflict Resolution, 41:1 (February 1997), pp. 12-37; and Jack S. Levy and Katherine Barbieri, “Trading With the Enemy During Wartime,” Security Studies, 13:3 (December 2004), pp. 1-47.

Highlights Declining uncertainty over policy, stabilizing growth in China and improvements in international liquidity, all will allow global economic activity to pick up in the months ahead. A weak dollar will reinforce this positive economic outlook; investors should favor pro-cyclical currencies such as the AUD, NZD and SEK. Bond yields will rise and stocks will outperform bonds on a 12- to 18-month basis. Cyclical stocks are more attractive than defensives. European stocks will outperform U.S. equities and European financials will shine. Copper is a promising buy; stay long the silver-to-gold ratio. Feature The outlook for risk assets and bond yields hinges on global economic activity. The S&P 500 has hit a new high, but our BCA Equity Scorecard Indicator remains non-committal towards stocks (Chart I-1). If global economic activity improves, the Scorecard will begin to flash a clear buy signal, but if growth deteriorates, the indicator will point towards sell. Chart I-1Stocks Could Go Either Way Stocks Could Go Either Way Stocks Could Go Either Way Cautious optimism is in order. Politics, China, liquidity conditions and the dollar collectively will determine the global economic outlook. The liquidity backdrop has significantly improved, political uncertainty should recede and China will morph from a headwind to a modest tailwind. A weak dollar will indicate that the world is healing, and also will ease global financial conditions which will facilitate economic strength. We remain committed to a positive stance on equities on a 12- to 18-month horizon, and recommend below-benchmark duration in fixed-income portfolios. Cyclicals should outperform defensives, European banks offer an attractive tactical buying opportunity and European equities will outperform their U.S. counterparts. Heightened Risks… Chart I-2Risks To The Economy And Stocks Risks To The Economy And Stocks Risks To The Economy And Stocks Many domestic indicators overstate the intrinsic fragility in the U.S. The Duncan LEI, which is the ratio of consumer durable spending and residential and business investment to final sales, has flattened. Therefore, the S&P 500 looks vulnerable and real GDP may contract (Chart I-2). CEO confidence and small business capex intentions warn of a looming retrenchment in household income (Chart I-2, bottom two panels). If consumer spending weakens, then a recession will be unavoidable. As worrisome as these indicators may be, we previously discussed that the major debt imbalances that often precede U.S. recessions are absent,1 the rebound in housing starts and homebuilding confidence is inconsistent with a restrictive monetary stance,2 and pipeline inflationary pressures are absent.3 Instead, business confidence and the Duncan LEI have been eroded by heightened political uncertainty and weak global manufacturing and trade. … Meet Receding Policy Uncertainty … The two biggest sources of policy uncertainty affecting markets, the Sino-U.S. trade war and Brexit, are diminishing. However, the U.S. election will continue to lurk in the background. Chart I-3Weaker Brexit Support = No Hard Brexit Support Weaker Brexit Support = No Hard Brexit Support Weaker Brexit Support = No Hard Brexit Support Brexit Westminster and Britain’s Supreme Court have rebuked U.K. Prime Minister Boris Johnson’s threat of a “No-Deal” Brexit. Moreover, parliamentary support for his latest plan, which essentially keeps Northern Ireland’s economy within the EU, indicates that the probability of a “No-Deal” Brexit has collapsed to less than 5%. This assessment is reinforced by the delay of Brexit to January 31, 2020. An election is scheduled for December 12 and the chance of a new referendum to vet the deal is escalating. According to Matt Gertken, BCA’s Geopolitical Strategist, an election does not increase the risk of a hard Brexit. Meanwhile, support for Brexit is near its lowest point since the June 2016 referendum (Chart I-3). Thus, a new plebiscite would not favor a “No Deal” Brexit. Sino-U.S. Trade War Chart I-4Why The Trade-War Ceasefire? Why The Trade-War Ceasefire? Why The Trade-War Ceasefire? The trade war truce will also greatly diminish economic uncertainty. Uncertainty created by the China-U.S. conflict accentuated the collapse in business confidence and capex intentions. The “phase one deal” announced earlier this month will likely materialize. The White House’s tactical retreat on trade is tied to U.S. President Donald Trump’s desire for a second term. He cannot risk inflicting further economic pain on his base of constituents.  Weekly earnings are decreasing for workers in swing states located in the industrial rust belt, especially in those areas that Trump carried in 2016 (Chart I-4). Those swing states are most affected by the slowdown in the global manufacturing and trade sectors. Beijing is also motivated to agree to truce due to its soft economy and deflationary pressures. An easing in trade uncertainty will be positive for the domestic economy. China’s willingness to replace Carrie Lam, the embattled Chief Executive of Hong Kong, and to withdraw the extradition bill at the heart of the protests confirms its eagerness to come to an agreement with the U.S. China’s readiness to make a deal is also made evident by its increasing imports of U.S. agricultural products (Chart I-4, bottom panel). Ultimately, the U.S. will not implement tariffs in December on $160 billion of Chinese shipments. Consequently, investors and businesses should become less concerned about the chances of a worsening trade war. Moreover, chances are growing of a decrease (but not a complete annulation) of the previously imposed U.S. tariffs on China. … And A Q1 2020 Acceleration In Global Growth Global economic activity will improve in Q1 2020 because the drag from China will dissipate and global liquidity conditions will improve. Many activity indicators increasingly reflect these fundamental supports. China China’s economy has reached a new low point: Q3 annual GDP growth is at a 27-year low of 6%, capital spending is weak, industrial production and profits show little life, the labor market is soft, and imports and exports continue to contract. However, a turn in policy has materialized, which will protect the domestic economy. Moreover, this summer’s Politburo and State Council statements showed an increased willingness to reflate the economy. The global economy will accelerate in Q1 2020. Credit creation has stabilized and monetary conditions have eased (Chart I-5). Faced with producer price inflation of -1.2% and employment PMIs of 47.3 and 48.2 in the manufacturing and non-manufacturing sectors, respectively, authorities have allowed the credit impulse to improve to 26% of GDP from a low of 23.8%. In accordance with this new policy direction, the drag from the shadow banking system’s contraction will slow considerably, thanks to a stabilization in both the growth rate of deposits of non-depository financial institutions and the issuance of bonds by small financial institutions. Additionally, the emission of local government bonds will accelerate. Beijing has also meaningfully eased fiscal policy, which is its preferred reflationary tool. Policymakers have cut taxes by 2.8% of GDP in the past two years. The marginal propensity of households to consume is trying to bottom (Chart I-5, bottom). If history is a guide, the acceleration in the rate of change of public-sector capex will fuel this turnaround in China’s marginal propensity to consume, and push up BCA’s China Activity Indicator (Chart I-6). Chart I-5Overlooked Chinese Improvements Overlooked Chinese Improvements Overlooked Chinese Improvements Chart I-6Public Investment Matters Public Investment Matters Public Investment Matters   Chart I-7A Bottom In Chinese Exports Growth? A Bottom In Chinese Exports Growth? A Bottom In Chinese Exports Growth? China’s economy is unlikely to bounce back as violently as in 2009, 2012 or 2016. Authorities are much more circumspect in their use of credit to reflate the economy than they were previously. Moreover, the regulatory environment will prevent a boom in the shadow banking system. Nonetheless, the fiscal push and the end of the decline in aggregate credit growth will allow the Chinese economy to stabilize and maybe pick up a bit. Therefore, China will move from a large headwind to a slight tailwind for global activity (Chart I-7, top panel). Mounting public capex also points toward a modest global recovery (Chart I-7, middle panel). Finally, the upturn in our Chinese reflation indicator, which incorporates both fiscal and monetary policy, points to a re-acceleration in U.S. capex intentions (Chart I-7, bottom panel). Global Liquidity Global liquidity conditions continue to improve and the global economy should soon respond within normal policy lags. 95% of central banks are loosening policy, which normally leads to an escalation in global activity (Chart I-8). The dominant central banks (the Federal Reserve, the European Central Bank and the Bank of Japan) will not tighten anytime soon. Inflation expectations in the U.S., the euro area and Japan stand at 1.9%, 1.1%, and 0.2%, respectively, well below levels consistent with a 2% inflation target. Moreover, U.S. core CPI has been perky, but both the ISM and the performance of transportation equities relative to utilities indicate that a deceleration in inflation is imminent (Chart I-9). Salaries are not yet inflationary either because U.S. real wages are growing in line with productivity (Chart I-9, bottom panel). In the euro area and Japan, realized core inflation remains at 1.0% and 0.5%, respectively, and supports the dovish message emanating from inflation expectations. Chart I-8Easier Global Policy Is Important Easier Global Policy Is Important Easier Global Policy Is Important Chart I-9If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief If Inflation Peaks, The U.S. Economy Will Breath A Sigh Of Relief     Liquidity indicators are reflecting this accommodative policy setting. The growth of U.S. and European bank deposits has reaccelerated from 2.5% to 6%, a development linked to the exit of a soft patch (Chart I-10). Moreover, BCA’s U.S. Financial Liquidity Indicator is still moving higher and flashing a resurgence in the BCA Global Leading Economic Indicator (LEI), the ISM Manufacturing Index, commodity prices, and EM export prices (Chart I-11). Finally, U.S. and global excess money reinforce the message of BCA’s U.S. Financial liquidity Indicator (Chart I-12). Chart I-10Deposits Suggest The Worst Of The Slowdown Is Behind Us Deposits Suggest The Worst Of The Slowdown Is Behind Us Deposits Suggest The Worst Of The Slowdown Is Behind Us Chart I-11Continued Pick-Up In Financial Liquidity Continued Pick-Up In Financial Liquidity Continued Pick-Up In Financial Liquidity       The Fed will add to the supply of global liquidity by tackling the repo market’s seize-up. Depleting excess reserves and mounting financing needs among primary dealers resulted in the September surge in the Secured Overnight Financing Rate (SOFR). The Fed announced three weeks ago it would buy $60 billion per month of T-Bills and T-Notes, which will lead to a climbing stock of excess reserves. Higher excess reserves create a weaker dollar, stronger EM currencies and firming global PMIs (Chart I-13). Ultimately, EM currency strength eases EM financial conditions, which supports global growth (Chart I-13, bottom panel). Chart I-12Excess Liquidity Is Accelerating Excess Liquidity Is Accelerating Excess Liquidity Is Accelerating Chart I-13U.S. Excess Reserves Will Grow Again U.S. Excess Reserves Will Grow Again U.S. Excess Reserves Will Grow Again   Borrowing activity in Advanced Economies is showing signs of life. Bank credit is already responding to the drop in global yields, and global corporate bond issuance in