Trade

Highlights U.S. consumption remains robust despite the recent intensification of global growth headwinds. The G-20 meeting will not result in an escalation nor a major resolution of Sino-U.S. tensions. Kicking the can down the road is the most likely outcome. China’s reflationary efforts will intensify, impacting global growth in the second half of 2019. Fearful of collapsing inflation expectations, global central banks are easing policy, which is supporting global liquidity conditions and growth prospects. Bond yields have upside, especially inflation expectations. Equities have some short-term downside, but the cyclical peak still lies ahead. The equity rally will leave stocks vulnerable to the inevitable pick-up in interest rates later this cycle. Gold stocks may provide an attractive hedge for now. A spike in oil prices creates a major risk to our view. Stay overweight oil plays. Feature Global growth has clearly deteriorated this year, and bond yields around the world have cratered. German yields have plunged below -0.3% and U.S. yields briefly dipped below 2%. Even if the S&P 500 remains near all-time highs, the performance of cyclical sectors relative to defensive ones is corroborating the message from the bond market. Bonds and stocks are therefore not as much in disagreement as appears at first glance. To devise an appropriate strategy, now more than ever investors must decide whether or not a recession is on the near-term horizon. Answering yes to this question means bond prices will continue to rise, the dollar will rally further, stocks will weaken, and defensive stocks will keep outperforming cyclical ones. Answering no, one should sell bonds, sell the dollar, buy stocks, and overweight cyclical sectors. The weak global backdrop can still capsize the domestic U.S. economy. We stand in the ‘no’ camp: We do not believe a recession is in the offing and, while the current growth slowdown has been painful, it is not the end of the business cycle. Logically, we are selling bonds, selling the dollar and maintaining a positive cyclical stance on stocks. We also expect international equities to outperform U.S. ones, and we are becoming particularly positive on gold stocks. Oil prices should also benefit from the upcoming improvement in global growth. Has The U.S. Economy Met Its Iceberg? Investors betting on a recession often point to the inversion of the 3-month/10-year yield curve and the performance of cyclical stocks. However, we must also remember Paul Samuelson’s famous quip that “markets have predicted nine of the five previous recessions.” In any case, these market moves tell us what we already know: growth has weakened. We must decide whether it will weaken further. A simple probit model based on the yield curve slope and the new orders component of the ISM Manufacturing Index shows that there is a 40% probability of recession over the next 12 months. We need to keep in mind that in 1966 and 1998, this model was flagging a similar message, yet no recession followed over the course of the next year (Chart I-1). This means we must go back and study the fundamentals of U.S. growth. Chart I-1The Risk Of A Recession Has Risen, But It Is Not A No Brainer Chart I-2Lower Rates Will Help Residential Investment On the purely domestic front, the U.S. economy is not showing major stresses. Last month, we argued that we are not seeing the key symptoms of tight monetary policy: Homebuilders remain confident, mortgage applications for purchases are near cyclical highs, homebuilder stocks have been outperforming the broad market for three quarters, and lumber prices are rebounding.1 Moreover, the previous fall in mortgage yields is already lifting existing home sales, and it is only a matter of time before residential investment follows (Chart I-2). Households remain in fine form. Real consumer spending is growing at a 2.8% pace, and despite rising economic uncertainty, the Atlanta Fed GDPNow model expects real household spending to expand at a 3.9% rate in the second quarter (Chart I-3). This is key, as consumers’ spending and investment patterns drive the larger trends in the economy.2 Chart I-3Consumers Are Spending Chart I-4The Labor Market Is Still Doing Fine... Going forward, we expect consumption to stay the course. Despite its latest dip, consumer confidence remains elevated, household debt levels have fallen from 134% of disposable income in 2007 to 99% today, and debt-servicing costs only represent 9.9% of after-tax income, a multi-generational low. In this context, stronger household income growth should support spending. The May payrolls report is likely to have been an anomaly. Layoffs are still minimal, initial jobless claims continue to flirt near 50-year lows, the Conference Board’s Leading Credit index shows no stress, and the employment components of both the manufacturing and non-manufacturing ISM are at elevated levels (Chart I-4). If these leading indicators of employment are correct, both the employment-to-population ratio for prime-age workers and salaries have upside (Chart I-5), especially as productivity growth is accelerating. Despite these positives, the weak global backdrop can still capsize the domestic U.S. economy, and force the ISM non-manufacturing PMI to converge toward the manufacturing index. If global growth worsens, the dollar will strengthen, quality spreads will widen and stocks will weaken, resulting in tighter financial conditions. Since economic and trade uncertainty is still high, further deterioration in external conditions will cause U.S. capex to collapse. Employment would follow, confidence suffer and consumption fall. Global growth still holds the key to the future. Following The Chinese Impulse As the world’s foremost trading nation, Chinese activity lies at the center of the global growth equation. The China-U.S. trade war remains at the forefront of investors’ minds. The meeting between U.S. President Donald Trump and Chinese President Xi Jinping over the next two days is important. It implies a thawing of Sino-U.S. trade negotiations. However, an overall truce is unlikely. An agreement to resume the talks is the most likely outcome. No additional tariffs will be levied on the remaining $300 billion of untaxed Chinese exports to the U.S., but the previous levies will not be meaningfully changed. Removing this $300 billion Damocles sword hanging over global growth is a positive at the margin. However, it also means that the can has been kicked down the road and that trade will remain a source of headline risk, at least until the end of the year. Chart I-6The Rubicon Has Been Crossed Trade uncertainty will nudge Chinese policymakers to ease policy further. In previous speeches, Premier Li Keqiang set the labor market as a line in the sand. If it were to deteriorate, the deleveraging campaign could be put on the backburner. Today, the employment component of the Chinese PMI is at its lowest level since the Great Financial Crisis (Chart I-6). This alone warrants more reflationary efforts by Beijing. Adding trade uncertainty to this mix guarantees additional credit and fiscal stimulus. More Chinese stimulus will be crucial for Chinese and global growth. Historically, it has taken approximatively nine months for previous credit and fiscal expansions to lift economic activity. We therefore expect that over the course of the summer, the imports component of the Chinese PMI should improve further, and the overall EM Manufacturing PMI should begin to rebound (Chart I-7, top and second panel). More generally, this summer should witness the bottom in global trade, as exemplified by Asian or European export growth (Chart I-7, third and fourth panel). The prospect for additional Chinese stimulus means that the associated pick-up in industrial activity should have longevity. Global central banks are running a brand new experiment. We are already seeing one traditional signpost that Chinese stimulus is having an impact on growth. Within the real estate investment component of GDP, equipment purchases are growing at a 30% annual rate, a development that normally precedes a rebound in manufacturing activity (Chart I-8, top panel). We are also keeping an eye out for the growth of M1 relative to M2. When Chinese M1 outperforms M2, it implies that demand deposits are growing faster than savings deposits. The inference is that the money injected in the economy is not being saved, but is ready to be deployed. Historically, a rebounding Chinese M1 to M2 ratio accompanies improvements in global trade, commodities prices, and industrial production (Chart I-8, bottom panel). Chart I-7The Turn In Chinese Credit Will Soon Be Felt Around The World Chart I-8China's Stimulus Is Beginning To Have An Impact   To be sure, China is not worry free. Auto sales are still soft, global semiconductor shipments remain weak, and capex has yet to turn the corner. But the turnaround in credit and in the key indicators listed above suggests the slowdown is long in the tooth. In the second half of 2019, China will begin to add to global growth once again. Advanced Economies’ Central Banks: A Brave New World Chart I-9The Inflation Expectations Panic While China is important, it is not the only game in town. Global central banks are running a brand new experiment. It seems they have stopped targeting realized inflation and are increasingly focused on inflation expectations. The collapse in inflation expectations is worrying central bankers (Chart I-9). Falling anticipated inflation can anchor actual inflation at lower levels than would have otherwise been the case. It also limits the downside to real rates when growth slows, and therefore, the capacity of monetary policy to support economic activity. Essentially, central banks fear that permanently depressed inflation expectations renders them impotent. The change in policy focus is evident for anyone to see. As recently as January 2019, 52% of global central banks were lifting interest rates. Now that inflation expectations are collapsing, other than the Norges Bank, none are doing so (Chart I-10). Instead, the opposite is happening and the RBA, RBNZ and RBI are cutting rates. Moreover, as investors are pricing in lower policy rates around the world, G-10 bond yields are collapsing, which is easing global liquidity conditions. Indeed, as Chart I-11 illustrates, when the share of economies with falling 2-year forward rates is as high as it is today, the BCA Global Leading Indicator rebounds three months later. Chart I-10Central Banks Are In Easing Mode, Everywhere The European Central Bank stands at the vanguard of this fight. As we argued two months ago, deflationary pressures in Europe are intact and are likely to be a problem for years to come.3 The ECB is aware of this headwind and knows it needs to act pre-emptively. Four months ago, it announced a new TLRTO-III package to provide plentiful funding for stressed banks in the European periphery. On June 6th, ECB President Mario Draghi unveiled very generous financing terms for the TLTRO-III. Last week, at the ECB’s Sintra conference in Portugal, ECB Vice President Luis de Guindos professed that the ECB could cut rates if inflation expectations weaken. The following day, Draghi himself strongly hinted at an upcoming rate cut in Europe and a potential resumption of the ECB QE program. These measures are starting to ease financial conditions where Europe needs it most: Italy. An important contributor to the contraction in the European credit impulse over the past 21 months was the rapid tightening in Italian financial conditions that followed the surge in BTP yields from May 2018. Now that the ECB is becoming increasingly dovish, Italian yields have fallen to 2.1%, and are finally below the neutral rate of interest for Europe. BTP yields are again at accommodative levels. Chart I-11This Much Of An Easing Bias Boosts Growth Prospects With financial conditions in Europe easing and exports set to pick up in response to Chinese growth, European loan demand should regain some vigor. Meanwhile, the TLTRO-III measures, which are easing bank funding costs, should boost banks’ willingness to lend. The European credit impulse is therefore set to move back into positive territory this fall. European growth will rebound, and contribute to improving global growth conditions. The Fed’s Patience Is Running Out The Federal Reserve did not cut interest rates last week, but its intentions to do so next month were clear. First, the language of the statement changed drastically. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” Second, the fed funds rate projections from the Summary of Economic Projections were meaningfully revised down. In March, 17 FOMC participants expected the Fed to stay on hold for the remainder of 2019, while six foresaw hikes. Today, eight expect a steady fed funds rate, but seven are calling for two rate cuts this year. Only one member is still penciling in a hike. Moreover, nine out of 17 participants anticipate that rates will be lower in 2020 than today (Chart I-12). The FOMC’s unwillingness to push back very dovish market expectations signals an imminent interest rate cut. Like other advanced economy central banks, the Fed’s sudden dovish turn is aimed at reviving moribund inflation expectations (Chart I-13). In order to do so, the Fed will have to keep real interest rates at low levels, at least relative to real GDP growth. Even if the real policy rate goes up, so long as it increases more slowly than GDP growth, it will signify that money supply is growing faster than money demand.4 TIPS yields are anticipating these dynamics and will likely remain soft relative to nominal interest rates. Chart I-13...As Inflation Expectations Plunge Since the Fed intends to conduct easy monetary policy until inflation expectations have normalized to the 2.3% to 2.5% zone, our liquidity gauges will become more supportive of economic activity and asset prices over the coming two to three quarters: Our BCA Monetary indicator has not only clearly hooked up, it is now above the zero line, in expansionary territory (see Section III, page 41). Excess money growth, defined as money-of-zero-maturity over loan growth, is once again accelerating. This cycle, global growth variables such as our Global Nowcast, BCA’s Global Leading Economic Indicator, or worldwide export prices have all reliably followed this variable (Chart I-14). After collapsing through 2018, our U.S. Financial Liquidity Index is rebounding sharply, and the imminent end of the Fed’s balance sheet runoff will only solidify this progress. This indicator gauges how cheap and plentiful high-powered money is for global markets. Its recovery suggests that commodities, globally-traded goods prices, and economic activity are all set to improve (Chart I-15). Chart I-14Excess Money Has Turned Up Chart I-15Improving Liquidity Conditions Argue That Nominal Growth Will Pick Up...   