Trade / BOP

Highlights An expansion in the Federal Reserve’s balance sheet will increase dollar liquidity. This should be negative for the greenback, barring a recession over the next six to 12 months. Interest rate differentials have largely moved against the dollar. The biggest divergences are versus the more export-dependent NOK, SEK and GBP. A weak dollar will supercharge the gold uptrend. Gold will also benefit from abundant liquidity, and persistently low/negative real rates. Remain short USD/JPY. The path to a lower yen is via an overshoot, as the BoJ will need a shock to act more aggressively. The Bank of Canada left rates on hold, but may be hard-pressed to continue meeting its inflation mandate amid a widening output gap. Go long AUD/CAD for a trade. Feature Chart I-1A Well-Defined Channel Signposts For A Reversal In The Dollar Bull Market Signposts For A Reversal In The Dollar Bull Market The DXY index has been trading within a very narrow band this year, defined by the upward-sloped channel drawn from the February lows (Chart I-1). At 97, the DXY index is just a few ticks away from the lower bound of this channel, which could be tested in the coming weeks. A decisive break below will represent an important fundamental shift, since it will declare the winner in the ongoing battle between deteriorating global growth and easing financial conditions. Global Growth And The Dollar One of the defining features of the currency landscape last year was that U.S. interest rates became too tight relative to underlying conditions. This tightened dollar liquidity both domestically and abroad. Chart I-2 plots the neutral rate of interest in the U.S. relative to the fed funds target rate. A widening gap suggests underlying financing conditions are low relative to the potential growth rate of the economy. Not surprisingly, this also tends to track the yield curve pretty closely, assuming long-term rates are a proxy for the economy’s structural growth rate, while short-term rates reflect borrowing costs. For economic agents, a narrowing spread suggests a rising risk of capital misallocation, as the gap between the cost of capital and return on capital closes. This is most evident for banks through their net interest margins. At the epicenter of this shrinking spread are the Fed’s macroeconomic policies. These include raising interest rates (especially in the face of a trade slowdown) and/or shrinking its balance sheet. These are the very policies that also tend to strengthen the greenback. The result is a rise in the velocity of international U.S. dollars, pushing up offshore rates and lifting the cost of capital for borrowing countries. A widening gap between U.S. neutral rate of interest and fed funds target rate suggests underlying financing conditions are low relative to the potential growth rate of the economy.  This has been the backdrop for the dollar for much of the past two years. The good news is that more recently, the Fed has been quick to rectify the situation. The funding crisis among U.S. domestic banks will be resolved through repurchase agreements and a resumption of the Fed's bond purchases. Chart I-3 shows that the interest rate the Fed pays on excess reserves may soon exceed the effective fed funds rate, meaning the liquidity crisis among U.S. banks may soon be over. Correspondingly, banks’ excess reserves should start rising anew. The drop in rates and the easing in funding conditions have been partly sniffed out by a steepening yield curve (Chart I-3, bottom panel). This will incentivize banks to lend, which in turn, will boost U.S. money supply. As the economy recovers and demand for imports (machinery, commodities, consumer goods) rises, this will widen the current account deficit and increase the international supply of dollars. This should further calm dollar offshore rates, helping short-circuit any negative feedback loops that might have hampered growth in the past. Chart I-2The Fed Has Pivoted The Fed Has Pivoted The Fed Has Pivoted Chart I-3Easing Liquidity Strains Easing Liquidity Strains Easing Liquidity Strains The message from both global fixed-income markets and international stocks is that we may have reached a tipping point, where easing in financial conditions is sufficient to end the manufacturing recession. This is especially the case given this week’s breakout in the S&P 500, the Swedish OMX, and the Swiss Market Index (Chart I-4) – indices with large international exposure and very much tied to the global cycle. Such market cycles also tend to correspond with a weaker dollar, especially when the return on capital appears marginally higher outside the U.S. (Chart I-5). Chart I-4A Few Equity Breakouts A Few Equity Breakouts A Few Equity Breakouts Chart I-5Europe And EM Leading The Rally Europe And EM Leading The Rally Europe And EM Leading The Rally Chart I-6Less Stress In Offshore