September 2019 rose to $434 billion. In the U.S., new issues of corporate bonds have also reaccelerated (Chart I-14). Global Growth Indicators Crucial indicators of global economic activity are picking up on this improving fundamental backdrop. The list includes: A sharp takeoff in the annualized three-month rate of change of capital goods orders in the U.S., the Eurozone and Japan (Chart I-15, top panel). Improvement in this indicator precedes progress in the annual growth rate of orders and in capex itself. Chart I-14Borrowers Are Responding To Easier Financial Conditions Borrowers Are Responding To Easier Financial Conditions Borrowers Are Responding To Easier Financial Conditions Chart I-15Some Green Shoots Are Coming Through Some Green Shoots Are Coming Through Some Green Shoots Are Coming Through Chart I-16Positive Market Signals Positive Market Signals Positive Market Signals A significant upturn in the Philly Fed, Empire State, and Richmond Fed manufacturing surveys for October, which sends a positive signal for the ISM Manufacturing Index (Chart I-15, second panel). Moreover, the new orders and employment components of these surveys indicate that cyclical sectors of the economy will recover and the recent deterioration in employment conditions will be fleeting. A rebound in BCA’s EM economic diffusion index, which incorporates 23 variables. Such an increase usually precedes inflections in global industrial production (Chart I-15, bottom panel). An acceleration – both in absolute and relative terms - in the annual appreciation of Taiwanese stocks. A strong and outperforming Taiwanese equity market is a harbinger of firmer PMIs (Chart I-16, top two panels). A solid performance of EM carry trades financed in yen, European luxury equities, and the relative performance of global semiconductors, materials and industrial stocks, which signal stronger global PMIs (Chart I-16, bottom three panels). Bottom Line: The global economy will accelerate in Q1 2020. A melting probability of a “No-Deal” Brexit and a truce in the Sino-U.S. trade war will allow global uncertainty to recede. Concurrently, China’s economic slowdown is ending and global liquidity conditions are improving. The Dollar As The Arbiter Of Growth Chart I-17The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The Dollar Is A Counter-Cyclical Currency The dollar faces potent headwinds. The greenback is a countercyclical currency; a business cycle upswing and a weak USD go hand in hand (Chart I-17). The tightness of this relationship results from a powerful feedback loop: weak growth boosts the dollar, but the dollar’s strength foments additional economic slowdown. Global liquidity and activity indicators signal a weaker dollar because they point toward an economic recovery. BCA’s U.S. Financial Liquidity Index, which foresaw a deceleration in the greenback’s rate of appreciation, is calling for an outright depreciation (Chart I-18, top panel). The expanding holdings of securities on U.S. commercial banks’ balance sheets (a key measure of liquidity) corroborates this message. According to a model based on the U.S., Eurozone, Japanese and Chinese broad money supply, the USD should significantly depreciate in the coming 12 months (Chart I-18, third panel). Finally, our EM Economic Diffusion Index validates pressures on the greenback, especially against commodity currencies (Chart I-18, bottom two panels). Chart I-18Liquidity And Growth Indicators Point To A Weaker Dollar Liquidity And Growth Indicators Point To A Weaker Dollar Liquidity And Growth Indicators Point To A Weaker Dollar Growth differentials support this picture. Late last year, the stimulating effect of President Trump’s tax cuts allowed the U.S. to temporarily diverge from a weak global economy, but the U.S. manufacturing sector is now succumbing to the global slowdown. Once global growth snaps back, the U.S. is likely to lag behind as fiscal policy is becoming more stimulative outside the U.S. than in the U.S. Based on historical delays, this will continue to hurt the dollar (Chart I-19, top panel). Finally, the European economy generally outperforms the U.S. when China reflates, especially if Beijing’s push lifts the growth rate of M1 relative to M2, a proxy for China’s aggregate marginal propensity to consume (Chart I-20). Europe’s greater cyclicality reflects is larger exposure to both trade and manufacturing compared with the U.S. Chart I-19A Global Growth Convergence Will Hurt The Dollar A Global Growth Convergence Will Hurt The Dollar A Global Growth Convergence Will Hurt The Dollar Chart I-20European Growth To Rise Vis-A-Vis The U.S. European Growth To Rise Vis-A-Vis The U.S. European Growth To Rise Vis-A-Vis The U.S.   The greenback is expensive and technically vulnerable, which compounds its cyclical risk. The trade-weighted dollar is at a 25% premium to its purchasing power parity equilibrium (PPP), an overvaluation comparable to its 1985 and 2002 peaks. Moreover, our Composite Technical Indicator is overextended and has formed a negative divergence with the price of the dollar (see page 54, Section III). Finally, speculators are massively long the U.S. Dollar Index (DXY). Balance-of-payment flows also flash a significant downside in the dollar (Chart I-21). The U.S. current account deficit stands at 2.5% of GDP, but it is widening in response to the dollar’s overvaluation and the White House’s expansive fiscal policy. Since 2011, foreign direct investments (FDI) have been the main driver of the dollar’s gyrations. Last year, net FDI surged in response to profit repatriations encouraged by the Tax Cuts and Jobs Act of 2017, while portfolio flows stayed in neutral territory. This regulatory change had a one-off impact and FDI will begin to dry out. Therefore, financing the widening current account deficit will become harder. Finally, after years in the red, net portfolio flows into Europe have turned positive (Chart I-21, bottom panel). The USD’s depreciation will ease global financial conditions and supports growth further. In this context, interest rate differentials are noteworthy. The two-year spread in real rates between the U.S. and the rest of the G-10 has fallen significantly since October 2018. Reversals in real rates herald a weaker dollar, especially when it faces valuation, technical and flow handicaps. Moreover, European five-year forward short rate expectations are near record lows. If global growth can stabilize, then the five-year forward one-month OIS will pick up, especially relative to the U.S. An uptick will boost the EUR/USD pair and hurt the dollar (Chart I-22). Chart I-21Balance-Of-Payments Dynamics Turning Against The USD Balance-Of-Payments Dynamics Turning Against The USD Balance-Of-Payments Dynamics Turning Against The USD Chart I-22Relative Long-Term Rate Expectations And The Euro Relative Long-Term Rate Expectations And The Euro Relative Long-Term Rate Expectations And The Euro   The three most pro-cyclical currencies in the G-10 – the AUD, NZD and SEK - strengthen the most when BCA’s Global LEI bottoms but global inflation slows (Chart I-23). The GBP will likely generate a much stronger-than-normal performance next year. Cable trades at a 22% discount to PPP. It is also 19% cheap versus short-term interest rate parity models. The absence of a “No-Deal” Brexit should allow these risk premia to dissipate and the pound to recover. The CAD is also more attractive than Chart I-23 implies. The loonie is trading 10% below its PPP, and the USD/CAD often lags the EUR/CAD, a pair that has broken down (Chart I-24). Chart I-23Currency Performance As A Function Of Growth And Inflation November 2019 November 2019 Chart I-24EUR/CAD Flashing A Bearish USD/CAD Signal EUR/CAD Flashing A Bearish USD/CAD Signal EUR/CAD Flashing A Bearish USD/CAD Signal Bottom Line: A rebound in the global manufacturing sector next year will hurt the USD. The dollar is particularly vulnerable because growth differentials between the U.S. and the rest of the world have melted, the greenback is expensive, balance-of-payment dynamics are deteriorating and interest rate differentials are becoming less supportive. The USD’s depreciation will ease global financial conditions and supports growth further. Additional Investment Implications Bond Yields Have More Upside While the short-term outlook for bonds remains murky, the 12- to 18-month outlook is unambiguously bearish. The BCA Bond Valuation Index is still consistent with much higher U.S. yields in the next 12-18 months (see Section III, page 51). BCA’s Composite Technical Indicator for T-Notes is massively overbought and sentiment, as approximated by the Long-Term Interest Rates component of the ZEW survey, is overly bullish (Chart I-25). Thus, bonds represent an attractive cyclical sell. The Fed will not cut rates aggressively enough for bonds to ignore these valuation and technical risks. Treasurys have outperformed cash by 7.5% in the past year. Based on historical relationships, the Fed needs to cut rates to zero for bonds to beat cash in the coming 12 months (Chart I-26). After this week’s Fed cut to 1.75%, our base case is none to maybe one more rate cut. Chart I-25Sentiment Points To Yield Upside Sentiment Points To Yield Upside Sentiment Points To Yield Upside Chart I-26The Fed Must Cut To Zero For T-Notes To Outperform Cash Further The Fed Must Cut To Zero For T-Notes To Outperform Cash Further The Fed Must Cut To Zero For T-Notes To Outperform Cash Further   Bond yields will need a recession to move lower. The deviation of 10-year Treasury yields from their two-year moving average closely tracks the Swedish Economic Diffusion Index (Chart I-27, top panel). Sweden, a small, open economy highly levered to the global industrial cycle, is a good gauge of the global business cycle. The broad weakness in the Swedish economy is unlikely to worsen unless the global slowdown morphs into a deep recession. Even if global growth remains mediocre, Sweden’s Economic Diffusion Index will rise along with yields. The expansion in securities holdings of U.S. commercial banks and the stabilization in China’s credit flows both support this notion (Chart I-27, bottom panel). Financial market developments also point to higher yields. Sectors that typically capture the momentum in the global economy are perking up. For example, bottoms in the annual performance of European luxury equities or Taiwanese stocks have preceded increases in yields (Chart I-28). Chart I-27Yields Have Upside Yields Have Upside Yields Have Upside Chart I-28Key Financial Market Signals For Yields Key Financial Market Signals For Yields Key Financial Market Signals For Yields   Stocks Will Outperform Bonds Our conviction is strengthening that equities will outperform bonds. The total return of the stock-to-bond ratio has upside. BCA’s Global Economic and Financial Diffusion Index has rallied sharply, which often precedes an ascent in the stock-to-bond ratio, both in the U.S. and globally (Chart I-29). Bonds are much more expensive than stocks, therefore, only a recession will allow stocks to underperform in the coming 12 to 18 months. The environment is positive for equities. BCA’s Monetary Indicator is very elevated and our Composite Sentiment Indicator shows little complacency toward stocks among investors (see Section III, page 47). Finally, the strength in the U.S. Financial Liquidity Indicator supports the S&P 500’s returns (Chart I-30). Chart I-29Cyclical Indicators Argue In Favor Of Stocks Over Bonds Cyclical Indicators Argue In Favor Of Stocks Over Bonds Cyclical Indicators Argue In Favor Of Stocks Over Bonds Chart I-30Liquidity Tailwind For The S&P 500 Liquidity Tailwind For The S&P 500 Liquidity Tailwind For The S&P 500   A few market developments are noteworthy. 