The dollar is losing momentum and should soon fall, which will reinforce the improvement in global liquidity conditions. A trough in our U.S. Financial Liquidity Index is often followed by a weakening dollar (Chart I-16). Moreover, the Greenback’s strength has been turbocharged by exceptional repatriations of funds by U.S. economic agents (Chart I-17). The end of the repatriation holiday along with a more dovish Fed and the completion of the balance sheet runoff will likely weigh on the dollar. Once the Greenback depreciates, the cost of borrowing for foreign issuers of dollar-denominated debt will decline, along with the cost of liquidity, especially if the massive U.S. repatriation flows are staunched. This will further support global growth conditions. Chart I-16...And That The Dollar Will Turn Down... Trade relations are unlikely to deteriorate further, China is likely to stimulate more aggressively; and easing central banks around the world, including the Fed, are responding to falling inflation expectations. This backdrop points to a rebound in global growth in the second half of the year. As a corollary, the deflationary patch currently engulfing the world should end soon after. As a result, this growing reflationary mindset should delay any recession until late 2021 if not 2022. However, as the business cycle extends further, greater inflationary pressures will build down the road and force the Fed to lift rates – even more than it would have done prior to this wave of easing. Chart I-17...Especially If Repatriation Flows Slow Investment Implications Bonds BCA’s U.S. Bond Strategy service relies on the Golden Rule of Treasury Investing. This simple rule states that when the Fed turns out to be more dovish than anticipated by interest rate markets 12 months prior, Treasurys outperform cash. If the Fed is more hawkish than was expected by market participants, Treasurys underperform (Chart I-18). Today, the Treasury market’s outperformance is already consistent with a Fed generating a very dovish surprise over the next 12 months. However, the interest rate market is already pricing in a 98% probability of two rates cuts this year, and the December 2020 fed funds rate futures imply a halving of the policy rate. The Fed is unlikely to clear these very tall dovish hurdles as global growth is set to rebound, the fed funds rate is not meaningfully above neutral and the household sector remains resilient. Chart I-18Treasurys Already Anticipate Large Dovish Surprises Reflecting elevated pessimism toward global growth, the performance of transport relative to utilities stocks is as oversold as it gets. The likely rebound in this ratio should push yields higher, especially as foreign private investors are already aggressively buying U.S. government securities (Chart I-19). As occurred in 1998, Treasury yields should rebound soon after the Fed begins cutting rates. Moreover, with all the major central banks focusing on keeping rates at accommodative levels, the selloff in bonds should be led by inflation breakevens, also as occurred in 1998 (Chart I-20), especially if the dollar weakens. Chart I-19Yields Will Follow Transportation Relative To Utilities Stocks Chart I-201998: Yields Rebounded As Soon As The Fed Began Cutting     Equities A global economic rebound should provide support for equities on a cyclical horizon. The tactical picture remains murky as the stock market may have become too optimistic that Osaka will deliver an all-encompassing deal. However, this short-term downside is likely to prove limited compared to the cyclical strength lying ahead. This is particularly true for global equities, where valuations are more attractive than in the U.S. Chart I-21Easier Liquidity Conditions Lead To Higher Stock Prices Even if the S&P 500 isn’t the prime beneficiary of the recovery in global growth, it should nonetheless generate positive absolute returns on a cyclical horizon. As Chart I-21 illustrates, a pickup in our U.S. Financial Liquidity Index often precedes a rally in U.S. stocks. Since the U.S. Financial Liquidity Index has done a superb job of forecasting the weakness in stocks over the past 18 months, it is likely to track the upcoming strength as well. A weaker dollar should provide an additional tailwind to boost profit growth, especially as U.S. productivity is accelerating. This view is problematic for long-term investors. The cheapness of stocks relative to bonds is the only reason why our long-term valuation index is not yet at nosebleed levels Chart I-22). If we are correct that the current global reflationary push will build greater inflationary pressures down the road and will ultimately result in even higher interest rates, this relative undervaluation of equities will vanish. The overall valuation index will then hit near-record highs, leaving the stock market vulnerable to a very sharp pullback. Long-term investors should use this rally to lighten their strategic exposure to stocks, especially when taking into account the risk that populism will force a retrenchment in corporate market power, an issue discussed in Section II. Gone is the Fed’s patience; instead, there is an urgency to “act as appropriate to sustain the expansion.” In this environment, gold stocks are particularly attractive. Central banks are targeting very accommodative policy settings, which will limit the upside for real rates. Moreover, generous liquidity conditions and a falling dollar should prove to be great friends to gold. These fundamentals are being amplified by a supportive technical backdrop, as gold prices have broken out and the gold A/D line keeps making new highs (Chart I-23). Chart I-22Beware What Will Happen To Valuations Once Rates Rise Again Chart I-23Strong Technical Backdrop For The Gold   Structural forces reinforce these positives for gold. EM reserve managers are increasingly diversifying into gold, fearful of growing geopolitical tensions with the U.S. (Chart I-24). Meanwhile, G-10 central banks are not selling the yellow metal anymore. This positive demand backdrop is materializing as global gold producers have been focused on returning cash to shareholders instead of pouring funds into capex. This lack of investment will weigh on output growth going forward. Chart I-24EM Central Banks Are Diversifying Into Gold This emphasis on returning cash to shareholders makes gold stocks particularly attractive. Gold producers are trading at a large discount to the market and to gold itself as investors remain concerned by the historical lack of management discipline. However, boosting dividends, curtailing debt levels and only focusing on the most productive projects ultimately creates value for shareholders. A wave of consolidation will only amplify these tailwinds. Our overall investment recommendation is to overweight stocks over bonds on a cyclical horizon while building an overweight position in gold equities. Our inclination to buy gold stocks transcends our long-term concerns for equities, as rising long-term inflation should favor gold as well. The Key Risk: Iran The biggest risk to our view remains the growing stress in the Middle East. BCA’s Geopolitical Strategy team assigns a less than 40% chance that tensions between the U.S. and Iran will deteriorate into a full-fledged military conflict. The U.S.’s reluctance to respond with force to recent Iranian provocations may even argue that this probability could be too high. Nonetheless, if a military conflict were to happen, it would involve a closing of the Strait of Hormuz, a bottleneck through which more than 20% of global oil production transits. In such a scenario, Brent prices could easily cross above US$150/bbl. Chart I-25Oil Inventories Are Set To Decline To mitigate this risk, we recommend overweighting oil plays in global portfolios. Not only would such an allocation benefit in the event of a blow-up in the Persian Gulf, oil is supported by positive supply/demand fundamentals and Brent should end the year $75/bbl. After five years of limited oil capex, Wood Mackenzie estimates that the supply of oil will be close to 5 million barrels per day smaller than would have otherwise been the case. Moreover, OPEC and Russia remain disciplined oil producers, which is limiting growth in crude output today. Meanwhile, in light of the global growth deceleration, demand for oil has proved surprisingly robust. Demand is likely to pick up further when global growth reaccelerates in the second half of the year. As a result, BCA’s Commodity and Energy Strategy currently expects additional inventory drawdowns that will only push oil prices higher in an environment of growing global reflation (Chart I-25). A falling dollar would accentuate these developments.   Mathieu Savary Vice President The Bank Credit Analyst June 27, 2019 Next Report: July 25, 2019   II. The Productivity Puzzle: Competition Is The Missing Ingredient Productivity growth is experiencing a cyclical rebound, but remains structurally weak. The end of the deepening of globalization, statistical hurdles, and the possibility that today’s technological advances may not be as revolutionary as past ones all hamper productivity. On the back of rising market power and concentration, companies are increasing markups instead of production. This is depressing productivity and lowering the neutral rate of interest. For now, investors can generate alpha by focusing on consolidating industries. Growing market power cannot last forever and will meet a political wall. Structurally, this will hurt asset prices.   “We don’t have a free market; don’t kid yourself. (…) Businesspeople are enemies of free markets, not friends (…) businesspeople are all in favor of freedom for everybody else (…) but when it comes to their own business, they want to go to Washington to protect their businesses.” Milton Friedman, January 1991. Despite the explosion of applications of growing computing power, U.S. productivity growth has been lacking this cycle. This incapacity to do more with less has weighed on trend growth and on the neutral rate of interest, and has been a powerful force behind the low level of yields at home and abroad. In this report, we look at the different factors and theories advanced to explain the structural decline in productivity. Among them, a steady increase in corporate market power not only goes a long way in explaining the lack of productivity in the U.S., but also the high level of profit margins along with the depressed level of investment and real neutral rates. A Simple Cyclical Explanation The decline in productivity growth is both a structural and cyclical story. Historically, productivity growth has followed economic activity. When demand is strong, businesses can generate more revenue and therefore produce more. The historical correlation between U.S. nonfarm business productivity and the ISM manufacturing index illustrates this relationship (Chart II-1). Chart II-1The Cyclical Behavior Of Productivity Chart II-2Deleveraging Hurts Productivity Since 2008, as households worked off their previous over-indebtedness, the U.S. private sector has experienced its longest deleveraging period since the Great Depression. This frugality has depressed demand and contributed to lower growth this cycle. Since productivity is measured as output generated by unit of input, weak demand growth has depressed productivity statistics. On this dimension, the brief deleveraging experience of the early 1990s is instructive: productivity picked up only after 1993, once the private sector began to accumulate debt faster than the pace of GDP growth (Chart II-2). The recent pick-up in productivity reflects these debt dynamics. Since 2009, the U.S. non-financial private sector has stopped deleveraging, removing one anchor on demand, allowing productivity to blossom. Moreover, the pick-up in capex from 2017 to present is also helping productivity by raising the capital-to-workers ratio. While this is a positive development for the U.S. economy, the decline in productivity nonetheless seems structural, as the five-year moving average of labor productivity growth remains near its early 1980s nadir (Chart II-3). Something else is at play. The Usual Suspects Three major forces are often used to explain why observed productivity growth is currently in decline: A slowdown in global trade penetration, the fact that statisticians do not have a good grasp on productivity growth in a service-based economy, and innovation that simply isn’t what it used to be. Slowdown In Global Trade Penetration Two hundred years ago, David Ricardo argued that due to competitive advantages, countries should always engage in trade to increase their economic welfare. This insight has laid the foundation of the argument that exchanges between nations maximizes the utilization of resources domestically and around the world. Rarely was this argument more relevant than over the past 40 years. On the heels of the supply-side revolution of the early 1980s and the fall of the Berlin Wall, globalization took off. The share of the world's population participating in the global capitalist system rose from 30% in 1985 to nearly 100% today. The collapse in new business formation in the U.S. is another fascinating development. Generating elevated productivity gains is simpler when a country’s capital stock is underdeveloped: each unit of investment grows the capital-to-labor ratio by a greater proportion. As a result, productivity – which reflects the capital-to-worker ratio – can grow quickly. As more poor countries have joined the global economy and benefitted from FDI and other capital inflows, their productivity has flourished. Consequently, even if productivity growth has been poor in advanced economies over the past 10 years, global productivity has remained high and has tracked the share of exports in global GDP (Chart II-4). Chart II-4The Apex Of Globalization Represented The Summit Of Global Productivity Growth This globalization tailwind to global productivity growth is dissipating. First, following an investment boom where poor decisions were made, EM productivity growth has been declining. Second, with nearly 100% of the world’s labor supply already participating in the global economy, it is increasingly difficult to expand the share of global trade in global GDP and increase the benefit of cross-border specialization. Finally, the popular backlash in advanced economies against globalization could force global trade into reverse. As economic nationalism takes hold, cross-border investments could decline, moving the world economy further away from an optimal allocation of capital. These forces may explain why global productivity peaked earlier this decade. Productivity Is Mismeasured Recently deceased luminary Martin Feldstein argued that the structural decline in productivity is an illusion. As the argument goes, productivity is not weak; it is only underestimated. This is pure market power, and it helps explain the gap between wages and productivity. A parallel with the introduction of electricity in the late 19th century often comes to mind. Back then, U.S. statistical agencies found it difficult to disentangle price changes from quantity changes in the quickly growing revenues of electrical utilities. As a result, the Bureau Of Labor Statistics overestimated price changes in the early 20th century, which depressed the estimated output growth of utilities by a similar factor. Since productivity is measured as output per unit of labor, this also understated actual productivity growth – not just for utilities but for the economy as a whole. Ultimately, overall productivity growth was revised upward. Chart II-5Plenty Of Room To Mismeasure Real Output Growth In today’s economy, this could be a larger problem, as 70% of output is generated in the service sector. Estimating productivity growth is much harder in the service sector than in the manufacturing sector, as there is no actual countable output to measure. Thus, distinguishing price increases from quantity or quality improvements is challenging. Adding to this difficulty, the service sector is one of the main beneficiaries of the increase in computational power currently disrupting industries around the world. The growing share of components of the consumer price index subject to hedonic adjustments highlight this challenge (Chart II-5). Estimating quality changes is hard and may bias the increase in prices in the economy. If prices are unreliably measured, so will output and productivity. Chart II-6A Multifaceted Decline In Productivity Pushing The Production Frontier Is Increasingly Hard Another school of thought simply accepts that productivity growth has declined in a structural fashion. It is far from clear that the current technological revolution is much more productivity-enhancing than the introduction of electricity 140 years ago, the development of the internal combustion engine in the late 19th century, the adoption of indoor plumbing, or the discovery of penicillin in 1928. It is easy to overestimate the economic impact of new technologies. At first, like their predecessors, the microprocessor and the internet created entirely new industries. But this is not the case anymore. For all its virtues, e-commerce is only a new method of selling goods and services. Cloud computing is mainly a way to outsource hardware spending. Social media’s main economic value has been to gather more information on consumers, allowing sellers to reach potential buyers in a more targeted way. Without creating entirely new industries, spending on new technologies often ends up cannibalizing spending on older technologies. For example, while Google captures 32.4% of global ad revenues, similar revenues for the print industry have fallen by 70% since their apex in 2000. If new technologies are not as accretive to production as the introduction of previous ones were, productivity growth remains constrained by the same old economic forces of capex, human capital growth and resource utilization. And as Chart II-6 shows, labor input, the utilization of capital and multifactor productivity have all weakened. Some key drivers help understand why productivity growth has downshifted structurally. Chart II-8Demographics Are Hurting Productivity Let’s look at human capital. It is much easier to grow human capital when very few people have a high-school diploma: just make a larger share of your population finish high school, or even better, complete a university degree. But once the share of university-educated citizens has risen, building human capital further becomes increasingly difficult. Chart II-7 illustrates this problem. Growth in educational achievement has been slowing since 1995 in both advanced and developing economies. This means that the growth of human capital is slowing. This is without even wading into whether or not the quality of education has remained constant. Human capital is also negatively impacted by demographic trends. Workers in their forties tend to be at the peak of their careers, with the highest accumulated job know-how. Problematically, these workers represent a shrinking share of the labor force, which is hurting productivity trends (Chart II-8). The capital stock too is experiencing its own headwinds. While Moore’s Law seems more or less intact, the decline in the cost of storing information is clearly decelerating (Chart II-9). Today, quality adjusted IT prices are contracting at a pace of 2.3% per annum, compared to annual declines of 14% at the turn of the millennium. Thus, even if nominal spending in IT investment had remained constant, real investment growth would have sharply decelerated (Chart II-10). But since nominal spending has decelerated greatly from its late 1990s pace, real investment in IT has fallen substantially. The growth of the capital stock is therefore lagging its previous pace, which is hurting productivity growth. Chart II-10The Impact Of Slowing IT Deflation Chart II-11A Dearth Of New Businesses   The collapse in new business formation in the U.S. is another fascinating development (Chart II-11). New businesses are a large source of productivity gains. Ultimately, 20% of productivity gains have come from small businesses becoming large ones. Think Apple in 1977 versus Apple today. A large decline in the pace of new business formation suggests that fewer seeds have been planted over the past 20 years to generate those enormous productivity explosions than was the case in the previous 50 years. The X Factor: Growing Market Concentration Chart II-12Wide Profit Margins: A Testament To The Weakness Of Labor The three aforementioned explanations for the decline in productivity are all appealing, but they generally leave investors looking for more. Why are companies investing less, especially when profit margins are near record highs? Why is inflation low? Why has the pace of new business formation collapsed? These are all somewhat paradoxical. This is where a growing body of works comes in. Our economy is moving away from the Adam Smith idea of perfect competition. Industry concentration has progressively risen, and few companies dominate their line of business and control both their selling prices and input costs. They behave as monopolies and monopsonies, all at once.1 This helps explain why selling prices have been able to rise relative to unit labor costs, raising margins in the process (Chart II-12). Let’s start by looking at the concept of market concentration. According to Grullon, Larkin and Michaely, sales of the median publicly traded firms, expressed in constant dollars, have nearly tripled since the mid-1990s, while real GDP has only increased 70% (Chart II-13).2 The escalation in market concentration is also vividly demonstrated in Chart II-14. The top panel shows that since 1997, most U.S. industries have experienced sharp increases in their Herfindahl-Hirshman Index (HHI),3 a measure of concentration. In fact, more than half of U.S. industries have experienced concentration increases of more than 40%, and as a corollary, more than 75% of industries have seen the number of firms decline by more than 40%. The last panel of the chart also highlights that this increase in concentration has been top-heavy, with a third of industries seeing the market share of their four biggest players rise by more than 40%. Rising market concentration is therefore a broad phenomenon – not one unique to the tech sector.     This rising market concentration has also happened on the employment front. In 1995, less than 24% of U.S. private sector employees worked for firms with 10,000 or more employees, versus nearly 28% today. This does not seem particularly dramatic. However, at the local level, the number of regions where employment is concentrated with one or two large employers has risen. Azar, Marinescu and Steinbaum developed Map II-1, which shows that 75% of non-metropolitan areas now have high or extreme levels of employment concentration.4 Chart II-15The Owners Of Capital Are Keeping The Proceeds Of The Meagre Productivity Gains This growing market power of companies on employment can have a large impact on wages. Chart II-15 shows that real wages have lagged productivity since the turn of the millennium. Meanwhile, Chart II-16 plots real wages on the y-axis versus the HHI of applications (top panel) and vacancies (bottom panel). This chart shows that for any given industry, if applicants in a geographical area do not have many options where to apply – i.e. a few dominant employers provide most of the jobs in the region – real wages lag the national average. The more concentrated vacancies as well as applications are with one employer, the greater the discount to national wages in that industry.5 This is pure market power, and it helps explain the gap between wages and productivity as well as the widening gap between metropolitan and non-metropolitan household incomes. Growing market power and concentration do not only compress labor costs, they also result in higher prices for consumers. This seems paradoxical in a world of low inflation. But inflation could have been even lower if market concentration had remained at pre-2000s levels. In 2009, Matthew Weinberg showed that over the previous 22 years, horizontal mergers within an industry resulted in higher prices.6 In a 2014 meta-study conducted by Weinberg along with Orley Ashenfelter and Daniel Hosken, the authors showed that across 49 studies ranging across 21 industries, 36 showed that horizontal mergers resulted in higher prices for consumers.7 While today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins. In a low-inflation environment, the only way for companies to garner pricing power is to decrease competition, and M&As are the quickest way to achieve this goal. After examining nearly 50 merger and antitrust studies spanning more than 3,000 merger cases, John Kwoka found that, following mergers that augmented an industry’s concentration, prices increased in 95% of cases, and on average by 4.5%.8 In no industry is this effect more vividly demonstrated than in the healthcare field, an industry that has undergone a massive wave of consolidation – from hospitals, to pharmacies to drug manufacturers. As Chart II-17 illustrates, between 1980 and 2016, healthcare costs have increased at a much faster pace in the U.S. than in the rest of the world. However, life expectancy increased much less than in other advanced economies. In this context of growing market concentration, it is easy to see why, as De Loecker and Eeckhout have argued, markups have been rising steadily since the 1980s (Chart II-18, top panel) and have tracked M&A activity (Chart II-18, bottom panel).9 In essence, mergers and acquisitions have been the main tool used by firms to increase their concentration. Another tool at their disposal has been the increase in patents. The top panel of Chart II-19 shows that the total number of patent applications in the U.S. has increased by 3.6-fold since the 1980s, but most interestingly, the share of patents coming from large, dominant players within each industry has risen by 10% over the same timeframe (Chart II-19, bottom panel). To use Warren Buffet’s terminology, M&A and patents have been how firms build large “moats” to limit competition and protect their businesses. Chart II-18Markups Rise Along With Growing M&A Activity Chart II-19How To Build A Moat?   Why is this rise in market concentration affecting productivity? First, from an empirical perspective, rising markups and concentration tend to lead to lower levels of capex. A recent IMF study shows that the more concentrated industries become, the higher the corporate savings rate goes (Chart II-20, top panel).10 These elevated savings reflect wider markups, but also firms with markups in the top decile of the distribution display significantly lower investment rates (Chart II-20, bottom panel). If more of the U.S. output is generated by larger, more concentrated firms, this leads to a lower pace of increase in the capital stock, which hurts productivity.   Second, downward pressure on real wages is also linked to a drag on productivity. Monopolies and oligopolies are not incentivized to maximize output. In fact, for any market, a monopoly should lead to lower production than perfect competition would. Diagram II-I from De Loecker and Eeckhout shows that moving from perfect competition to a monopoly results in a steeper labor demand curve as the monopolist produces less. As a result, real wages move downward and the labor participation force declines. Does this sound familiar? The rise of market power might mean that in some way Martin Feldstein was right about productivity being mismeasured – just not the way he anticipated. In a June 2017 Bank Credit Analyst Special Report, Peter Berezin showed that labor-saving technologies like AI and robotics, which are increasingly being deployed today, could lead to lower wages (Chart II-21).11 For a given level of technology in the economy, productivity is positively linked to real wages but inversely linked to markups – especially if the technology is of the labor-saving kind. So, if markups rise on the back of firms’ growing market power, the ensuing labor savings will not be used to increase actual input. Rather, corporate savings will rise. Thus, while today’s technology may be enhancing the productive potential of our economies, this is not benefiting output and measured productivity. Instead, it is boosting profit margins.12 Unsurprisingly, return on assets and market concentration are positively correlated (Chart II-22).     Finally, market power and concentration weighing on capex, wages and productivity are fully consistent with higher returns of cash to shareholders and lower interest rates. The higher profits and lower capex liberate cash flows available to be redistributed to shareholders. Moreover, lower capex also depresses demand for savings in the economy, while weak wages depress middle-class incomes, which hurts aggregate demand. Additionally, higher corporate savings increases the wealth of the richest households, who have a high marginal propensity to save. This results in higher savings for the economy. With a greater supply of savings and lower demand for those savings, the neutral rate of interest has been depressed. Investment Implications First, in an environment of low inflation, investors should continue to favor businesses that can generate higher markups via pricing power. Equity investors should therefore continue to prefer industries where horizontal mergers are still increasing market concentration. Second, so long as the status quo continues, wages will have a natural cap, and so will the neutral rate of interest. This does not mean that wage growth cannot increase further on a cyclical basis, but it means that wages are unlikely to blossom as they did in the late 1960s, even within a very tight labor market. Without too-severe an inflation push from wages, the business cycle could remain intact even longer, keeping a window open for risk assets to rise further on a cyclical basis. Third, long-term investors need to keep a keen eye on the political sphere. A much more laissez-faire approach to regulation, a push toward self-regulation, and a much laxer enforcement of antitrust laws and merger rules were behind the rise in market power and concentration.13 The particularly sharp ascent of populism in Anglo-Saxon economies, where market power increased by the greatest extent, is not surprising. So far, populists have not blamed the corporate sector, but if the recent antitrust noise toward the Silicon Valley behemoths is any indication, the clock is ticking. On a structural basis, this could be very negative for asset prices. An end to this rise in market power would force profit margins to mean-revert toward their long-term trend, which is 4.7 percentage-points below current levels. This will require discounting much lower cash flows in the future. Additionally, by raising wages and capex, more competition would increase aggregate demand and lift real interest rates. Higher wages and aggregate demand could also structurally lift inflation. Thus, not only will investors need to discount lower cash flows, they will have to do so at higher discount rates. As a result, this cycle will likely witness both a generational peak in equity valuations as well as structural lows in bond yields. As we mentioned, these changes are political in nature. We will look forward to studying the political angle of this thesis to get a better handle on when these turning points will likely emerge. Mathieu Savary Vice President The Bank Credit Analyst   III. Indicators And Reference Charts Over the past two weeks, the ECB has made a dovish pivot, President Trump announced he would meet President Xi, and the Fed telegraphed a rate cut for July. In response, the S&P 500 made marginal new highs before softening anew. This lack of continuation after such an incredible alignment of stars shows that the bulls lack conviction. These dynamics increase the probability that the market sells off after the G-20 meeting, as we saw last December following the supposed truce in Buenos Aires. The short-term outlook remains dangerous. Our Revealed Preference Indicator (RPI) confirms this intuition. 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 stong market momentum is not supported by valuation and policy, investors should lean against the market trend. Cheaper valuations, a pick-up in global growth or an actual policy easing is required before stocks can resume their ascent. The cyclical outlook is brighter than the tactical one. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan continues to improve. However, it remains flat 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. In aggregate, the WTP currently suggests that investors are still inclined to add to their stock holdings. Hence, we expect global investors will continue to buy the dips. Our Monetary Indicator is moving deeper into stimulative territory, supporting our cyclically constructive equity view. The Fed and the ECB are set to cut rates while other global central banks have been opening the monetary spigots. This will support global monetary conditions. The BCA Composite Valuation Indicator, an amalgamation of 11 measures, is in overvalued territory, but it is not high enough to negate the positive message from our Monetary Indicator, especially as our Composite Technical Indicator remains above its 9-month moving average. These dynamics confirm that despite the near-term downside, equities have more cyclical upside. According to our model, 10-year Treasurys are now expensive. Moreover, our technical indicator is increasingly overbought while the CRB Raw Industrials is oversold, a combination that often heralds the end of bond rallies. Additionally, duration surveys show that investors have very elevated portfolio duration, and both the term premium and Fed expectations are very depressed. Considering this technical backdrop, BCA’s economic view implies minimal short-term downside for yields, but significant downside for Treasury prices over the upcoming year. On a PPP basis, the U.S. dollar remains very expensive. Additionally, after forming a negative divergence with prices, our Composite Technical Indicator is falling quickly. Being a momentum currency, the dollar could suffer significant downside if this indicator falls below zero. Monitor these developments closely. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst Footnotes 1       Please see The Bank Credit Analyst "June 2019," dated May 30, 2019, available at bca.bcaresearch.com 2       Please see Global Investment Strategy Special Report "Give Credit Where Credit Is Due," dated November 27, 2015, available at gis.bcaresearch.com 3       Please see The Bank Credit Analyst Special Report "Europe: Here I Am, Stuck In A Liquidity Trap," dated April 25, 2019, available at bca.bcaresearch.com 4       Money demand is mostly driven by the level of activity and wealth. If the price of money – interest rates – is growing more slowly than money demand, the most likely cause is that money supply is increasing faster than money demand and policy is accommodative. 5       A monopsony is a firm that controls the price of its input because it is the dominant, if not unique, buyer of said input. 6       G. Grullon, Y. Larkin and R. Michaely, “Are Us Industries Becoming More Concentrated?,” April 2017. 7       The Herfindahl-Hirschman Index (HHI) is calculated by taking the market share of each firm in the industry, squaring them, and summing the result. Consider a hypothetical industry with four total firm where firm1, firm2, firm3 and firm4 has 40%, 30%, 15% and 15% of market share, respectively. Then HHI is 402+302+152+152 = 2,950. 8       J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 9     J. Azar, I. Marinescu, M. Steinbaum, “Labor Market Concentration,” December 2017. 10     M. Weinberg, “The Price Effects Of Horizontal Mergers”, Journal of Competition Law & Economics, Volume 4, Issue 2, June 2008, Pages 433–447. 11     O. Ashenfelter, D. Hosken, M. Weinberg, "Did Robert Bork Understate the Competitive Impact of Mergers? Evidence from Consummated Mergers," Journal of Law and Economics, University of Chicago Press, vol. 57(S3), pages S67 - S100. 12    J. Kwoka, “Mergers, Merger Control, and Remedies: A Retrospective Analysis of U.S. Policy,” MIT Press, 2015. 13     J. De Loecker, J. Eeckhout, G. Unger, "The Rise Of Market Power And The Macroeconomic Implications," Mimeo 2018. 14     “Chapter 2: The Rise of Corporate Market Power and Its Macroeconomic Effects,” World Economic Outlook, April 2019. 15     Please see The Bank Credit Analyst Special Report "Is Slow Productivity Growth Good Or Bad For Bonds?"dated May 31, 2017, available at bca.bcaresearch.com. 16     Productivity can be written as: 17     J. Tepper, D. Hearn, “The Myth of Capitalism: Monopolies and the Death of Competition,” Wiley, November 2018. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights When it comes to policy easing, the euro area 5-year yield at -0.15 percent is running out of road, while the U.S. 5-year yield is still at the dizzying heights of 1.8 percent. Hence, the ECB is likely to come out the loser in any ‘battle of the doves’ with the Federal Reserve. German bunds will continue to underperform U.S. T-bonds Take profits in the overweighting to Spanish Bonos and Portuguese bonds. Equity investors should go underweight European industrials and switch to the less economically-sensitive and price-sensitive healthcare sector. Feature The German 5-year bund yield recently plunged to -0.7 percent – significantly below even the -0.25 percent yield on the Japanese 5-year government bond (JGB) (Chart of the Week). This has left many people scratching their heads and wondering: is the bond market signalling that Europe is on the cusp of a vicious deflationary vortex? Chart I-1Bund Yield, How Low Can You Go? The answer is, not necessarily. The head-to-head comparison of the yields on German bunds and JGBs is misleading, because the German bund yield includes a significant discount for the possibility of currency redenomination to a new ‘super deutschmark’ (Chart I-2) while the JGB yield does not, and cannot, have such a redenomination discount given that the yen cannot break up. Chart I-2The German 5-Year Bund Yield Carries A Redenomination Discount Why The German Bund Yield Can Go Deeply Negative The German bund yield can drop to deeply negative levels, even when the policy interest rate is, and expected to remain, close to zero. This is because a negative yield on the German bund is rational if investors anticipate an equal and opposite currency gain in the event that the euro broke up. A negative yield on the German bund is rational if investors anticipate an equal and opposite currency gain. For example, if you were certain that the bund was going to deliver you deutschmarks worth 20 percent more than euros, you would accept a symmetrically negative yield near -20 percent; if you were sure of a 10 percent redenomination gain, you would accept a yield near -10 percent; and even if you expected a relatively low one-in-twenty likelihood of the 10 percent redenomination gain, this would equate to an expected gain of 0.5 percent, so you would accept a negative yield near -0.5 percent.1   Hence, an individual euro area bond yield is made up of three components: The interest rate term-structure. The likely size and direction of a currency redenomination. The likelihood of such a currency redenomination event. Chart I-3The Euro Area Term-Structure Is Much Lower Than In The U.S., But Not Quite As Low As In Japan By contrast, the yield on the JGB, U.S. T-bond and U.K. gilt is made up of just the first component, the interest rate term-structure. So, unlike the JGB, T-bond, or gilt, we cannot get information about the euro area’s interest rate term-structure from the German bund yield – or any other euro area bond yield – by itself. Fortunately, we can derive the euro area interest rate term-structure from the average euro area bond yield because, at the aggregate level, the expected currency redenomination must sum to zero.2 Understanding the components of the German 5-year bund yield enables us to decompose its current -0.7 percent yield into two parts: -0.15 percent is from the interest rate term-structure – which is low but not quite as low as Japan (Chart I-3) – while the lion’s share, -0.55 percent, is from the redenomination discount. A Strategy For Bonds Turning to the decline in the yield through the past nine months, the lion’s share has not come from a widening redenomination discount. It has come from a collapse in the global interest rate term-structure, during which the redenomination discount has actually narrowed by 0.2 percent. One important consequence is that German bunds have underperformed their peers as their yield shortfall versus both U.S. T-bonds and Italian BTPs has narrowed (Chart I-4 and Chart I-5). Can the trend continue? Chart I-4The German 5-Year Bund's Yield Shortfall Has Narrowed Versus Both U.S. T-Bonds And Italian BTPs Chart I-5The German 10-Year Bund's Yield Shortfall Has Narrowed Versus Both U.S. T-Bonds And Italian BTPs The answer is yes. When it comes to policy easing, the euro area 5-year yield at -0.15 percent is running out of road, compared with the U.S. 5-year yield at the dizzying heights of 1.8 percent. Put bluntly, from these levels of yields the ECB is likely to come out the loser in any ‘battle of the doves’ with the Federal Reserve and bunds will underperform T-bonds – exactly as we witnessed last week. Meanwhile, as absolute yields have declined euro redenomination (break-up) risk has actually diminished (Chart I-6). This makes perfect sense because solvency is an absolute concept, and the solvency of fragile Italian banks has improved in line with the higher capital values of their Italian BTP holdings. Many euro area ‘periphery’ yield spreads have already compressed to wafer-thin levels. That said, many euro area ‘periphery’ yield spreads have already compressed to wafer-thin levels. Hence, we are pleased to report that our overweighting to Spanish Bonos (versus French OATS) is now up 10 percent while our long-standing overweighting to Portuguese bonds is up 50 percent. Given that most of the yield spread compression for Spain and Portugal is now over, we are closing these positions and taking the healthy profits (Chart I-7). Chart I-6Euro Break-Up Risk Has Diminished Recently Chart I-7For Spain, Most Of The Yield Spread Compression Has Already Happened Where President Trump Is Right About Europe President Trump and the ECB might be like chalk and cheese, but they do agree on one thing. The ECB’s own analysis – available at https://www.ecb.europa.eu/stats – shows that the trade-weighted euro needs to appreciate by at least 10 percent to cancel the euro area’s competitive advantage versus its major trading partners including the United States (Chart I-8). Chart I-8The Euro Needs To Appreciate By 10 Percent To Cancel The Euro Area’s ##br##Over-Competitiveness Even more controversially, the central bank’s own analysis shows that the ECB itself is to blame for the euro area’s significant competitive advantage. Prior to the ECB’s extreme and unprecedented policy easing, the euro area’s competitiveness was exactly in line with its trading partners. The ECB does not explicitly target the exchange rate, but it is fully aware that extremely accommodative monetary policy, and especially relative monetary policy, will boost the euro area’s competitiveness and thereby create trade imbalances. On this point, President Trump is spot on (Chart I-9). Chart I-9Relative Monetary Policy Has Created The Huge Trade Imbalance Between The Euro Area And The U.S. Even if the ECB feels justified in its policy, it is now running out of road. To reiterate, in the coming months the ECB is likely to come out second best in any ‘battle of the doves’ with the Federal Reserve. Any resulting yield spread compression between the euro area and U.S. will lift the euro and start to correct the euro area’s massive trade surplus with the U.S. The euro needs to appreciate by 10 percent to cancel the euro area’s competitive advantage. Another development is that the up-oscillation in growth that has benefited the euro area, and world, economy over the past two or three quarters is about to end and flip into a down-oscillation. We will expand on this crucial issue in next week’s report, so don’t miss it! Putting this all together, euro area firms exporting price-elastic discretionary goods and services are likely to get hurt. For the second half of the year, equity investors should go underweight European industrials and switch to the less economically-sensitive and price-sensitive healthcare sector. Finally, following the dovish surprises from central banks in recent weeks, our short 30:60:10 portfolio of equities, bonds and oil reached its 3 percent technical stop-loss. However, we are maintaining the short portfolio for the time being, in the belief that a continued synchronized rally across all asset-classes is now harder to deliver.  Fractal Trading System*  Supporting the fundamental argument in the main body of the report, the fractal trading system highlights that the 6-month outperformance of euro area industrials is now technically extended and vulnerable to a trend-reversal. Accordingly, this week’s recommended trade is to short euro area industrials versus the market. The tickers are EXH4 versus EXSA, and the profit target is 2 percent with a symmetrical stop-loss. In other trades, short bitcoin reached its stop-loss and is now closed. The other trades are all in profit.  For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10Euro Area Industrials Vs. Market The post-June 9, 2016 fractal trading model rules are: 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 Footnotes 1 The numbers quoted are for a simplified example. Consider a zero-coupon German bund redeeming at 100 a year from now. If the interest rate was zero, then you would pay 100 for it today, meaning the bund yield would be zero. But if you were certain that the bund would redeem not in euros, but in deutschmarks which would appreciate 20 percent versus the euro, you would pay 120 for the bund, meaning it would yield -17 percent. If the certain redenomination was a 10 percent appreciation, you would pay 110, and the yield would be -9 percent. But if this 10 percent redenomination was uncertain with a probability of 5 percent, your expected gain would be 0.5, you would pay 100.5, and the yield would be -0.5 percent. 2 Effectively, we can think of the euro as the sum of its strong and weak ‘component’ currencies. Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems.  Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix

Special Report