55.6% of the S&P 500’s constituents have reported Q3 earnings, and 74% of those firms are beating estimates. Moreover, the market is generously rewarding firms with the largest positive earnings surprises. Additionally, the Value Line Geometric Index is forming a reverse head-and-shoulder pattern, while the relative performance of the Russell 2000 has formed a double bottom (Chart I-31). The environment also favors cyclicals relative to defensive equities. By lifting bond yields, stronger economic activity leads to a contraction in the multiples of defensives relative to cyclicals. The latter’s earnings expectations respond more positively to reviving economic activity, which creates an offset to climbing discount rates. As a result, cyclicals often outperform defensives when the stock-to-bond ratio increases, or after Taiwanese equities gain momentum (Chart I-32). Chart I-31Improving Equity Market Dynamics Improving Equity Market Dynamics Improving Equity Market Dynamics Chart I-32Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives Favor Cyclicals Over Defensives   Compared to other equity markets, the U.S. faces the most challenges. Our model forecasts a 3% annual drop in the S&P 500’s operating earnings in June 2020, and the deviation of U.S. equities from their 200-day moving average has greatly diverged from net earnings revisions (Chart I-33). U.S. equities have already discounted a turnaround in earnings. Moreover, the S&P 500’s margins have downside, a topic covered by BCA’s Chief Equity Strategist Anastasios Avgeriou.4 Our Composite Margin Proxy, Operating Margins Diffusion Index and Corporate Pricing Power Indicator all remain weak (Chart I-34). Downward pressure on margins will limit how rapidly earnings respond when a rebound in global economic activity lifts revenues. Finally, the S&P 500 trades at a historically elevated forward P/E ratio of 18.4, the MSCI EAFE trade at a much more reasonable 14-times forward earnings. Chart I-33Headwinds For U.S. Stocks Headwinds For U.S. Stocks Headwinds For U.S. Stocks Chart I-34Headwinds For U.S. Margins Headwinds For U.S. Margins Headwinds For U.S. Margins   The tech sector will also weigh on the performance of U.S. equities relative to international stocks. Tech stocks represent 22.5% of the U.S. benchmark, compared with 9.7% for the euro area. Anastasios recently argued that software spending has remained surprisingly resilient despite the global economic slowdown; it will likely lag spending on machinery and structures when the cycle picks up.5 Consequently, tech earnings will lag other traditional cyclical sectors. Moreover, tech multiples will suffer when the dollar depreciates and bond yields rise (Chart I-35). As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to discount factors. Unaffected by those negatives, European equities will benefit most from the outperformance of stocks relative to bonds. A weak dollar will be the first positive for the common-currency returns of European equities. Valuations are the second tailwind. The risk premium for European equities is 300 basis points higher than for U.S. stocks. Moreover, U.S. margins will likely diminish relative to the Eurozone’s because of stronger unit labor costs in the U.S. Sector composition will also dictate the performance of European equities. Compared with the U.S., Europe is underweight tech and healthcare stocks, a defensive sector (Table I-1). Investors who favor Europe will also bet against these two sectors. Europe is a wager on the other cyclical sectors: materials, industrials, energy and financials. Chart I-35Tech P/Es Are At Risk Tech P/Es Are At Risk Tech P/Es Are At Risk Table I-1Europe Overweights The Correct Cyclicals November 2019 November 2019   European financials are particularly attractive. Negative European yields are a major handicap for European financials, but this handicap is already reflected in their price. European banks trade at a price-to-book ratio of 0.6 versus 1.3 for the U.S. This discount should be narrowing, not widening. Yields are bottoming and European loan growth is contracting at a -2% annual rate relative to the U.S. versus -8.6% five years ago. Meanwhile, the annual rate of change of European deposits is in line with the U.S. The attraction of European banks comes from the outlook for their return on tangible equity. A model shows that three variables govern European banks’ ROE: German yields, Italian spreads and the momentum of the silver-to-gold ratio (SGR). German yields impact net interest margins, Italian spreads drive peripheral financial conditions and thus, loan generation in the European periphery, and the SGR tracks the global manufacturing cycle (silver has more industrial uses than gold, but is equally sensitive to real yields), which affects loan flows in the European core. This model logically tracks the performance of European banks and financials (Chart I-36). Our positive outlook on global growth and yields, along with the fall in Italian spreads, augurs well for cheap European financial equities and banks in particular. Commodities Our constructive stance on the global business cycle and yields, plus our negative view on the greenback, is consistent with higher industrial commodity prices. Copper looks particularly attractive. Speculators are aggressively selling the metal, whose price stands at an important technical juncture (Chart I-37). Chart I-36The Drivers Of RoE Point To Higher European Bank Stock Prices The Drivers Of RoE Point To Higher European Bank Stock Prices The Drivers Of RoE Point To Higher European Bank Stock Prices Chart I-37Cooper Is An Attractive Play On Global Growth Cooper Is An Attractive Play On Global Growth Cooper Is An Attractive Play On Global Growth   Chart I-38Favorable Technical Backdrop For Silver-To-Gold Ratio Favorable Technical Backdrop For Silver-To-Gold Ratio Favorable Technical Backdrop For Silver-To-Gold Ratio Finally, we have favored the SGR since late June. Silver is deeply oversold and under-owned relative to the yellow metal (Chart I-38). Consequently, silver’s greater industrial usage should be a potent tailwind for the SGR.6 Mathieu Savary Vice President The Bank Credit Analyst October 31, 2019 Next Report: November 22, 2019 - Outlook 2020   II. Back To The Nineteenth Century The Cold War is a limited analogy for the U.S.-China conflict; In a multipolar world, complete bifurcation of trade is difficult if not impossible; History suggests that trade between rivals will continue, with minimal impediments; On a secular horizon, buy defense stocks, Europe, capex, and non-aligned countries. There is a growing consensus that China and the U.S. are hurtling towards a Cold War. BCA Research played some part in this consensus – at least as far as the investment community is concerned – by publishing “Power and Politics in East Asia: Cold War 2.0?” in September 2012.7 For much of this decade, Geopolitical Strategy focused on the thesis that geopolitical risk was rotating out of the Middle East, where it was increasingly irrelevant, to East Asia, where it would become increasingly relevant. This thesis remains cogent, but it does not mean that a “Silicon Curtain” will necessarily divide the world into two bifurcated zones of capitalism. Trade, capital flows, and human exchanges between China and the U.S. will continue and may even grow. But the risk of conflict, including a military one, will not decline. In this report, we first review the geopolitical logic that underpins Sino-American tensions. We then survey the academic literature for clues on how that relationship will develop vis-à-vis trade and economic relations. The evidence from political theory is surprising and highly investment relevant. We then look back at history for clues as to what this means for investors. The U.S.-China conflict will not lead to complete bifurcation of the global economy. Our conclusion is that it is highly likely that the U.S. and China will continue to be geopolitical rivals. However, due to the geopolitical context of multipolarity, it is unlikely that the result will be “Bifurcated Capitalism.” Rather, we expect an exciting and volatile environment for investors where geopolitics takes its historical place alongside valuation, momentum, fundamentals, and macroeconomics in the pantheon of factors that determine investment opportunities and risks. The Thucydides Trap Is Real … Speaking in the Reichstag in 1897, German Foreign Secretary Bernhard von Bülow proclaimed that it was time for Germany to demand “its own place in the sun.”8 The occasion was a debate on Germany’s policy towards East Asia. Bülow soon ascended to the Chancellorship under Kaiser Wilhelm II and oversaw the evolution of German foreign policy from Realpolitik to Weltpolitik. While Realpolitik was characterized by Germany’s cautious balancing of global powers under Chancellor Otto von Bismarck, Weltpolitik saw Bülow and Wilhelm II seek to redraw the status quo through aggressive foreign and trade policy. Imperial Germany joined a long list of antagonists, from Athens to today’s People’s Republic of China, in the tragic play of human history dubbed the “Thucydides Trap.”9 Chart II-1Imperial Overstretch Imperial Overstretch Imperial Overstretch The underlying concept is well known to all students of world history. It takes its name from the Greek historian Thucydides and his seminal History of the Peloponnesian War. Thucydides explains why Sparta and Athens went to war but, unlike his contemporaries, he does not moralize or blame the gods. Instead, he dispassionately describes how the conflict between a revisionist Athens and established Sparta became inevitable due to a cycle of mistrust. Graham Allison, one of America’s preeminent scholars of international relations, has argued that the interplay between a status quo power and a challenger has almost always led to conflict. In 12 out of the 16 cases he surveyed, actual military conflict broke out. Of the four cases where war did not develop, three involved transitions between countries that shared a deep cultural affinity and a respect for the prevailing institutions.10 In those cases, the transition was a case of new management running largely the same organizational structure. And one of the four non-war outcomes was nothing less than the Cold War between the Soviet Union and the U.S. The fundamental problem for a status quo power is that its empire or “sphere of influence” remains the same size as when it stood at the zenith of power. However, its decline in a relative sense leads to a classic problem of “imperial overstretch.” The hegemonic or imperial power erroneously doubles down on maintaining a status quo that it can no longer afford (Chart II-1). The challenger power is not blameless. It senses weakness in the hegemon and begins to develop a regional sphere of influence. The problem is that regional hegemony is a perfect jumping off point towards global hegemony. And while the challenger’s intentions may be limited and restrained (though they often are ambitious and overweening), the status quo power must react to capabilities, not intentions. The former are material and real, whereas the latter are perceived and ephemeral. In a multipolar world, the U.S. will not be able to exclude China from the global system. The challenging power always has an internal logic justifying its ambitions. In China’s case today, there is a sense among the elite that the country is merely mean-reverting to the way things were for many centuries in China’s and Asia’s long history (Chart II-2). In other words, China is a “challenger” power only if one describes the status quo as the past three hundred years. It is the “established” power if one goes back to an earlier state of affairs. As such, the consensus in China is that it should not have to pay deference to the prevailing status quo given that the contemporary context is merely the result of western imperialist “challenges” to the established Chinese and regional order. Chart II-2China’s Mean Reverting Narrative November 2019 November 2019 In addition, China has a legitimate claim that it is at least as relevant to the global economy as the U.S. and therefore deserves a greater say in global governance. While the U.S. still takes a larger share of the global economy, China has