Highlights Bad news is still looming in the trade war. Public opinion polling in the U.S. gives President Trump more leeway to push the envelope on tariffs and sanctions against China than the consensus recognizes. Trump’s tendency to push the envelope is forcing China into a corner in which structural concessions become too risky. Unrest in Hong Kong reveals the city-state’s political woes as well as the tail-risk of a geopolitical incident in Taiwan. Tariffs on Mexico are still possible. Close long MXN/BRL. Maintain tactical safe-haven plays. Feature Judging by the S&P 500, the Federal Reserve has cut interest rates and the G20 summit between Presidents Donald Trump and Xi Jinping has been a success (Chart 1). Chart 1Trade War? Who Cares! The problem is that there is not yet a compelling, positive, political catalyst on the trade front. And the Fed has an incentive to wait until after the June 28-29 G20 to make its decision on any cut. At least in the case of the December 1 G20 summit in Buenos Aires there was significant diplomatic preparation ahead of time. That is not yet the case for the summit in Osaka, Japan. And even Buenos Aires ended up being a flop given the subsequent tariff escalation. We are maintaining our tactical safe-haven recommendations – long gold, Swiss bonds, and Japanese yen – until we see a clearer pathway for the risk-on phase to resume amid a summer loaded with fair-probability geopolitical risks: Trump’s aggressive foreign policy, the Democratic primary, China’s domestic policy, the U.S. immigration crisis, and Brexit. Beyond this near-term caution, we agree with BCA’s House View in remaining overweight equities on a cyclical basis (12 months). China’s economic stimulus is likely to pick up further this summer and it still has the capacity to deliver positive surprises. Preparing For The G20 Over the course of this year we have argued for a 50% chance and then 40% chance that the U.S. and China would conclude a trade deal by the G20 summit. However, Commerce Secretary Wilbur Ross and other administration officials, including Chief of Staff Mick Mulvaney, have recently indicated that the best case at the G20 is for the leaders to have dinner and agree to a new timetable that aims to close the negotiations in the coming months. The Trump-Xi summit itself remains unconfirmed as we go to press. This suggests that we were too optimistic about even a barebones trade deal at the G20. We are now extending our time frame to the November 2020 election -- the only deadline that really matters. Diagram 1 presents a cogent and conservative decision tree that results in a 41% chance of a major, Cold War-style escalation in tensions; a 27% chance of a minor escalation that is contained but without a final trade agreement; and a 28% chance of a tenuous or short-term deal. It gives only a 4% chance of a “grand compromise” that initiates a new phase of re-engagement between the two economies. These outcomes clearly represent a large downside risk given where equities are positioned today. Diagram 1Trade War Decision Tree (Updated June 13, 2019) Why such gloom when the two sides may be on the brink of a new tariff ceasefire? First, delaying the talks beyond the G20 is disadvantageous for Trump and will make him angry sooner or later. The Trump administration, unlike its predecessors, has made a point of opposing China’s traditional playbook of drawing out negotiations. China benefits in talks over the long run because it gains economic and strategic leverage. This has been the case in every major round of dialogue since the 1980s and it is specifically the case today, as China gradually stimulates its way out of the slowdown that afflicted it at the time of the last G20 (Chart 2). Chart 2China's Bargaining Leverage To Improve On Stimulus Trump would not have called a ceasefire on Dec. 1, 2018 if the stock market had held up amid Fed rate hikes and the Sept. 24 implementation of the 10% tariff on $200 billion. This year the U.S. equity market has bounced back and the Fed has paused, but China’s economy has not yet fully recovered. This gives Trump an advantage that may not last if the talks extend through the rest of the year. And this reasoning explains why Trump raised the tariff rate and blacklisted China’s tech companies in May – to try to clinch a deal by the end of June. He is also threatening to impose tariffs on the remaining $300 billion worth of imports if Xi snubs him in Osaka. If the G20 fails to produce progress, we would bet that Trump will proceed with a sweeping tariff on the remaining $300 billion worth of Chinese imports, whether immediately after the summit or at some later point when he decides that the Chinese are indeed playing for time. How can we be confident of this? After all, Trump’s approval rating has fallen since he escalated the trade war in May and it remains well beneath the average post-World War II presidents at this stage in their first terms, including President Obama’s rating in the summer of 2011 (Chart 3). Recent opinion polls suggest that voters are getting wise to the negative impact of tariffs on their pocketbooks. The financial and political constraints on Trump are not very pressing. We are confident because the financial and political constraints on Trump are not very pressing, at least not at the moment. First, the stock market has risen despite the tariff hikes, so Trump is likely emboldened. Second, Trump is less constrained in the use of tariffs than in other areas. He is bogged down with a Democratic Congress, investigations, and scandals at home. He cannot pursue policy through legislation – he shifted to the threat of tariffs on Mexico because he could not build his border wall. By turbo-charging his trade policy and foreign policy – against China, Iran, Mexico, Russia, most recently Germany … basically everyone except North Korea – he creates the option of turning 2020 into a “foreign policy election” rather than an election about the economy or social policy. A strong economy has not enabled him to break through his ceiling in public opinion thus far and he will lose a social policy election easily (see health care). The risk of his aggressive foreign policy is that it triggers an international crisis. But that would likely benefit him in the polls, given the natural inclination to defend America against foreign enemies. See George W. Bush, 2004 (Chart 4). Third, popular opposition to Trump’s trade war is not clear-cut – voters are ambivalent. In the past we have shown that President Trump’s 2020 run still depends on his ability to increase voter turnout among whites, specifically white males, low-income whites, and whites without college degrees. Recent polls suggest that voters have turned against tariffs and the trade war – namely the Quinnipiac and Monmouth University polls released in late May after the latest tariff hike. But it is essential to dig beneath the surface. These polls reveal that the key voting groups look more favorably than the rest of the country upon Trump’s policies on both trade and China (Chart 5). These voters’ assessment of Trump’s performance overall, across a range of policies, is not disapproving, despite all of the unorthodox and disruptive decisions that Trump has made in his presidency thus far (Chart 6). American voters are neither as enthusiastic about free trade nor as appalled by protectionism as the headline polling suggests. For instance, take the Monmouth University poll, which asked very specific questions about trade, tariffs, and retaliation. If we combine the group of voters who are clearly protectionist with those who are “not sure” or think the answer “depends,” the results do not suggest that Trump is heavily constrained (Table 1). Table 1Americans Are Not As Pro-Free Trade As It Seems In swing counties 51% of voters think that free trade is either a bad idea or are undecided. And even 57% percent of voters in counties that voted for Hillary Clinton by more than a 10% margin are in favor of tariffs or unsure. And a majority of voters in the most relevant categories – independents, moderates, non-college graduates, low-income earners – believe that Trump’s tariffs will bring manufacturing back, a highly relevant point for an election that will likely swing on the Rust Belt yet again. This includes Clinton’s most secure districts (Chart 7)! The point is not that Trump lacks political constraints on the trade war – after all, these voters are on the borderline in many cases and concerned about all-out trade war with China. Rather, his aggressive trade tactics enable him to reconnect with and energize his voter base at a time when his other signature policies are tied down. This is critical because his reelection prospects, which we have pegged at 55%, are in great peril, at least judging by his lag in the head-to-head polling against the top Democrats in swing states. Bottom Line: Going forward, Trump has more room to push the envelope than investors realize. A failed G20 summit poses the risk of another selloff in global equities. We are maintaining our tactical safe-haven trades.   What About Xi Jinping’s Constraints? Xi is president for life and must be attentive to long-term ramifications. Chart 8Xi Jinping's Immediate Constraint If Trump is tempted to continue pushing the envelope, will President Xi back down? While not constrained by the stock market or elections, he does face the prospect of instability in the manufacturing sector and large-scale unemployment (Chart 8), which Beijing has not had to deal with for 20 years. The point is not to claim that laid-off Chinese workers will turn around and protest against their own country in the face of gunboat diplomacy by capitalist imperialists – on the 70th anniversary of the regime, no less. Rather, Xi is president for life and must be attentive to the long-term ramifications of a disruptive transition in the excessively large manufacturing sector. This would cause economic and, yes, ultimately socio-political problems for him down the road. If Trump continues to move toward his 2016 campaign pledge of a 45% tariff on all Chinese imports, as the 2020 election approaches, China’s leaders have far less incentive to put their careers (and lives) on the line to produce structural concessions. A tariff covering all Chinese goods is an absolutist position that China can only address by doubling down on its demand for full tariff rollback. Yet Trump needs to retain some tariffs to enforce the implementation of any agreement. Thus slapping tariffs on all Chinese imports is almost, but not quite, an irreversible step. This is captured in Diagram 1 via the 29% chance that tensions are contained even if a deal falls through. Tensions are even less likely to be contained if the Trump administration follows through on its threats against China’s tech sector. On August 19, the Commerce Department will decide whether to renew the license for U.S. companies to sell key components to Huawei and other blacklisted companies. If the administration denies the license – and moves further ahead with export controls on emerging and foundational technologies – then Beijing faces an outright technological blockade. It will retaliate against U.S. companies – a process already beginning1 – and will likely act on other threats such as a rare earths embargo. In this case strategic tensions will escalate dramatically, including saber-rattling in the air, in cyberspace, or on the high seas. At the moment political frictions in Hong Kong are exacerbating U.S.-China distrust. Bottom Line: Since President Xi’s constraints are longer-term, he has the ability to deny structural concessions to Trump. But Trump’s ability to push the trade war further and further risks forcing China to a point of no return. There is not a clear basis for the geopolitical risk affecting the global trade and growth outlook to fall. Hong Kong: A New Front In The U.S.-China Struggle The large-scale protests that have erupted in Hong Kong – first on April 28 and most recently on June 9 –are important for several reasons: they highlight the immense geopolitical pressure in East Asia emanating from China’s “New Era” under Xi Jinping; they are rapidly becoming entangled in U.S.-China tensions, particularly over technological acquisition; and they foreshadow the political instability on the horizon in Taiwan. Tensions have been rising between Hong Kong and mainland China since the Great Recession and the shock to capitalist financial centers around the world. The tensions are symptomatic of the dramatic change in China over the past decade; the decline of the post-Cold War status quo; and the broader decline of the western world order (e.g. the British Empire). After all, the West is lacking tools to preserve the rights and privileges that Hong Kong was supposed to be guaranteed when the transfer of sovereignty occurred in 1997. More immediately, the current protests are part of a process going back to 2012 in which the disaffected and marginalized parts of Hong Kong society began speaking up against the political establishment. This emerged because of high income inequality (Chart 9), shortcomings in quality of life, excessive property prices (Chart 10), and the mainland’s reassertion of Communist Party rule and encroachments on Hong Kong’s autonomy. Chart 10Another Source Of Hong Kong's Unrest A simple comparison with Singapore, the other major East Asian city-state, shows that Hong Kong has trailed in GDP per capita and wage gains, while property price inflation has soared ahead (Chart 11). These structural economic factors contributed to the emergence of the “Occupy Central” protests in 2014, which were smaller than today’s protests but signaled the abrupt shift in the political sphere toward disenchantment and activism. Chart 11Why Hong Kong Is Not As Quiet As Singapore The 2016 elections for the Legislative Council (LegCo) resulted in a fiasco by which a number of pro-democracy activists, known as “localists,” were squeezed out of the legislature through a combination of juvenile mistakes and heavy-handed intervention by Beijing and the pro-mainland Hong Kong authorities (Chart 12 A&B). Beijing exploited the occasion to extend its legal writ over Hong Kong society and curb some of the city’s freedoms.2 The democratic opposition and dissidents have been sidelined or repressed — and now they face the prospect of being extradited, given that the LegCo is highly likely to pass the “Fugitive Offenders and Mutual Legal Assistance in Criminal Matters” bill that sparked the protests this year. The exclusion of the localists from power runs the risk of radicalizing them and increasing disaffection, making mass protests likely to recur both in the near term and in future. Hong Kongers are losing confidence in the “One Country, Two Systems” arrangement (Chart 13). They are similarly becoming more disillusioned with mainland China, adding fuel to the fire over time (Chart 14). However, in the specific case of the city-state, there is no alternative to Beijing’s ultimate say – and the older generations will continue to support the political establishment. Nevertheless Hong Kong’s discontents will become entangled in the broader Cold War emerging between the U.S. and China. Beijing is accusing the protesters of being lackeys of foreign powers. The U.S. Congress, on both sides of the aisle, is threatening to declare that Hong Kong is no longer sufficiently autonomous from Beijing and therefore no longer eligible for special privileges. Hong Kong faces rising political dependency on China and the potential for special relations with the United States to decline. Part of Washington’s concern lies with Beijing’s aggressive technological acquisition program. Hong Kong has been able to import advanced dual-use technology products from the United States without Beijing’s restrictions. This is not apparent from the proportion of exports but it is important on the technological level (Chart 15). It introduces a backdoor for China to acquire these goods and has prompted a rethink in Washington. Hong Kong is also accused of facilitating the circumventing of sanctions on U.S. enemies. It thus faces rising political dependency on China and the potential for special relations with the United States to decline. These pressures also highlight why we view Taiwan as a potential “Black Swan.” Similar political fissures are emerging as Beijing expands its economic and military dominance over Taiwan. Of course, the political backlash against Beijing has recently been receding in Taiwanese opinion, due to the fact that the nominally pro-independence Democratic Progressive Party has lost most of the momentum it gained after the large-scale “Sunflower” student protests of 2014 (Chart 16). But there are still several reasons that the January 2020 election could become a geopolitical flashpoint: namely the developments in Hong Kong, China’s handling of them, Beijing’s tensions with Washington, and the Trump administration’s temptation to achieve some key goals with the Tsai Ing-wen administration before it leaves office (including arms sales). Even if the Taiwanese political winds shift to become less confrontational toward Beijing after January, the time between now and then is ripe for an “incident” of some kind. Beyond that, the pro-independence opposition will begin activating and marching against the next government if it proves obsequious to the mainland. Chart 16Taiwan: Pro-Mainland Forces Revive Over the long run, Taiwan is far more autonomous than Hong Kong, harder for Beijing to control, and much more attractive for Beijing’s enemies to defend – namely the U.S. and Japan. Moreover, as the tech conflict with Washington heats up, Taiwan becomes vital for China’s technological self-sufficiency, putting it at higher risk (Chart 17). Beijing will also frown upon the role of Taiwanese companies like FoxConn for taking early steps to diversify the supply chain away from China. This regional strategic reality is not conducive to U.S.-China trade negotiations. And even aside from the U.S., Beijing’s growing power generates resistance from its periphery. This is true of Chinese ally North Korea, which is trying to broaden its options, as well as a historic enemy like Vietnam. Other countries at a bit more of a distance are trying to accommodate both Beijing and Washington, but are increasingly seeing their regimes vacillate based on their orientation toward China – this is true of Thailand in 2014, the Philippines in 2015, South Korea in 2017, and Malaysia in 2018. These changes inject economic policy uncertainty on the country level. Over the long run we see Southeast Asia as a beneficiary of the relocation of supply chains out of China. But at the moment, with the trade war escalating and unresolved and with China taking a heavier hand, we are only recommending holding relatively insulated countries like Thailand. Bottom Line: Our theme of U.S.-China conflict is intertwined with our theme of geopolitical risk rotation to East Asia. States that have domestic-oriented economies, limited exposure to China, or greater U.S. support – including Japan, Thailand, South Korea, Indonesia, and Malaysia – face less geopolitical risk than those heavily exposed to China (Taiwan) or that lack U.S. security guarantees (Hong Kong, Vietnam). Investment Recommendations In addition to our safe-haven tactical trades – long spot gold, long Swiss bonds, and long JPY-USD – we are maintaining our long recommendation for a basket of companies in the MVIS global rare earth and strategic metals index. The basket includes companies not based in mainland China that have seen their stock prices appreciate this year yet have a P/E ratio under 35 (Chart 18). Chart 18Go Long Rare Earth Firms Ex-China We remain short the CNY-USD on the expectation that trade tensions will encourage Beijing to use depreciation as a countervailing tool, despite our expectation of increasing fiscal-and-credit stimulus. Over the long run, we would observe that trade escalation between the U.S. and China bodes poorly for China’s long-term productivity and efficiency. The basis for a reduction in trade tensions is a recommitment to the liberal structural reform agenda that Chinese state economists outlined at the beginning of Xi Jinping’s term in 2012-13. The current trajectory of “the New Long March,” in which Beijing pursues personalized power and uses stimulus to improve self-sufficiency and import-substitution, goes the opposite direction. It is not a pathway for innovation, openness, and technological progress. A simple comparison of China’s long-term equity total return highlights the market’s lack of enthusiasm about the current administration’s approach (Chart 19). The contexts were different, but the earlier outperformance grew from painful structural reforms and a grand compromise with the United States in the late 1990s and early 2000s. Chart 19The Market Wants Reforms And Trade Deal We are closing our long MXN / short BRL trade for a gain of 4.6%. This trade has bounced back from the U.S.-Mexico deal to avert tariffs. The agreement was not entirely hollow compared to earlier agreements: it calls for Mexico to accelerate the deployment of the National Guard to stem the flow of refugees from Guatemala and central America and expand the Migrant Protection Protocols across the southern border. Trump’s reversal – under Senate pressure, entirely unlike the China dynamic – gave the peso a boost, benefiting our trade. However, one of the fundamental reasons for this trade – the improvement in Mexico’s relative current account balance – has now rolled over (Chart 20) and the tariff threat will reemerge if Mexico proves unable or unwilling to stem the inflow of asylum seekers into the United States (Chart 21). Chart 20Peso Has Outperformed The Real   As we go to press, the attacks on tankers in Oman highlight our view that oil prices will witness policy-induced volatility and a rising geopolitical risk premium as “fire and fury” shifts to the U.S. and Iran in the near-term. Our expectation of increasing Chinese stimulus helps underpin the constructive view on oil and energy-producing emerging markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The American Chamber of Commerce in China and Shanghai released a survey on May 22, 2019 revealing that while 53% of companies have not yet experienced “non-tariff” retaliation by Chinese authorities, 47% had experienced it: 20.1% through increased inspections; 19.7% through slower customs clearance; 14.2% through slow license approvals; another 14.2% through bureaucratic and regulatory complications; and smaller numbers dealing with problems associated with American employees’ visas, increased difficulty closing investment deals, products rejected by customs, and rejections of licenses and applications. 2 We noted at the time, “Mainland forces will bring down the hammer on the pro-independence movement. The election of a new chief executive will appear to reinforce the status quo but in reality Beijing will tighten its legal, political, and security grip. Large protests are likely; political uncertainty will remain high.” See BCA Geopolitical Strategy, “Strategic Outlook 2017: We Are All Geopolitical Strategists Now,” December 14, 2016, available at www.bcaresearch.com.

Feature Markets have turned jittery in the past month. Global growth data have deteriorated further (Chart 1), with Korean exports, the German manufacturing PMI, and even U.S. industrial production weak. Moreover, trade negotiations between the U.S. and China appear to have broken down, with China threatening to retaliate against U.S. sanctions on Huawei by blocking sales of rare earths, and refusing to negotiate further unless the U.S. eases tariffs. BCA’s Geopolitical Strategists now give only a 40% probability of a trade deal by the time of the G20 summit at the end of June (Table 1). As a result, BCA alerted clients on 10 May to the risk of a further short-term 5% correction in global equities.1 Recommended Allocation Chart 1Worrying Signs? Table 1Chances Of A Trade Deal Fading Fast What is essentially behind the global slowdown, especially outside the U.S., is that both China and the U.S. last year were tightening monetary policy – China by slowing credit growth, the U.S. via Fed hikes. The U.S. economy was robust enough to withstand this, but economies in Europe, Asia, and Emerging Markets were not (Chart 2). The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. China has already triggered a rebound in credit growth since January (Chart 3). Chart 2U.S. Holding Up Better Than Elsewhere Chart 3China Stimulus Has Only Just Begun This has not come through clearly in Chinese – and other countries’ – activity data yet, partly because there is usually a lag of 3-12 months before this happens, and partly because Chinese authorities seemingly eased back somewhat on the gas pedal in April given rising expectations of a trade deal. But, judging by previous episodes such as 2009 and 2016, the Chinese will stimulate now based on the worst-case scenario. The risk is more that they overdo the stimulus than that they fail to do enough. Yes, China is worried about its excess debt situation. But this year they will prioritize growth – not least because of some sensitive anniversaries in the months ahead (for example, the 70th anniversary of the People’s Republic on October 1), and because the government is falling behind on its promise to double per capita real income between 2010 and 2020 (Chart 4). Chart 4Chinese Communist Party Needs To Prioritize Growth Chart 5U.S. Consumers Look In Fine State     In the U.S., consumption is likely to continue to buoy the economy. Wages are growing 3.2% a year and set to accelerate further, and consumer confidence is close to a 50-year high (Chart 5). It is easy to exaggerate the impact of even an all-out trade war. For China, exports to the U.S. are only 3.4% of GDP. A hit to this could easily be offset by stimulus leading to greater capital expenditure. For the U.S, most academic studies show that the impact of tariffs will largely be passed on to the consumer via higher prices.2 But even if the U.S. imposes 25% tariffs on all Chinese exports and all is passed on to the consumer with no substitutions for goods from other countries the impact, about $130 billion, would represent only 1% of total U.S. consumption. The question now is whether the Chinese authorities and the Fed will come to the rescue and add stimulus that will cause a recovery in global growth. But if China will bail out the global economy, we are not so convinced that the Fed will cut rates any time soon. The market has priced in two Fed rate cuts over the next 12 months (Chart 6). But we agree with comments from Fed officials that recent softness in inflation is transitory. For example, financial services inflation (mostly comprising financial advisor fees, linked to assets under management, and therefore very sensitive to the stock market) alone has deducted 0.4 percentage points from core PCE inflation over the past six months (Chart 7). The trimmed mean PCE (which cuts out other volatile items besides energy and food, which are excluded from the commonly used core PCE measure) is close to 2% and continues to drift up. Chart 6Will The Fed Really Cut Twice In 12 Months? Chart 7Soft Inflation Probably Is Transitory     Fed policy remains mildly accommodative: the current Fed Funds Rate is still two hikes below the neutral rate, as defined by the median terminal-rate dot in the FOMC’s Summary of Economic Projections (Chart 8). The market may be trying to push the Fed into cutting rates and could be disappointed if it does not. For now, we tend to agree with the Fed’s view that policy is about correct (Chart 9) but, if global growth does recover before the end of the year, one hike would be justified in early 2020 – before the upcoming Presidential election in November 2020 makes it less comfortable for the Fed to move. Chart 8Fed Policy Is Still Accommodative Chart 9Fed Doesn't Need To Move For Now     In this macro environment, we see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. The risk of a global recession over the next year or so is not high, in our opinion. We, therefore, continue to recommend an overweight on global equities and underweight on bonds over the cyclical horizon.  We see global bond yields bottoming not far below their current (very depressed) levels, and equities eking out reasonable gains over the next 12 months. Fixed Income: Government bond yields have fallen sharply over the past eight months (by 110 basis points for the U.S. 10-year, for example) because of 1) falling inflation expectations, caused mostly by a weak oil price, 2) expectations of Fed rate cuts, 3) especially weak growth in Europe, which pulled German yields down to -20 basis points in May, and 4) global risk aversion which pushed asset allocators into government bonds, and lowered the term premium to near record low levels (Chart 10). If Brent crude rises to $80 a barrel this year as we forecast, the Fed does not cut rates, and European growth rebounds because of Chinese stimulus, we find it highly improbable that yields will fall much further. Ultimately, the global risk-free rate is driven by global growth (Chart 11). Investors are already positioned very aggressively for a further fall in yields (Chart 12). We would expect the U.S. 10-year yield to move back towards 3% over the next 12 months. We remain moderately positive on credit, which should also benefit from a growth rebound: U.S. high-yield spreads are still around 70 basis points for Ba-rated bonds, and 110 basis points for B-rated ones, above the levels at which they typically bottom in expansions; investment-grade bonds, though, have less room for spread contraction (Chart 13). Chart 10Term Premium Near Record Low Chart 11Global Rebound Would Push Up Yields   Chart 12Investors Very Long Duration Chart 13Credit Spreads Can Tighten Further     Equities:  We remain overweight U.S. equities, partly as a hedge against our overweight on the equity asset class, since the U.S. remains a relatively low beta market. Our call for the second half will be 1) when will Chinese stimulus start to boost growth disproportionately for commodity and capital-goods exporters, and 2) does that justify a shift out of the U.S. (which may be somewhat hurt short term by the Trade War) and into euro zone and Emerging Markets equities. Given the structural headwinds in both (the chronically weak banking system and political issues in Europe; high debt and lack of structural reforms in EM), we want clear evidence that the Chinese stimulus is working before making this call. We are likely to remain more cautious on Japan, even though it is a clear beneficiary of Chinese growth, because of the risk presented by the rise in the consumption tax in October: after previous such hikes, consumption not only slumped immediately afterwards but remained depressed (Chart 14). Chart 14Japan's Sales Tax Hike Is A Worry Chart 15Dollar Is A Counter-Cyclical Currency   Currencies:  Again, China is the key. The dollar is a counter-cyclical currency, and a pickup in global growth would weaken it (Chart 15). Any further easing by the ECB – for example, significantly easier terms on the next Targeted Longer-Term Refinancing Operations (TLTRO) – might actually be positive for the euro since it would augur stronger growth in the euro area. Moreover, long dollar is a clear consensus view, with very skewed market positioning (Chart 16). Also, on a fundamental basis, compared to Purchasing Power Parity, the dollar is around 15% overvalued versus the euro and 11% versus the yen. Chart 17Industrial Metals Driven By China Too Commodities: Industrial metals prices have generally been weak in recent months with copper, for example, falling by 10% since mid-April. It will require a sustained rebound in Chinese infrastructure spending to push prices back up (Chart 17). Oil continues to be driven by supply-side factors, not demand. With OPEC discipline holding, Iran sanctions about to be reimposed, political turmoil in Libya and Venezuela, BCA’s energy strategists continue to see inventories drawing down this year, and therefore forecast Brent crude to reach $80 during 2019 (Chart 18). Chart 18Oil Supply Remains Tight Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1       Please see Global Investment Strategy, Special Report, “Stay Cyclically Overweight Global Equities, But Hedge Near-Term Downside Risks From An Escalation Of A Trade War,” dated May 10, 2019, available at gis.bcaresearch.com 2      Please see, for example, Mary Amiti, Sebastian Heise, and Noah Kwicklis, “The Impact of Import Tariffs on U.S. Domestic Prices,” Federal Reserve Bank of New York Liberty Street Economics, dated 4 January 2019. Recommended Asset Allocation  