contributed 23% to incremental global GDP over the past two decades, compared to 13% for the U.S. (Chart II-3). Chart II-3The Beijing Consensus November 2019 November 2019 Bottom Line: The emerging tensions between China and the U.S. fit neatly into the theoretical and empirical outlines of the Thucydides Trap. We do not see any way for the two countries to avoid struggle and conflict on a secular or forecastable horizon. What does this mean for investors? For one, the secular tailwinds behind defense stocks will persist. But what beyond that? Is the global economy destined to witness complete bifurcation into two armed camps separated by a Silicon Curtain? Will the Alibaba and Amazon Pacts suspiciously glare at each other the way that NATO and Warsaw Pacts did amidst the Cold War? The answer, tentatively, is no. … But It Will Not Lead To Economic Bifurcation President Trump’s aggressive trade policy also fits neatly into political theory, to a point. Realism in political science focuses on relative gains over absolute gains in all relationships, including trade. This is because trade leads to economic prosperity, prosperity to the accumulation of economic surplus, and economic surplus to military spending, research, and development. Two states that care only about relative gains due to rivalry produce a zero-sum game with no room for cooperation. It is a “Prisoner’s Dilemma” that can lead to sub-optimal economic outcomes in which both actors chose not to cooperate. Diagram II-1 illustrates the effects of relative gain calculations on the trade behavior of states. In the absence of geopolitics, demand (Q3) is satisfied via trade (Q3-Q0) due to the inability of domestic production (Q0) to meet it. Diagram II-1Trade War In A Bipolar World November 2019 November 2019 However, geopolitical externality – a rivalry with another state – raises the marginal social cost of imports – i.e. trade allows the rival to gain more out of trade and “catch up” in terms of geopolitical capabilities. The trading state therefore eliminates such externalities with a tariff (t), raising domestic output to Q1, while shrinking demand to Q2, thus reducing imports to merely Q2-Q1, a fraction of where they would be in a world where geopolitics do not matter. The dynamic of relative gains can also have a powerful pull on the hegemon as it begins to weaken and rethink its originally magnanimous trade relations. As political scientist Duncan Snidal argued in a 1991 paper, When the global system is first set up, the hegemon makes deals with smaller states. The hegemon is concerned more with absolute gains, smaller states are more concerned with relative, so they are tougher negotiators. Cooperative arrangements favoring smaller states contribute to relative hegemonic decline. As the unequal distribution of benefits in favor of smaller states helps them catch up to the hegemonic actor, it also lowers the relative gains weight they place on the hegemonic actor. At the same time, declining relative preponderance increases the hegemonic state’s concern for relative gains with other states, especially any rising challengers. The net result is increasing pressure from the largest actor to change the prevailing system to gain a greater share of cooperative benefits.11 History teaches us that trade occurs even amongst rivals and during wartime. The reason small states are initially more concerned with relative gains is because they are far more concerned with national security than the hegemon. The hegemon has a preponderance of power and is therefore more relaxed about its security needs. This explains why Presidents George Bush Sr., Bill Clinton, and George Bush Jr. all made “bad deals” with China. Writing nearly thirty years ago, Snidal cogently described the current U.S.-China trade war. Snidal thought he was describing a coming decade of anarchy. But he and fellow political scientists writing in the early 1990s underestimated American power. The “unipolar moment” of American supremacy was not over, it was just beginning! As such, the dynamic Snidal described took thirty years to come to fruition. When thinking about the transition away from U.S. hegemony, most investors anchor themselves to the Cold War as it is the only world they have known that was not unipolar. Moreover the Cold War provides a simple, bipolar distribution of power that is easy to model through game theory. If this is the world we are about to inhabit, with the U.S. and China dividing the whole planet into spheres like the U.S. and Soviet Union, then the paragraph we lifted from Snidal’s paper would be the end of it. America would abandon globalization in totality, impose a draconian Silicon Curtain around China, and coerce its allies to follow suit. But most of recent human history has been defined by a multipolar distribution of power between states, not a bipolar one. The term “cold war” is applicable to the U.S. and China in the sense that comparable military power may prevent them from fighting a full-blown “hot war.” But ultimately the U.S.-Soviet Cold War is a poor analogy for today’s world. In a multipolar world, Snidal concludes, “states that do not cooperate fall behind other relative gains maximizers that cooperate among themselves. This makes cooperation the best defense (as well as the best offense) when your rivals are cooperating in a multilateral relative gains world.” Snidal shows via formal modeling that as the number of players increases from two, relative-gains sensitivity drops sharply.12 The U.S.-China relationship does not occur in a vacuum — it is moderated by the global context. Today’s global context is one of multipolarity. Multipolarity refers to the distribution of geopolitical power, which is no longer dominated by one or two great powers (Chart II-4). Europe and Japan, for instance, have formidable economies and military capabilities. Russia remains a potent military power, even as India surpasses it in terms of overall geopolitical power. Chart II-4The World Is No Longer Bipolar The World Is No Longer Bipolar The World Is No Longer Bipolar A multipolar world is the least “ordered” and the most unstable of world systems (Chart II-5). This is for three reasons: Chart II-5Multipolarity Is Messy Multipolarity Is Messy Multipolarity Is Messy Math: Multipolarity engenders more potential “conflict dyads” that can lead to conflict. In a unipolar world, there is only one country that determines norms and rules of behavior. Conflict is possible, but only if the hegemon wishes it. In a bipolar world, conflict is possible, but it must align along the axis of the two dominant powers. In a multipolar world, alliances are constantly shifting and producing novel conflict dyads. Lack of coordination: Global coordination suffers in periods of multipolarity as there are more “veto players.” This is particularly problematic during times of stress, such as when an aggressive revisionist power uses force or when the world is faced with an economic crisis. Charles Kindleberger has argued that it was exactly such hegemonic instability that caused the Great Depression to descend into the Second World War in his seminal The World In Depression.13 Mistakes: In a unipolar and bipolar world, there are a very limited number of dice being rolled at once. As such, the odds of tragic mistakes are low and can be mitigated with complex formal relationships (such as U.S.-Soviet Mutually Assured Destruction, grounded in formal modeling of game theory). But in a multipolar world, something as random as an assassination of a dignitary can set in motion a global war. The multipolar system is far more dynamic and thus unpredictable. Diagram II-2 is modified for a multipolar world. Everything is the same, except that we highlight the trade lost to other great powers. The state considering using tariffs to lower the marginal social cost of trading with a rival must account for this “lost trade.” In the context of today’s trade war with China, this would be the sum of all European Airbuses and Brazilian soybeans sold to China in the place of American exports. For China, it would be the sum of all the machinery, electronics, and capital goods produced in the rest of Asia and shipped to the United States. Diagram II-2Trade War In A Multipolar World November 2019 November 2019 Could Washington ask its allies – Europe, Japan, South Korea, Taiwan, etc. – not to take advantage of the lucrative trade (Q3-Q0)-(Q2-Q1) lost due to its trade tiff with China? Sure, but empirical research shows that they would likely ignore such pleas for unity. Alliances produced by a bipolar system produce a statistically significant and large impact on bilateral trade flows, a relationship that weakens in a multipolar context. This is the conclusion of a 1993 paper by Joanne Gowa and Edward D. Mansfield.14 The authors draw their conclusion from an 80-year period beginning in 1905, which captures several decades of global multipolarity. Unless the U.S. produces a wholehearted diplomatic effort to tighten up its alliances and enforce trade sanctions – something hardly foreseeable under the current administration – the self-interest of U.S. allies will drive them to continue trading with China. The U.S. will not be able to exclude China from the global system; nor will China be able to achieve Xi Jinping’s vaunted “self-sufficiency.” A risk to our view is that we have misjudged the global system, just as political scientists writing in the early 1990s did. To that effect, we accept that Charts II-1 and II-4 do not really support a view that the world is in a balanced multipolar state. The U.S. clearly remains the most powerful country in the world. The problem is that it is also clearly in a relative decline and that its sphere of influence is global – and thus very expensive – whereas its rivals have merely regional ambitions (for the time being). As such, we concede that American hegemony could be reasserted relatively quickly, but it would require a significant calamity in one of the other poles of power. For instance, a breakdown in China’s internal stability alongside the recovery of U.S. political stability. Bottom Line: The trade war between the U.S. and China is geopolitically unsustainable. The only way it could continue is if the two states existed in a bipolar world where the rest of the states closely aligned themselves behind the two superpowers. We have a high conviction view that today’s world is – for the time being – multipolar. American allies will cheat and skirt around Washington’s demands that China be isolated. This is because the U.S. no longer has the preponderance of power that it enjoyed in the last decade of the twentieth and the first decade of the twenty-first century. Insights presented thus far come from formal theory in political science. What does history teach us? Trading With The Enemy In 1896, a bestselling pamphlet in the U.K., “Made in Germany,” painted an ominous picture: “A gigantic commercial State is arising to menace our prosperity, and contend with us for the trade of the world.”15 Look around your own houses, author E.E. Williams urged his readers. “The toys, and the dolls, and the fairy books which your children maltreat in the nursery are made in Germany: nay, the material of your favorite (patriotic) newspaper had the same birthplace as like as not.” Williams later wrote that tariffs were the answer and that they “would bring Germany to her knees, pleading for our clemency.”16 By the late 1890s, it was clear to the U.K. that Germany was its greatest national security threat. The Germany Navy Laws of 1898 and 1900 launched a massive naval buildup with the singular objective of liberating the German Empire from the geographic constraints of the Jutland Peninsula. By 1902, the First Lord of the Royal Navy pointed out that “the great new German navy is being carefully built up from the point of view of a war with us.”17 There is absolutely no doubt that Germany was the U.K.’s gravest national security threat. As a result, London signed in April 