Highlights Global equities face near-term downside risks from the trade war, but should be higher in 12 months’ time. Its claims to novelty notwithstanding, Modern Monetary Theory is basically indistinguishable from standard Keynesian economics except that MMT assumes that changes in interest rates have no discernible effect on aggregate demand. This straightforward but unrealistic assumption allows MMT’s proponents to argue that the neutral rate of interest does not exist, that crowding out is impossible, and that while fiscal deficits do matter (because too much government spending can stoke inflation), debt levels do not. Despite its many shortcomings, MMT’s focus on financial balances and the role of sovereign-issued money is laudable. A better understanding of these concepts would have made investors a lot of money during the past decade. Today, most economies are still running large private-sector financial surpluses. This surplus of desired savings relative to investment has kept interest rates low, which have allowed governments to finance their budgets at favorable terms. As these surpluses decline, inflation will rise. Feature Greetings From Down Under I have been meeting clients in Australia and New Zealand this week. The mood has been generally negative on the outlook for both the domestic and global economies. As one might imagine, the brewing China-U.S. trade war has been a hot topic of discussion. We went tactically short the S&P 500 on May 10th, a move that for the time being effectively neutralizes our structurally overweight stance on global equities. As we indicated when we initiated the hedge, we will take profits on the position if the S&P 500 drops below 2711. Despite the darkening clouds hanging over the trade war, we still expect a detente to be reached that prevents a further escalation of the conflict. Both sides would suffer from an extended trade war. For China, it is no longer just about losing access to the vast U.S. market. It is also about losing access to vital technology. The blacklisting of Huawei deprives China of critical components needed to realize its dream of becoming a world leader in AI and robotics. The trade war will not harm the U.S. as much as it will China, but it has still raised prices for American consumers, while lowering the prices of key agricultural exports such as soybeans. It has also hurt the stock market, which Trump seems to view as a barometer for his own success as president. If a trade detente is eventually reached, market attention will shift back to the outlook for global growth. We expect the combination of aggressive Chinese fiscal/credit stimulus and the palliative effects of falling global bond yields over the past seven months to lift growth in the back half of the year. As a countercyclical currency, the U.S. dollar is likely to weaken when global growth starts to strengthen. This will provide an opportune time to go overweight EM and European equities as well as the more cyclical sectors of the stock market. Are You Now Or Have You Ever Been A Member Of The MMT Movement? Last week’s report1 argued that a global deflationary ice age is unlikely to transpire because politicians will pursue large-scale fiscal stimulus to preclude this outcome. We noted that many countries are easing fiscal policy at the margin, partly in response to populist pressures. Even in Japan, the likelihood that the government will raise the sales tax this year has diminished, while structural forces will continue to drain savings for years to come. This will set the stage for higher inflation in Japan, something the market is not at all anticipating. Somewhat controversially, we contended that larger budget deficits are unlikely to imperil debt sustainability, at least for countries that are able to issue debt in their own currencies. This implies that any government with its own printing press should simply ease fiscal policy until long-term inflation expectations reach their target level. MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. A number of readers pointed out that our analysis sounded suspiciously supportive of Modern Monetary Theory (MMT). Are we really closet MMT devotees? No, we are not. Our approach shares some commonalities with MMT (so if you want to call me a “MMT sympathizer,” go ahead). However, it also differs from MMT in a number of important respects. As we discuss below, these differences have significant implications for market outcomes, particularly one’s views about the long-term direction of government bond yields. MMT: A “Special Case” Of Keynesian Economics Modern Monetary Theory is not nearly as novel as its backers claim. In fact, MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. Outside of liquidity trap conditions, most economists believe that monetary policy is an effective aggregate demand management tool. MMT’s supporters reject this. In their view, changes in interest rates have no impact on spending. In the technical parlance of economics, MMT is basically the Hicksian IS/LM model but with a vertical IS curve and an LM curve that intersects the IS curve at an interest rate of zero (Chart 1). This seemingly small variation on the traditional Keynesian framework has far-reaching consequences. For one thing, it renders meaningless the entire concept of the neutral rate of interest. If changes in interest rates have no effect on aggregate demand, then one cannot identify an equilibrium level of interest rates that is consistent with full employment and stable inflation. Given their leftist roots, it is not surprising that most MMTers favor keeping rates low, preferably near zero. Higher rates shift income from borrowers to lenders. The latter tend to be richer than the former. Why reward fat cats when you don’t have to? Low rates also allow the government to spend more without putting the debt-to-GDP ratio on an unsustainable trajectory. If the interest rate at which the government borrows stays below the growth rate of the economy, the government can run a stable Ponzi scheme, perpetually issuing new debt to pay the interest on existing debt (Chart 2). In such a world, budget deficits only matter to the extent that too much fiscal stimulus can stoke inflation. The level of debt, in contrast, never matters. Interest Rates Do Affect Aggregate Demand Chart 3Mortgage Rate Swings Matter For The Housing Market Despite MMT’s efforts to deny any role for monetary policy in stabilizing the economy, the empirical evidence clearly shows that changes in interest rates do affect consumption and investment decisions. Housing activity, in particular, is very sensitive to movements in mortgage rates. The recent drop in mortgage rates bodes well for U.S. housing activity during the remainder of the year (Chart 3). The dollar, like most currencies, is also influenced by shifts in interest rate differentials (Chart 4). Changes in the dollar affect net exports, and hence overall employment. Once we acknowledge that interest rates affect aggregate demand, we are back in a world of trade-offs between monetary and fiscal policy. One can have easy monetary policy and tight fiscal policy, or tight monetary policy and easy fiscal policy. But outside of liquidity trap conditions, one cannot have both easy monetary and fiscal policies for a prolonged period of time without tolerating higher and rising inflation.   Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials The Perils Of Accounting Identities MMT proponents love accounting identities. They are particularly fond of saying that government deficits endow the private sector with additional wealth in the form of government bonds or cash. Unfortunately, the penchant to “argue by accounting identity” is almost always a recipe for disaster since such arguments usually fail to identify the causal forces by which one thing affects the other. For example, no competent economist would deny that an increase in the fiscal deficit must tautologically imply an increase in the private sector’s financial balance (the difference between the private sector’s income and spending). What MMT adherents fail to appreciate is that private-sector savings can increase either if incomes rise or spending falls. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. When an economy is depressed, fiscal stimulus is likely to increase employment. In such a setting, rising payrolls will boost incomes, leading to a larger private-sector surplus. In contrast, when the economy is operating at full employment, any increase in the private-sector surplus must come about through a decline in private-sector spending. That is to say, if the government consumes more of the economy’s output, the private sector has to consume less.  There is a huge difference between the two cases. MMTers tend to gloss over this distinction because they do not really have a theory for why the private-sector financial balance moves around in the first place. To them, private-sector spending is completely exogenous. It is determined by such things as animal spirits that the government has no control over. The government’s only job is to adjust the fiscal balance to ensure that it is the mirror image of the private-sector’s balance. Budget deficits cannot crowd out private-sector spending in this context because the government plays no role in determining how much the private sector wishes to spend. Investment Conclusions Economics gets a bad rap these days. Although most people would not go as far as Nassim Taleb who once mused about running over economists in his Lexus, it is fair to say that there is a lot of disillusionment towards the economics profession. Ostensibly heterodox theories like MMT help fill an intellectual void for those hoping to rewrite the economics textbooks for the 21st century. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. Shortly after the financial crisis, when the world was still mired in a deep slump, Keynesian economics predicted that large budget deficits would not push up interest rates and that QE would not lead to runaway inflation. In contrast, Taleb said in early February 2010, when the 10-year Treasury yield was trading at around 3.6%, that Ben Bernanke was “immoral” and that “Every single human being should short Treasury bonds. It’s a no-brainer.” The study of financial balances is not unique to MMT, nor is MMT’s approach to thinking about financial balances the best one. Even so, a basic understanding of the concept would have prevented Taleb and countless others from making the mistakes they did. The fact that MMT has brought the discussion of financial balances, along with related concepts such as the role of sovereign-issued money in an economy, back into the spotlight is its greatest virtue. Today, most economies are still running large private-sector financial surpluses (Chart 5). Given that interest rates are so low, it is difficult to argue that budget deficits are crowding out private spending. This may change over time, however. Falling unemployment is boosting consumer confidence, which will bolster spending. U.S. wage growth has already accelerated sharply among workers at the bottom end of the income distribution (Chart 6). These are the workers with the highest marginal propensity to consume. Chart 5AMost Major Countries Run Private-Sector Surpluses (I) Chart 5BMost Major Countries Run Private-Sector Surpluses (II) Meanwhile, baby boomers are leaving the labor force. More retirees means less production, but not necessarily less consumption. Once health care spending is added to the tally, consumption actually increases in old age (Chart 7). If production falls in relation to consumption, excess savings will decline and the neutral rate of interest will rise. Chart 7Savings Over The Life Cycle When this happens, will governments tighten fiscal policy, as the MMT prescription requires? In a world where entitlement programs are politically sacrosanct, that seems unlikely. The end result is that economies will overheat and inflation will rise. Will central banks tighten monetary policy in response to higher inflation? That depends on what one means by tighten. Central banks will undoubtedly raise rates, but in a world of high debt levels, they will be loath to push interest rates above the growth rate of the economy. Interest rates will rise in nominal terms, but probably very little or not at all in real terms. In such an environment, investors should maintain below-benchmark duration exposure in their fixed-income portfolios, while favouring inflation-linked bonds over nominal bonds. Owning traditional inflation hedges such as gold would also make sense.    Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1          Please see Global Investment Strategy Weekly Report, “Ice Age Cometh?” dated May 24, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights So What? U.S.-China relations are still in free fall as we go to press. Why? The trade war will elicit Chinese stimulus but downside risks to markets are front-loaded. The oil risk premium will remain elevated as Iran tensions will not abate any time soon. The odds of a no-deal Brexit are rising. Our GeoRisk Indicators show that Turkish and Brazilian risks have subsided, albeit only temporarily. Maintain safe-haven trades. Short the CNY-USD and go long non-Chinese rare earth providers. Feature The single-greatest reason for the increase in geopolitical risk remains the United States. The Democratic Primary race will heat up in June and President Trump, while favored in 2020 barring a recession, is currently lagging both Joe Biden and Bernie Sanders in the head-to-head polling. Trump’s legislative initiatives are bogged down in gridlock and scandal. The remaining avenue for him to achieve policy victories is foreign policy – hence his increasing aggressiveness on both China and Iran. The result is negative for global risk assets on a tactical horizon and possibly also on a cyclical horizon. A positive catalyst is badly needed in the form of greater Chinese stimulus, which we expect, and progress toward a trade agreement. Brexit, Italy, and European risks pale by comparison to what we have called “Cold War 2.0” since 2012. Nevertheless, the odds of Brexit actually happening are increasing. The uncertainty will weigh on sentiment in Europe through October even if it does not ultimately conclude in a no-deal shock that prevents the European economy from bouncing back. Yet the risk of a no-deal shock is higher than it was just weeks ago. We discuss these three headline geopolitical risks below: China, Iran, and the U.K. No End In Sight For U.S.-China Trade Tensions U.S.-China negotiations are in free fall, with no date set for another round of talks. On March 6 we argued that a deal had a 50% chance of getting settled by the June 28-29 G20 summit in Japan, with a 30% chance talks would totally collapse. Since then, we have reduced the odds of a deal to 40%, with a collapse at 50%, and a further downgrade on the horizon if a positive intervention is not forthcoming producing trade talks in early or mid-June (Table 1). Table 1U.S.-China Trade War: Probabilities Of A Deal By End Of June 2019 We illustrate the difficulties of agreeing to a deal through the concept of a “two-level game.” In a theoretical two-level game, each country strives to find overlap between its international interests and its rival’s interests and must also seek overlap in such a way that the agreement can be sold to a domestic audience at home. The reason why the “win-win scenario” is so remote in the U.S.-China trade conflict is because although China has a relatively large win set – it can easily sell a deal at home due to its authoritarian control – the U.S. win set is small (Diagram 1). Diagram 1Tiny Win-Win Scenario In U.S.