1904 a set of agreements with France that came to be known as Entente Cordiale. The entente was immediately tested by Germany in the 1905 First Moroccan Crisis, which only served to strengthen the alliance. Russia was brought into the pact in 1907, creating the Triple Entente. In hindsight, the alliance structure was obvious given Germany’s meteoric rise from unification in 1871. However, one should not underestimate the magnitude of these geopolitical events. For the U.K. and France to resolve centuries of differences and formalize an alliance in 1904 was a tectonic shift — one that they undertook against the grain of history, entrenched enmity, and ideology.18 Political scientists and historians have noted that geopolitical enmity rarely produces bifurcated economic relations exhibited during the Cold War. Both empirical research and formal modeling shows that trade occurs even amongst rivals and during wartime.19 This was certainly the case between the U.K. and Germany, whose trade steadily increased right up until the outbreak of World War One (Chart II-6). Could this be written off due to the U.K.’s ideological commitment to laissez-faire economics? Or perhaps London feared a move against its lightly defended colonies in case it became protectionist? These are fair arguments. However, they do not explain why Russia and France both saw ever-rising total trade with the German Empire during the same period (Chart II-7). Either all three states were led by incompetent policymakers who somehow did not see the war coming – unlikely given the empirical record – or they simply could not afford to lose out on the gains of trade with Germany to each other. Chart II-6The Allies Traded With Germany ... November 2019 November 2019 Chart II-7… Right Up To WWI November 2019 November 2019   Chart II-8Japan And U.S. Never Downshifted Trade November 2019 November 2019 A similar dynamic was afoot ahead of World War Two. Relations between the U.S. and Japan soured in the 1930s, with the Japanese invasion of Manchuria in 1931. In 1935, Japan withdrew from the 1922 Washington Naval Treaty – the bedrock of the Pacific balance of power – and began a massive naval buildup. In 1937, Japan invaded China. Despite a clear and present danger, the U.S. continued to trade with Japan right up until July 26, 1941, few days after Japan invaded southern Indochina (Chart II-8). On December 7, Japan attacked the U.S. A skeptic may argue that precisely because policymakers sleepwalked into war in the First and Second World Wars, they will not (or should not) make the same mistake this time around. First, we do not make policy prescriptions and therefore care not what should happen. Second, we are highly skeptical of the view that policymakers in the early and mid-twentieth century were somehow defective (as opposed to today’s enlightened leaders). Our constraints-based framework urges us to seek systemic reasons for the behavior of leaders. Political science provides a clear theoretical explanation for why London and Washington continued to trade with the enemy despite the clarity of the threat. The answer lies in the systemic nature of the constraint: a multipolar world reduces the sensitivity of policymakers to relative gains by introducing a collective action problem thanks to changing alliances and the difficulty of disciplining allies’ behavior. In the case of U.S. and China, this is further accentuated by President Trump’s strategy of skirting multilateral diplomacy and intense focus on mercantilist measures of power (i.e. obsession with the trade deficit). An anti-China trade policy that was accompanied by a magnanimous approach to trade relations with allies could have produced a “coalition of the willing” against Beijing. But after two years of tariffs and threats against the EU, Japan, and Canada, the Trump administration has already signaled to the rest of the world that old alliances and coordination avenues are up for revision. There are two outcomes that we can see emerging over the course of the next decade. First, U.S. leadership will become aware of the systemic constraints under which they operate, and trade with China will continue – albeit with limitations and variations. However, such trade will not reduce the geopolitical tensions, nor will it prevent a military conflict. In facts, the probability of military conflict may increase even as trade between China and the U.S. remains steady. Second, U.S. leadership will fail to correctly assess that they operate in a multipolar world and will give up the highlighted trade gains from Diagram II-2 to economic rivals such as Europe and Japan. Given our methodological adherence to constraint-based forecasting, we highly doubt that the latter scenario is likely. Bottom Line: The China-U.S. conflict is not a replay of the Cold War. Systemic pressures from global multipolarity will force the U.S. to continue to trade with China, with limitations on exchanges in emergent, dual-use technologies that China will nonetheless source from other technologically advanced countries. This will create a complicated but exciting world where geopolitics will cease to be seen as exogenous to investing. A risk to the sanguine conclusion is that the historical record is applicable to today, but that the hour is late, not early. It is already July 26, 1941 – when U.S. abrogated all trade with Japan – not 1930. As such, we do not have another decade of trade between U.S. and China remaining, we are at the end of the cycle. While this is a risk, it is unlikely. American policymakers would essentially have to be willing to risk a military conflict with China in order to take the trade war to the same level they did with Japan. It is an objective fact that China has meaningfully stepped up aggressive foreign policy in the region. But unlike Japan in 1941, China has not outright invaded any countries over the past decade. As such, the willingness of the public to support such a conflict is unclear, with only 21% of Americans considering China a top threat to the U.S. Investment Implications This analysis is not meant to be optimistic. First, the U.S. and China will continue to be rivals even if the economic relationship between them does not lead to global bifurcation. For one, China continues to be – much like Germany in the early twentieth century – concerned with access to external markets on which 19.5% of its economy still depend. China is therefore developing a modern navy and military not because it wants to dominate the rest of the world but because it wants to dominate its near abroad, much as the U.S. wanted to, beginning with the Monroe Doctrine. This will continue to lead to Chinese aggression in the South and East China Seas, raising the odds of a conflict with the U.S. Navy. Given that the Thucydides Trap narrative remains cogent, investors should look to overweight S&P 500 aerospace and defense stocks relative to global equity markets. An alternative way that one could play this thesis is by developing a basket of global defense stocks. Multipolarity may create constraints to trade protectionism, but it engenders geopolitical volatility and thus buoys defense spending. Second, we would not expect another uptick in globalization. Multipolarity may make it difficult for countries to completely close off trade with a rival, but globalization is built on more than just trade between rivals. Globalization requires a high level of coordination among great powers that is only possible under hegemonic conditions. Chart II-9 shows that the hegemony of the British and later American empires created a powerful tailwind for trade over the past two hundred years. Chart II-9The Apex Of Globalization Is Behind Us The Apex Of Globalization Is Behind Us The Apex Of Globalization Is Behind Us The Apex of Globalization has come and gone – it is all downhill from here. But this is not a binary view. Foreign trade will not go to zero. The U.S. and China will not completely seal each other’s sphere of influence behind a Silicon Curtain. Instead, we focus on five investment themes that flow from a world that is characterized by the three trends of multipolarity, Sino-U.S. geopolitical rivalry, and apex of globalization: Europe will profit: As the U.S. and China deepen their enmity, we expect some European companies to profit. There is some evidence that the investment community has already caught wind of this trend, with European equities modestly outperforming their U.S. counterparts whenever trade tensions flared up in 2019 (Chart II-10). Given our thesis, however, it is unlikely that the U.S. would completely lose market share in China to Europe. As such, we specifically focus on tech, where we expect the U.S. and China to ramp up non-tariff barriers to trade regardless of systemic pressures to continue to trade. A strategic long in the secularly beleaguered European tech companies relative to their U.S. counterparts may therefore make sense (Chart II-11). Chart II-10Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Europe: A Trade War Safe Haven Chart II-11Is Europe Really This Incompetent? Is Europe Really This Incompetent? Is Europe Really This Incompetent? USD bull market will end: A trade war is a very disruptive way to adjust one’s trade relationship. It opens one to retaliation and thus the kind of relative losses described in this analysis. As such, we expect that U.S. to eventually depreciate the USD, either by aggressively reversing 2018 tightening or by coercing its trade rivals to strengthen their currencies. Such a move will be yet another tailwind behind the diversification away from the USD as a reserve currency, a move that should benefit the euro. Bull market in capex: The re-wiring of global manufacturing chains will still take place. The bad news is that multinational corporations will have to dip into their profit margins to move their supply chains to adjust to the new geopolitical reality. The good news is that they will have to invest in manufacturing capex to accomplish the task. One way to articulate this theme is to buy an index of semiconductor capital companies (AMAT, LRCX, KLAC, MKSI, AEIS, BRIKS, and TER). Given the highly cyclical nature of capital companies, we would recommend an entry point once trade tensions subside and green shoots of global growth appear. “Non-aligned” markets will benefit: The last time the world was multipolar, great powers competed through imperialism. This time around, a same dynamic will develop as countries seek to replicate China’s “Belt and Road Initiative.” This is positive for frontier markets. A rush to provide them with exports and services will increase supply and thus lower costs, providing otherwise forgotten markets with a boon of investments. India, and Asia-ex-China more broadly, stand as intriguing alternatives to China, especially with the current administration aggressively reforming to take advantage of the rewiring of global manufacturing chains. Capital markets will remain globalized: With interest rates near zero in much of the developed world and the demographic burden putting an ever-greater pressure on pension plans to generate returns, the search for yield will continue to be a powerful drive that keeps capital markets globalized. Limitations are likely to grow, especially when it comes to cross-border private investments in dual-use technologies. But a completely bifurcation of capital markets is unlikely. The world we are describing is one where geopolitics will play an increasingly prominent role for global investors. It would be convenient if the world simply divided into two warring camps, leaving investors with neatly separated compartments that enabled them to go back to ignoring geopolitics. This is unlikely. Rather, the world will resemble the dynamic years at the end of the nineteenth century, a rough-and-tumble era that required a multi-disciplinary approach to investing. Marko Papic Consulting Editor, BCA Research Chief Strategist, Clocktower Group III. Indicators And Reference Charts The S&P 500 is making marginally new all-time highs. Seasonality is becoming very favorable for stock prices. However, our U.S. profit model continues to point south and expanding multiples have already driven this year’s equity gains. The S&P 500 has therefore already priced in a significant improvement in profits. Further P/E expansion will be harder to come by with bond yields set to rise. Thus, until the dollar falls and creates another tailwind for profits, stocks will not be as strong as seasonality suggests and will only make marginal new highs. Our Revealed Preference Indicator (RPI) remains cautious towards equities. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Until global growth bottoms and boosts the earnings forecasts of our models, stock gains will stay limited. The outlook for next year remains constructive for stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. continues to improve. This same indicator has recently turned lower in Japan. Meanwhile, it is deteriorating further in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Global yields have turned higher but they remain at exceptionally stimulating levels. Moreover, money and liquidity growth has picked up around the world, and global central banks continue to conduct very dovish policies. As a result, our Monetary Indicator remains at extremely elevated levels. Furthermore, our Composite Technical Indicator is still flashing a buy signal. Also, our BCA Composite Valuation index is still improving. As a result, our Speculation Indicator is back in the neutral zone. 10-year Treasury yields continue to rise, but they remain very expensive. Moreover, both our Bond Valuation Index and our Composite Technical Indicators are still flashing high-conviction sell signals. If the strengthening of the Commodity Index Advance/Decline line results in higher natural resource prices, then, inflation breakevens will also climb meaningfully. Therefore, the current setup argues for a below-benchmark duration in fixed-income portfolios. Weak global growth has been the key support for the dollar in recent months. On a PPP basis, the U.S. dollar remains extremely expensive. Additionally, our Composite Technical Indicator has lost momentum and has formed a negative divergence with the Greenback’s level. Moreover, the U.S. current account deficit has begun to widen anew. This backdrop makes the dollar highly vulnerable to a rebound in global growth. In fact, a breakdown in the greenback will be the clearest signal yet that global growth is rebounding for good. EQUITIES: Chart III-1U.S. Equity Indicators U.S. Equity Indicators U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Willingness To Pay For Risk Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Revealed Preference Indicator Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation U.S. Stock Market Valuation U.S. Stock Market Valuation Chart III-6U.S. Earnings U.S. Earnings U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations U.S. Treasurys And Valuations U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Yield Curve Slopes Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Selected U.S. Bond Yields Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield Components 10-Year Treasury Yield Components 10-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Global Bonds: Developed Markets Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets Global Bonds: Emerging Markets Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP U.S. Dollar And PPP U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator U.S. Dollar And Indicator U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals U.S. Dollar Fundamentals U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Japanese Yen Technicals Japanese Yen Technicals Chart III-20Euro Technicals Euro Technicals Euro Technicals Chart III-21Euro/Yen Technicals Euro/Yen Technicals Euro/Yen Technicals Chart III-23Euro/Pound Technicals Euro/Pound Technicals Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Broad Commodity Indicators Broad Commodity Indicators Chart III-24Commodity Prices Commodity Prices Commodity Prices Chart III-25Commodity Prices Commodity Prices Commodity Prices Chart III-26Commodity Sentiment Commodity Sentiment Commodity Sentiment Chart III-27Speculative Positioning Speculative Positioning Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot U.S. Macro Snapshot U.S. Macro Snapshot Chart III-30U.S. Growth Outlook U.S. Growth Outlook U.S. Growth Outlook Chart III-31U.S. Cyclical Spending U.S. Cyclical Spending U.S. Cyclical Spending Chart III-32U.S. Labor Market U.S. Labor Market U.S. Labor Market Chart III-33U.S. Consumption U.S. Consumption U.S. Consumption Chart III-34U.S. Housing U.S. Housing U.S. Housing Chart III-35U.S. Debt And Deleveraging U.S. Debt And Deleveraging U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions U.S. Financial Conditions U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Global Economic Snapshot: Europe Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Global Economic Snapshot: China Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1   Please see The Bank Credit Analyst "September 2019," dated August 29, 2019, available at bca.bcaresearch.com 2   Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 3   Please see The Bank Credit Analyst "August 2019," dated July 25, 2019, available at bca.bcaresearch.com 4   Please see U.S. Equity Strategy Special Report "Peak Margins," dated October 7, 2019, available at uses.bcaresearch.com 5   Please see U.S. Equity Strategy Weekly Report "Follow The Profit Trail," dated October 15, 2019, available at uses.bcaresearch.com 6   Please see Foreign  Exchange Strategy Weekly Report "On Money Velocity, EUR/USD And Silver," dated October 11, 2019, available on fes.bcaresearch.com 7   Please see BCA Research Geopolitical Strategy, “Power And Politics In East Asia: Cold War 2.0?,” September 25, 2012, “Sino-American Conflict: More Likely Than You Think,” October 4, 2013, “The Great Risk Rotation,” December 11, 2013, and “Strategic Outlook 2014 – Stay The Course: EM Risk – DM Reward,” January 23, 2014, “Underestimating Sino-American Tensions,” November 6, 2015, “The Geopolitics Of Trump,” December 2, 2016, “How To Play The Proxy Battles In Asia,” March 1, 2017, and others available at gps.bcaresearch.com or upon request. 8   Please see German Historical Institute, “Bernhard von Bulow on Germany’s ‘Place in the Sun’” (1897), available at http://germanhistorydocs.ghi-dc.org/ 9   See Graham Allison, Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Miffin Harcourt, 2017).  10  The three cases are Spain taking over from Portugal in the sixteenth century, the U.S. taking over from the U.K. in the twentieth century, and Germany rising to regional hegemony in Europe in the twenty-first century. 11   Duncan Snidal, “Relative Gains and the Pattern of International Cooperation,” The American Political Science Review, 85:3 (September 1991), pp. 701-726. 12   We do not review Snidal’s excellent game theory formal modeling in this paper as it is complex and detailed. However, we highly encourage the intrigued reader to pursue the study on their own.  13   See Charles P. Kindleberger, The World In Depression, 1929-1939 (Berkeley: University of California Press, 2013). 14   Joanne Gowa and Edward D. Mansfield, “Power Politics and International Trade,” The American Political Science Review, 87:2 (June 1993), pp. 408-420. 15   See Ernest Edwin Williams, Made in Germany (reprint, Ithaca: Cornell University Press), available at https://archive.org/details/cu31924031247830. 16   Quoted in Margaret MacMillan, The War That Ended Peace (Toronto: Allen Lane, 2014). 17   Peter Liberman, “Trading with the Enemy: Security and Relative Economic Gains,” international Security, 21:1 (Summer 1996), pp. 147-175. 18  Although France and Russia overcame even greater bitterness due to the ideological differences between a republic founded on a violent uprising against its aristocracy – France – and an aristocratic authoritarian regime – Russia.  19  See James Morrow, “When Do ‘Relative Gains’ Impede Trade?” The Journal of Conflict Resolution, 41:1 (February 1997), pp. 12-37; and Jack S. Levy and Katherine Barbieri, “Trading With the Enemy During Wartime,” Security Studies, 13:3 (December 2004), pp. 1-47.

Highlights China’s trade strategy toward the U.S. is not greatly affected by the early U.S. Democratic Party primary election. The sea change in American policy toward China began before Donald Trump and is grounded in U.S. grand strategy. Yet Trump is staging a tactical retreat in his trade war and China is reciprocating, suggesting that Beijing would rather avoid a “lame duck” Trump on the warpath. Beijing will not implement structural changes that would vindicate Trump’s negotiating strategy and set a precedent that is harmful to China’s national interests in the long run. Feature A U.S.-China trade ceasefire is in the works, based on the outcome of the latest high-level talks in Washington. President Trump, paying a surprise visit to the top Chinese negotiator, Vice Premier Liu He, agreed to pause the October 15 tariff hike in exchange for assurances that China would buy $40-$50 billion worth of agricultural goods to ease the economic pressure on Trump’s political base. Trump is now confirmed to attend the Asia Pacific Economic Cooperation summit in Santiago, Chile on November 16-17, where he hopes to cement this “phase one deal” with Chinese President Xi Jinping. Chart 1Global Policy Uncertainty To Fall Global Policy Uncertainty To Fall Global Policy Uncertainty To Fall Our market-based GeoRisk Indicator for Taiwan island – which calculates Taiwanese political risk based on any excessive deviation of the Taiwanese dollar from economic fundamentals – is a good proxy for Sino-American trade tensions due to Taiwan’s high level of exposure to China and the United States. At the moment it is signaling a sharp drop in tensions. We expect global uncertainty to follow over the coming month as Trump and Xi agree to some kind of ceasefire (Chart 1). Our Taiwan risk measure tracks closely with the Global Economic Policy Uncertainty Index, which measures risk via the word count of key terms in influential global newspapers, because Taiwan is highly exposed to the world economy and trade. Taiwan is also uniquely vulnerable to the biggest source of global policy uncertainty today: the Sino-American trade war. Not only are U.S.-China relations slightly thawing, but also the risk of the U.K. leaving the EU without a withdrawal agreement has collapsed. This will reinforce Europe’s underlying political stability despite the manufacturing recession and help create a drop in global uncertainty (Chart 2). Chart 2American Policy Uncertainty To Buck The Trend American Policy Uncertainty To Buck The Trend American Policy Uncertainty To Buck The Trend Uncertainty will remain elevated beyond the fourth quarter, however, for two main reasons. First, U.S. uncertainty will rise, not fall, as a result of the impending 2020 election. Second, the trade ceasefire is highly unlikely to resolve the slate of disagreements and underlying strategic distrust plaguing U.S.-China relations. This will cap the rebound we expect in global business sentiment. How can we be so sure that the U.S. and China will not strike a historic deal? We answer this question in this report, with particular reference to an important corollary question that has emerged in numerous client meetings: wouldn’t China rather deal with the “transactional” Trump than an “ideological” President Elizabeth Warren?   