-China Trade Conflict The Democrats will attack any deal that Trump negotiates, making him look weak on his own pet issue of trade with China. This is especially the case if a stock market selloff forces Trump to accept small concessions. His international interest might overlap with China’s interest in minimizing concessions on foreign trade and investment access while maximizing technological acquisition from foreign companies. He would not be able to sell such a deal – focused on large-scale commodity purchases as a sop to farm states – on the campaign trail. Democrats will attack any deal that Trump negotiates. While it is still possible for both sides to reach an agreement, this Diagram highlights the limitations faced by both players. Meanwhile China is threatening to restrict exports of rare earths – minerals which are critical to the economy and national defense. China dominates global production and export markets (Chart 1), so this would be a serious disruption in the near term. Global sentiment would worsen, weighing on all risk assets, and tech companies and manufacturers that rely on rare earth inputs from China would face a hit to their bottom lines. Chart 1China Dominates Rare Earths Supply Over the long haul, this form of retaliation is self-defeating. First, China would presumably have to embargo all exports of rare earths to the world to prevent countries and companies from re-exporting to the United States. Second, rare earths are not actually rare in terms of quantity: they simply occur in low concentrations. As the world learned when China cut off rare earths to Japan for two months in 2010 over their conflict in the East China Sea, a rare earths ban will push up prices and incentivize production and processing in other regions. It will also create rapid substitution effects, recycling, and the use of stockpiles. Ultimately demand for Chinese rare earths exports would fall. Over the nine years since the Japan conflict, China’s share of global production has fallen by 19%, mostly at the expense of rising output from Australia. A survey of American companies suggests that they have diversified their sources more than import statistics suggest (Chart 2). Chart 2Import Stats May Be Overstating China’s Dominance The risk of a rare earths embargo is high – it fits with our 30% scenario of a major escalation in the conflict. It would clearly be a negative catalyst for companies and share prices. But as with China’s implicit threat of selling U.S. Treasuries, it is not a threat that will cause Trump to halt the trade war. The costs of conflict are not prohibitive and there are some political gains. Bottome Line: The S&P 500 is down 3.4% since our Global Investment Strategists initiated their tactical short on May 10. This is nearly equal to the weighted average impact on the S&P 500 that they have estimated using our probabilities. Obviously the selloff can overshoot this target. As it does, the chances of the two sides attempting to contain the tensions will rise. If we do not witness a positive intervention in the coming weeks, it will be too late to salvage the G20 and the risk of a major escalation will go way up. We recommend going short CNY-USD as a strategic play despite China’s recent assurances that the currency can be adequately defended. Our negative structural view of China’s economy now coincides with our tactical view that escalation is more likely than de-escalation. We also recommend going long a basket of companies in the MVIS global rare earth and strategic metals index – specifically those companies not based in China that have seen share prices appreciate this year but have a P/E ratio under 35. U.S.-Iran: An Unintentional War With Unintentional Consequences? “I really believe that Iran would like to make a deal, and I think that’s very smart of them, and I think that’s a possibility to happen.” -President Donald Trump, May 27, 2019 … We currently see no prospect of negotiations with America ... Iran pays no attention to words; what matters to us is a change of approach and behavior.” -Iranian Foreign Ministry spokesman Abbas Mousavi, May 28, 2019 The U.S. decision not to extend sanction waivers on Iran multiplied geopolitical risks at a time of already heightened uncertainty. Elevated tensions surrounding major producers in the Middle East could impact oil production and flows. In energy markets, this is reflected in the elevated risk premium – represented by the residuals in the price decompositions that include both supply and demand factors (Chart 3). Chart 3The Risk Premium Is Rising In Brent Crude Oil Prices Tensions surrounding major oil producers ... are reflected in the elevated risk premium – represented by the residuals in the Brent price decomposition. Already Iranian exports are down 500k b/d in April relative to March – the U.S. is acting on its threat to bring Iran’s exports to zero and corporations are complying (Chart 4). Chart 4Iran Oil Exports Collapsing What is more, the U.S. is taking a more hawkish military stance towards Iran – recently deploying a carrier strike group and bombers, partially evacuating American personnel from Iraq, and announcing plans to send 1,500 troops to the Middle East. The result of all these actions is not only to reduce Iranian oil exports, but also to imperil supplies of neighboring oil producers such as Iraq and Saudi Arabia which may become the victims of retaliation by an incandescent Iran. Our expectation of Iranian retaliation is already taking shape. The missile strike on Saudi facilities and the drone attack on four tankers near the UAE are just a preview of what is to come. Although Iran has not claimed responsibility for the acts, its location and extensive network of militant proxies affords it the ability to threaten oil supplies coming out of the region. Iran has also revived its doomsday threat of closing down the Strait of Hormuz through which 20% of global oil supplies transit – which becomes a much fatter tail-risk if Iran comes to believe that the U.S. is genuinely pursuing immediate regime change, since the first-mover advantage in the strait is critical. This will keep markets jittery. Current OPEC spare capacity would allow the coalition to raise production to offset losses from Venezuela and Iran. Yet any additional losses – potentially from already unstable regions such as Libya, Algeria, or Nigeria – will raise the probability that global supplies are unable to cover demand. Going into the OPEC meeting in Vienna in late June, our Commodity & Energy Strategy expects OPEC 2.0 to relax supply cuts implemented since the beginning of the year. They expect production to be raised by 0.9mm b/d in 2H2019 vs. 1H2019.1 Nevertheless, oil producers will likely adopt a cautious approach when bringing supplies back online, wary of letting prices fall too far. This was expressed at the May Joint Ministerial Monitoring Committee meeting in Jeddah, which also highlighted the growing divergence of interests within the group. Russia is in support of raising production at a faster pace than Saudi Arabia, which favors a gradual increase (conditional on U.S. sanctions enforcement). Both the Iranians and Americans claim that they do not want the current standoff to escalate to war. On the American side, Trump is encouraging Prime Minister Shinzo Abe to try his hand as a mediator in a possible visit to Tehran in June. We would not dismiss this possibility since it could produce a badly needed “off ramp” for tensions to de-escalate when all other trends point toward a summer and fall of “fire and fury” between the U.S. and Iran. If forced to make a call, we think President Trump’s foreign policy priority will center on China, not Iran. But this does not mean that downside risks to oil prices will prevail. China will stimulate more aggressively in June and subsequent months. And regardless of Washington’s and Tehran’s intentions, a wrong move in an already heated part of the world can turn ugly very quickly. Bottom Line: President Trump’s foreign policy priority is China, not Iran. Nevertheless, a wrong move can trigger a nasty escalation in the current standoff, jeopardizing oil supplies coming out of the Gulf region. In response to this risk, OPEC 2.0 will likely move to cautiously raise production at the next meeting in late June. Meanwhile China’s stimulus overshoot in the midst of trade war will most likely shore up demand over the course of the year. Can A New Prime Minister Break The Deadlock In Westminster? “There is a limited appetite for change in the EU, and negotiating it won’t be easy.” - Outgoing U.K. Prime Minister Theresa May Prime Minister Theresa May’s resignation has hurled the Conservative Party into a scramble to select her successor. While the timeline for this process is straightforward,2 the impact on the Brexit process is not. The odds of a “no-deal Brexit” have increased but so has the prospect of parliament passing a soft Brexit prior to any new election or second referendum. The odds of a “no-deal Brexit” have increased. Eleven candidates have declared their entry to the race and the vast majority are “hard Brexiters” willing to sacrifice market access on the continent (Table 2). Prominent contenders such as Boris Johnson and Dominic Raab have stated that they are willing to exit the EU without a deal. Table 2“Hard Brexiters” Dominate The Tory Race Given that the average Tory MP is more Euroskeptic than the average non-conservative voter or Brit, the final two contenders left standing at the end of June are likely to shift to a more aggressive Brexit stance. They will say they are willing to deliver Brexit at all costs and will avoid repeating Theresa May’s mistakes. This means at the very least the rhetoric will be negative for the pound in the coming months. A clear constraint on the U.K. in trying to negotiate a new withdrawal agreement is that the EU has the upper hand. It is the larger economy and less exposed to the ramifications of a no-deal exit (though still exposed). This puts it in a position of relative strength – exemplified by the European Commission’s insistence on keeping the current Withdrawal Agreement. Whoever the new prime minister is, it is unlikely that he or she will be able to negotiate a more palatable deal with the EU. Rather, the new leader will lead a fractured Conservative Party that still lacks a strong majority in parliament. The no-deal option is the default scenario if an agreement is not finalized by the Halloween deadline and no further extension is granted. However, Speaker of the House of Commons John Bercow recently stated that the prime minister will be unable to deliver a no-deal Brexit without parliamentary support. This will likely manifest in the form of a bill to block a no-deal Brexit. Alternatively, an attempt to force a no-deal exit could prompt a vote of no confidence in the government, most likely resulting in a general election.3 Chart 5British Euroskeptics Made Gains In EP Election While the Brexit Party amassed the largest number of seats in the European Parliament elections at the expense of the Labour, Conservative, and UKIP parties (Chart 5), the results do not suggest that British voters have generally shifted back toward Brexit. In fact, if we group parties according to their stance, the Bremain camp has a slight lead over the Brexit camp (Chart 6). Thus, it is not remotely apparent that a hard Brexiter can succeed in parliament; that a new election can be forestalled if a no-deal exit is attempted; or that a second referendum will repeat the earlier referendum’s outcome. Chart 6Bremain Camp Still Dominates Bottom Line: While the new Tory leader is likely to be more on the hard Brexit end of the spectrum than Theresa May, this does not change the position of either the European Commission or the British MPs and voters on Brexit. The median voter both within parliament and the British electorate remains tilted towards a softer exit or remaining in the EU. This imposes constraints on the likes of Boris Johnson and Dominic Raab if they take the helm of the Tory Party. These leaders may ultimately be forced to try to push through something a lot like Theresa May’s plan, or risk a total collapse of their party and control of government. Still, the odds of a no-deal exit – the default option if no agreement is reached by the October 31 deadline – have gone up. In the meantime, the GBP will stay weak, gilts will remain well-bid, and risk-off tendencies will be reinforced. GeoRisk Indicators Update – May 31, 2019 Last month BCA’s Geopolitical Strategy introduced ten indicators to measure geopolitical risk implied by the market. These indicators attempt to capture risk premiums priced into various currencies – except for Euro Area countries, where the risk is embedded in equity prices. A currency or bourse that falls faster than it should fall, as implied by key explanatory variables, indicates increasing geopolitical risk. All ten indicators can be found in the Appendix, with full annotation. We will continue to highlight key developments on a monthly basis. This month, our GeoRisk indicators are picking up the following developments: Trade war: Our Korean and Taiwanese risk indicators are currently the best proxies to measure geopolitical risk implications of the U.S.-China trade war, as they are both based on trade data. Both measures, as expected, have increased more than our other indicators over the past month on the back of a sharp spike in tensions between the U.S. and China. Currently, the moves are largely due to depreciation in currencies, as trade is only beginning to feel the impact. We believe that we will see trade decline in the upcoming months. Brexit: While it is still too early to see the full effect of Prime Minister May’s resignation captured in our U.K. indicator, it has increased in recent days. We expect risk to continue to increase as a leadership race is beginning among the Conservatives that will raise the odds of a “no-deal exit” relative to “no exit.” EU elections: The EU elections did not register as a risk on our indicators. In fact, risk decreased slightly in France and Germany during the past few weeks, while it has steadily fallen in Spain and Italy. Moreover, the results of the election were largely in line with expectations – there was not a surprising wave of Euroskepticism. The real risks will emerge as the election results feed back into political risks in certain European countries, namely the U.K., where the hardline Conservatives will be emboldened, and Italy, where the anti-establishment League will also be emboldened. In both countries a new election could drastically increase uncertainty, but even without new elections the respective clashes with Brussels over Brexit and Italian fiscal policy will increase geopolitical risk. Emerging Markets: The largest positive moves in geopolitical risk were in Brazil and Turkey, where our indicators plunged to their lowest levels since late 2017 and early 2018. Brazilian risk has been steadily declining since pension reform – the most important element of Bolsonaro’s reform agenda – cleared an initial hurdle in Congress. While we would expect Bolsonaro to face many more ups and downs in the process of getting his reform bill passed, we have a high conviction view that the decrease in our Turkish risk indicator is unwarranted. This decrease can be attributed to the fact that the lira’s depreciation in recent weeks is slowing, which our model picks up as a decrease in risk. Nonetheless, uncertainty will prevail as a result of deepening political divisions (e.g. the ruling party’s attempt to overturn the Istanbul election), poor governance, ongoing clashes with the West, and an inability to defend the lira while also pursuing populist monetary policy. Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Footnotes 1 Please see BCA Research Commodity & Energy Strategy Weekly Report titled “Policy Risk Sustains Oil’s Unstable Equilibrium,” dated May 23, 2019, available at ces.bcaresearch.com. 2 The long list of candidates will be whittled down to two by the end of June through a series of votes by Tory MPs. Conservative Party members will then cast their votes via a postal ballot with the final result announced by the end of July, before the Parliament’s summer recess. 3 A vote of no confidence would trigger a 14-day period for someone else to form a government, otherwise it will result in a general election. Geopolitical Calendar

Special Report

We remain structurally overweight global equities, but hedged our long exposure on May 10th following what we regarded as an overly complacent reaction by investors to President Trump’s decision to further raise tariffs on Chinese imports. Last night’s announcement that the U.S. will increase tariffs on Mexican imports represents a further escalation of the trade war. About two-thirds of U.S.-Mexican cross-border trade is between the same companies. Higher tariffs and increased operating inefficiencies will eat into the profits of U.S.-listed firms. Accordingly, we are reducing the profit target on our short S&P 500 trade from 2711 to 2650.  Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com