Trump Is Not A “Lame Duck” Yet, Hence The Ceasefire President Trump is a uniquely commercial president. He did not become president through experience in military or government, but because he was a bold businessman who claimed he could negotiate better deals for the United States, including on immigration and trade. So he is even more vulnerable to an economic downturn than the average U.S. president. Industrial production, manufacturing, and core capital goods new orders are contracting, and sentiment is souring among both business leaders and average consumers (Chart 3). Trump faces a distinct risk that the manufacturing slowdown and psychological effects will morph into a general slowdown. Even if not outrightly recessionary, a generalized slowdown in the U.S. economy could easily lead to rising unemployment during the election year, which would all but ensure Trump’s loss of the White House. The degree of correlation between presidential approval and the unemployment rate fluctuates over time, but our survey of post-World War II presidents shows that the unemployment rate is the best indicator of the direction the approval rating will ultimately go by the end of the term in office. While Trump’s approval is highly correlated with unemployment, it is also very low – resembling President Obama’s at this point in his first term. Yet that was in the aftermath of the Great Recession, and Trump’s approval is declining as a result of the impeachment inquiry into his alleged attempt to convince Ukraine to interfere in the 2020 election in his favor. And his approval is low despite an incredibly low rate of unemployment, at 3.5%, that can hardly get better (Chart 4). Chart 3Trump Needs A Sentiment Boost For 2020 Trump Needs A Sentiment Boost For 2020 Trump Needs A Sentiment Boost For 2020 Chart 4Rising Unemployment Would Doom Trump 2020 Rising Unemployment Would Doom Trump 2020 Rising Unemployment Would Doom Trump 2020 In short, Trump has very little wiggle room. To be reelected he must not only keep unemployment from rising much, but also achieve some other policy wins in order to draw closer to the average approval rate among post-World War II presidents (top panel, Chart 5). Even the Republican-friendly pollster Rasmussen shows that Trump’s general approval is dangerously eroding (bottom panel, Chart 5). One way Trump can achieve a political and economic victory would be to agree to a trade deal with China. Chart 5 One clear way to achieve a policy victory and a boost to the economy would be to agree to a trade deal with China. Passing the U.S.-Mexico-Canada Agreement through Congress is out of his control. Policy toward China, by contrast, is entirely within his control. Just as he raised the tariffs unilaterally, so he can roll them back unilaterally to encourage the financial markets and CEO confidence – as long as talks are making progress. The downside of this argument is that if Trump becomes a “lame duck,” with a falling economy and/or approval rating virtually ensuring that he cannot get reelected, he is no longer constrained by financial markets or the economy. He would have an incentive to initiate “Cold War 2.0” with China right here and now – or some other foreign conflict – and encourage Americans to rally around the flag amid a historic confrontation with a foreign enemy. This is a huge risk to the 2020 outlook, but it runs afoul of the economic constraint, so we expect Trump to try the “Art of the Deal” one last time.     What about impeachment? When the House of Representatives brings formal impeachment articles against Trump, the Senate will hold the trial. Republicans have a 53-47 majority in the Senate, requiring 20 to defect against the president to generate the 67 votes needed to make him the first president in U.S. history to be removed from office in this way. A total of 16 senators hail from states that Trump won by less than 10% in the 2016 election – so 20 defectors is a strong political constraint. Chart 6 Unless, of course, grassroots Republican support for Trump collapses. Right now it is falling but in line with the average (top panel, Chart 6). Republicans are not warming to the idea of impeachment and removal from office (middle panel, Chart 6). We will reassess the risk of removal if Trump’s intra-party approval heads further south and begins to look like Richard Nixon’s (bottom panel, Chart 6). Bear in mind that the election is one year away – it is easier for Republicans to kick the decision over to voters than to remove one of their own from the Oval Office. A scandal big enough to prompt an exodus of Republican support will doom any chances of Republicans retaining the White House through Vice President Mike Pence or other candidates. Bottom Line: Trump’s approval rating is in dangerously low territory but he is not yet a “lame duck” freed from the shackles of political and economic constraints. He still has a shot at extending the business cycle and saving his election campaign. This is driving him to retreat from tariffs and pursue a trade ceasefire with China. The result should be a decline in global policy uncertainty in Q4. However, this decline will not last long, as American uncertainty will skyrocket during the election year and U.S.-China tensions will reemerge once the economic constraint has been reduced. China Will Accept A Ceasefire In a special report in these pages in August, we raised a critical question: if Trump is forced to retreat from his trade war, will President Xi Jinping reciprocate? Or will he refuse to bargain, leaving Trump overextended to suffer the negative economic repercussions of the trade war without the political benefit of striking a new deal? We now have our answer, at least for the near term. China resumed negotiations in October and has confirmed that progress was made. Beijing is continuing to offer some accommodation of U.S. demands in both domestic and foreign policy (e.g. financial sector opening, enforcement of sanctions on Iran). In Hong Kong SAR, not only has Beijing avoided a violent intervention and suppression of civilian protesters, but there are rumors that Chief Executive Carrie Lam is on the way out by March (which we find highly plausible). There are still plenty of risks across the broad range of U.S.-China disputes, but from the past month’s developments we can infer that President Xi is not going on the offensive in order to destroy Trump’s latest “deal-making” bid. How far will Xi go to accommodate Trump? Not so far as to implement major structural concessions. And this will limit the positive impact of the deal. Xi does not face an electoral constraint, or the loss of office (having removed term limits), nor does he face a domestic political constraint on a 12-month time frame (the twentieth national party congress is not until 2022). Economically China is much more vulnerable – this is a valid constraint. But tariffs do not force Beijing to make major structural concessions and implement them rapidly, certainly not on Trump’s time frame. The economy is slowing but not plummeting (Chart 7). China does not face conditions like 2015-16 and policymakers have decided it is best to save ammunition in case they need to use “bazooka” stimulus later. Chart 7China's Economy Holding Up China's Economy Holding Up China's Economy Holding Up Chart 8China Not Reflating Property Bubble (Yet) China Not Reflating Property Bubble (Yet) China Not Reflating Property Bubble (Yet) The fact that Beijing has maintained restrictions on the property sector and not allowed reflation to fuel the property bubble (Chart 8) underscores the current policy disposition: some parts of the economy need to be shored up but there is no need to panic. When it comes to tariffs, China ultimately has the option of depreciating the currency to offset the impact. The fact that the CNY-USD exchange rate has not fallen as far as the headline tariff numbers suggest it should fall indicates that Beijing is still maintaining a negotiation rather than letting the currency absorb the full impact (Chart 9). Chart 9China Can Depreciate To Offset Tariffs China Can Depreciate To Offset Tariffs China Can Depreciate To Offset Tariffs Since China is still capable of “irrigation-style” fiscal stimulus, the economic constraint can be mitigated further. Beijing can continue to fight if Trump returns to the offensive. Hence we do not expect major new trade concessions beyond what is already on the table – and many of the current offerings consist of promises more so than concrete actions (Table 1). Chart Chart 10Beijing Throws Trump A Bone Beijing Throws Trump A Bone Beijing Throws Trump A Bone We do expect China to try to avoid the worst-case scenario, since it would be destabilizing for China’s medium and long-term economy and single-party rule. Stimulus will increase as necessary to ensure that growth rebounds as Beijing seeks to improve the job market and manufacturing sector. And this also supports the logic for agreeing to a ceasefire with Trump. That China is reciprocating is apparent from the U.S.’s rebounding market share in China’s agricultural imports (Chart 10). The relevant constraint for China is that Trump could be rendered a “lame duck” and go ballistic on China, activating the full slate of threats – from high-tech export controls, to banking sanctions, to capital controls. The U.S. is still the more powerful nation in absolute terms, with enormous financial, economic, military, and technological leverage over China. Beijing also sees the danger in deliberately thwarting Trump only to have him somehow win reelection. He would then have a renewed passion for punitive measures, yet he would lack the first term’s electoral constraints. Hence there is a clear basis for President Xi to accept Trump’s tactical trade retreat. Bottom Line: President Xi does not face an imminent domestic political constraint, which gives him greater leverage than President Trump. Nevertheless he does face short term economic pressures, and enough of a geopolitical and economic constraint from a full-blown escalation of tensions to accept Trump’s offer of a ceasefire. Wouldn’t China Rather Deal With Trump Than Warren? What about the upside risk? What are the chances that Xi offers additional concessions – structural concessions – in order to achieve a groundbreaking deal with the American president? A grand compromise will not occur. Republicans and Communist Party leaders have a history of such deals, which pave the way for a new multi-year stint of deepening bilateral economic engagement. We have a high conviction view that such a grand compromise will not occur. But could the U.S. 2020 election change China’s calculus? In particular, wouldn’t China prefer to deal with Trump than Senator Elizabeth Warren? More and more investors are asking this last question as the early U.S. Democratic Party primary election heats up. Warren is a democratic progressive who aims to revolutionize U.S. trade policy to promote human rights, organized labor, and strict environmental standards. She is seen as more “ideological,” whereas Trump is more “transactional” – i.e. willing to make business tradeoffs while staying away from sensitive issues affecting China’s internal affairs. Moreover Trump is a known quantity, whereas Warren would represent an unknown – a progressive populist as president and another revolution in U.S. policy, reducing predictability for Beijing.  Our assessment is that the U.S. election process is too early and too uncertain to serve as a driver of Beijing’s trade negotiating strategy over the fourth quarter. Moreover there is not a clear basis for China to favor Trump to Warren. Chart 11Trade Dispute Precedes Trump Trade Dispute Precedes Trump Trade Dispute Precedes Trump There are three major trends to bear in mind: The sea change in U.S. policy toward China began under the Obama administration. President Obama entered office by slapping tire tariffs on Beijing. He endorsed Congress’s “Buy American” provisions in the fiscal stimulus package to fight the Great Recession. Under his administration, the U.S. effectively capped steel imports from China (Chart 11). The Obama administration orchestrated the “Pivot to Asia,” a diplomatic and military initiative to rebalance U.S. strategic commitment to focus on China and the western Pacific more than the Middle East. This included the Trans-Pacific Partnership (TPP), an advanced trade deal that deliberately excluded China. It eventually also included a robust reassertion of U.S. maritime supremacy via bulked up Freedom of Navigation Operations (FONOPs) in the South China Sea, a critical global sea lane where Beijing had become increasingly assertive (Diagram 1). Chart Chart 12U.S.-China THAAD Dispute Under Obama U.S.-China THAAD Dispute Under Obama U.S.-China THAAD Dispute Under Obama The Obama administration’s attempt to install the Terminal High Altitude Area Defense (THAAD) missile defense system in South Korea caused a strategic showdown with China, emblematized by Chinese sanctions against the Korean economy (Chart 12). Obama’s one major policy handover to President Trump was to focus attention on North Korea’s advancing nuclear weaponization and missile capabilities – another source of friction with China. There can be little doubt that if the Democrats win the 2020 election, they will return to some or all of these policies. But this says more about U.S. national policy than it does about which political party China should favor in 2020, because … 2. The Trump administration is unpredictable and disruptive to both the global status quo and China’s economy. President Trump’s significance is that he shifted the Republican Party from its traditional pro-corporate, pro-free trade, pro-China orientation to a more populist, protectionist, and China-bashing approach. He stole the thunder of protectionist Democrats in the manufacturing heartland. He continued the pivot to Asia, albeit by another name (a “free and open Indo-Pacific”). This approach emphasized coercive unilateral “hard power” rather than multilateral “soft power” and resulted in a negative impact on China’s economy. This change, while it has pros and cons, demonstrates that a harder line on China has policy consensus across administrations. Few doubt that this is the new bipartisan consensus in Washington. Trump has executed this policy shift in a way that is fundamentally unsettling and unpredictable for China: sweeping unilateral tariffs against China on national security grounds (Chart 13); sanctions on tech companies critical for China’s economic future (Chart 14); and tightening relations with Taiwan. This policy eschews traditional diplomacy, which is where China thrives, and it unsettles global supply chains, where China once enjoyed centrality. To some extent Trump is even prisoner to his own logic: as he softens policy to get a trade ceasefire, he faces challenges from Congress on everything from tech export controls to Hong Kong human rights to Chinese corporate listings on U.S. stock exchanges. The Democrats will accuse him of caving to China if he agrees to a deal. Still, if China were to grant Trump deep trade concessions, it would effectively vindicate Trump’s approach. Future American presidents could always threaten across-the-board tariffs whenever they want to extract rapid structural changes from China’s policymakers. This is an intolerable precedent to set. A hard line on China has policy consensus across U.S. administrations. Chart 13Trump's Trade Policy Highly Disruptive Trump's Trade Policy Highly Disruptive Trump's Trade Policy Highly Disruptive Chart 14China's Tech Sector Under Threat China's Tech Sector Under Threat China's Tech Sector Under Threat   3. China cannot predict the outcome of U.S. primary or general elections. No one knows who will win the Democratic Party’s primary election. Joe Biden is the frontrunner and has clear advantages in terms of electability versus Trump. But Elizabeth Warren is gaining on him and her chief progressive rival, Senator Bernie Sanders of Vermont, is likely to continue flagging in the polls and feeding her rise due to his ill health. It is highly unlikely that Xi Jinping will make decisions regarding a ceasefire with Trump, as early as next month, based on up-and-down developments in a primary election that has not technically even begun (the first vote is in February). Once Biden or Warren have clinched the nomination, it is not clear who will win in November 2020. President Trump narrowly seized the electoral college in 2016 and the risks to his reelection are extreme, as outlined above. Yet he is the incumbent and BCA Research does not expect a recession next year, which should create a baseline case of reelection. Meanwhile Biden’s debate performances and polling are lackluster, despite being the establishment pick and front runner. Warren’s far-left ideology is a liability, although she is at least capable of beating Trump. Chinese policymakers will assess the developments, but Beijing will conduct strategy to be prepared for any outcome. Summing up the above, all that China knows for certain is that Trump is the current standard-bearer of a broader sea change in the Republican Party and Washington. The new consensus is broadly antagonistic toward China’s growing global influence. Hence China is preparing for “protracted struggle” regardless of whether Trump or a Democrat sits in the Oval Office after 2020. The logical conclusion is to continue negotiating with Trump, and offer some concessions to maintain credibility, but not to capitulate to his gunboat diplomacy. Finally, there are a two key arguments that work against the argument that China prefers Warren to Trump: Democrats will need time to build a multilateral anti-China coalition: Trump’s greatest mistake in the trade war is arguably his failure to form a “coalition of the willing” among western nations to take on China’s mercantilist trade practices together. Chart 15Trump Missed Chance To Build Grand Coalition Trump Missed Chance To Build Grand Coalition Trump Missed Chance To Build Grand Coalition Such a coalition would have represented a much greater economic constraint for Chinese leaders (Chart 15), making structural concessions more likely. A future Democratic president would have better luck in galvanizing such a coalition. Thus, by favoring Trump, Beijing could perpetuate the division between “America First” and “the liberal Western order.” Yet western nations will still be reluctant to confront China and it will take years of diplomacy to build such a concerted effort. These are years in which China can improve its economic self-sufficiency and use diplomacy to undermine western cohesion. By contrast, a second-term Trump could pursue punitive measures immediately (beyond tariffs) and could also pursue more western alignment, for instance on tech sanctions. A Chinese policy focused on overall stability would not clearly prefer the latter. As for a Warren presidency, her trade policy has more in common with Trump’s than with Biden’s or the status quo. It is not at all clear that she would be able to unify the West against China on the issue of trade. Hence there is no clear advantage to China of preferring Trump. Biden is probably a greater threat to China on this front, since he would “renegotiate” (i.e. rejoin) the Trans-Pacific Partnership, and court the Europeans, while likely maintaining Obama’s line on China. Yet Biden is viewed as the most pro-China candidate of all.  In short, trade policy is a wash from China’s point of view. The U.S. has already taken a more protectionist turn. From China’s view, the U.S. as a whole has taken a protectionist turn. Democrats will not prioritize China: Trump will be unshackled from concerns about bear markets and recessions if he is reelected to a second term due to the two-term limit. Warren would enter as a first-term president and would therefore face the reelection constraint that has hindered Trump’s own trade policy. If Trump loses, Warren faces an implicit threat should she clash with China. Chart 16Market Sees Warren As Health Care Risk Market Sees Warren As Health Care Risk Market Sees Warren As Health Care Risk Warren will also, like President Obama, spend the majority of her first term engrossed in an ambitious domestic policy agenda. Her policy priority is a universal single-payer health care system, which is a much more dramatic undertaking than Biden’s proposal of restoring and enhancing Obamacare, which is why health sector equities are sensitive to Warren’s election chances (Chart 16). Obama did not devote his full attention to Iran and China until his second term, and it is normal for the second term to be the “foreign policy term” due to the absence of electoral constraints. Several of Warren’s policy priorities would also be more favorable to China. In particular, Warren’s desire to impose tougher restrictions on U.S. financials, energy companies, and tech companies is broadly beneficial to China’s efforts to create globally competitive champions. At the same time, Trump is more likely to continue the buildup in U.S. military spending, which, combined with the unlikelihood that Trump will ultimately abandon U.S. allies in Asia, poses a strategic threat for China (Chart 17). China cannot calculate its trade negotiations according to the ups and downs of volatile U.S. politics. Instead it has an incentive to play both sides: to give Trump promises while hesitating to implement them, so as not to render him a dangerous “lame duck” (Chart 18) but also not to gift-wrap the election for him. Chart 17Trump's Military Buildup Trump's Military Buildup Trump's Military Buildup Chart 18 The one thing that can be expected over the next two years is that China will try to maintain economic stability to attract Europe and Asia deeper into its orbit. This means incrementally more stimulus, as mentioned above. China cannot allow itself to risk debt-deflation while encouraging other economies to become less reliant on Chinese demand. Bottom Line: China cannot predict the future. Its best play is to try to undermine the emerging U.S. policy consensus to be tough on China. This means agreeing to a ceasefire to pacify Trump without giving him major structural concessions that improve his chances of reelection. If he loses, future presidents will be afraid of tackling China aggressively. If he wins, yes, China can try to exploit his “America First” policy to keep the U.S. divided within itself and with the rest of the West. If a Democrat wins, China will have set a precedent that gunboat diplomacy fails. It can try to bind the Democrat to the Trump ceasefire terms. If the Democrats tear up the deal then China will have a basis to begin negotiations as an aggrieved party. Investment Conclusions The problem for President Trump is that a weak, short-term ceasefire – in which China does not verifiably implement structural concessions and the threat of “tech war” continues to loom – will not have as positive of an impact on global and American economic sentiment as Trump hopes. Moreover it could collapse under the weight of Sino-American strategic distrust in areas outside trade. Thus while we expect global policy uncertainty to drop off – as we outlined at the beginning of this report – we expect the reduction to be moderate rather than dramatic and not to last all the way to the U.S. election.  Our colleagues Bob Ryan and Hugo Belanger have demonstrated that a rise in global policy uncertainty is correlated with a rise in the trade weighted dollar (Chart 19). If uncertainty falls, it will help the dollar ease, which improves global financial conditions and cultivates a rebound in global growth and trade. Chart 19Policy Uncertainty Boosts The Dollar Policy Uncertainty Boosts The Dollar Policy Uncertainty Boosts The Dollar Chart 20Falling Uncertainty Hurts US Outperformance Falling Uncertainty Hurts US Outperformance Falling Uncertainty Hurts US Outperformance This is corroborated by the U.S. trade policy uncertainty index, which reinforces not only the point about the dollar but also the implication that global equities can begin to outperform U.S. equities (Chart 20). With trade sentiment recovering, and U.S. domestic political risk rising due to the election, there is a basis for equity rotation. This assumes that China’s growth does incrementally improve, as we expect.   Matt Gertken Geopolitical Strategist mattg@bcaresearch.com