USD Funding Less Stress In Offshore USD Funding Less Stress In Offshore USD Funding Bottom Line: Rising dollar liquidity appears to have started greasing the international financial supply chain. One way to track if dollar funding is becoming more abundant is through the convenience yield, or cross-currency basis swap.1 This measures the difference in yield between an actual Treasury bond and a synthetic one trading in the offshore market. On this basis, we are well below the panic levels observed over the past decade (Chart I-6). Interest Rate Differentials And International Flows If the rise in global bond yields reflects a nascent pickup in growth, then the message from interest rate differentials has been clear: This growth pickup will be led by non-U.S. markets, similar to the message from international equities. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the U.S. (Chart I-7A and Chart I-7B). For example, yields in Norway, Sweden, Switzerland and Japan have risen by an average of 75 basis points versus those in the U.S. since the bottom. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the U.S.’ yield advantage. Chart I-7AInterest Differentials And Exchange Rates Interest Differentials And Exchange Rates Interest Differentials And Exchange Rates Chart I-7BInterest Differentials And Exchange Rates Interest Differentials And Exchange Rates Interest Differentials And Exchange Rates International investors might still find U.S. bond markets attractive in an absolute sense, but the currency risk is just too big a potential blindside at the current juncture. Markets with the potential for currency appreciation such as Australia, Canada, Norway or even the European periphery within Europe might be better bets. Flow data highlights just how precarious being long U.S. dollars is. As of last August, overall flows into the U.S. Treasury market have been negative, which may have contributed to the bottom in bond yields. Net foreign purchases by private investors are still positive at an annualized US$166 billion, but the momentum of these flows is clearly rolling over. This is more than offset by official net outflows that are running at $314 billion (Chart I-8). As interest rate differentials have started moving against the U.S., so has foreign investor appetite for Treasury bonds. More importantly, private purchases have not been driven on a net basis by foreign entities, but by U.S. domestic concerns repatriating capital on the back of the 2017 Trump tax cuts. On a rolling 12-month basis, the U.S. was repatriating back close to net $US400 billion in assets, or about 2% of GDP. Given that the tax break was a one-off, flows have since started to ease, contributing to the ebb in Treasury purchases (Chart I-9). Chart I-8A Growing Dearth Of Treasury Buyers A Growing Dearth Of Treasury Buyers A Growing Dearth Of Treasury Buyers Chart I-9Repatriation Flows Are Ebbing Repatriation Flows Are Ebbing Repatriation Flows Are Ebbing Meanwhile, while U.S. residents have been repatriating capital domestically, foreign investors have been fleeing U.S. equity markets at among the fastest pace in recent years. On a rolling 12-month total basis, the U.S. saw an exodus of about US$200 billion in equity from foreigners earlier this year, the largest on record. Foreigners are still net buyers of about $265 billion in U.S. securities (mostly agency bonds), but the downtrend in purchases in recent years is evident. Bottom Line: Flows into U.S. assets are rapidly dwindling. This may be partly because as the S&P 500 makes new highs amid lofty valuations, long-term investors are slowly realizing that future expected returns will pale in comparison to history. Given that being long Treasurys and the dollar remains a consensus trade (Chart I-10), international investors run the risk of a potential blindside from a sharp drop in the dollar. Chart I-10Unfavorable Dollar Technicals Unfavorable Dollar Technicals Unfavorable Dollar Technicals Dollar Reserve Status And Gold The decline in the dollar may not mark the ultimate peak in the bull market that began in 2011, but at least it will unveil some of the underlying forces that have been chipping away at the dollar’s reserve status over the past few years. China has risen within the ranks to become the number one contributor to the U.S. trade deficit over the past few years. At the same time, Beijing has been destocking its holding of Treasurys, if only as retaliation against past U.S. policies, or perhaps to make room for the internationalization of the RMB. In a broader sense, there has been an underlying shift in the global economy away from dollars and towards a more diversified basket of currencies. This makes sense, given that a growing proportion of trading – be it in crude, natural gas, bulk commodities or even softs – is being done outside U.S. exchanges. Gold continues to outperform Treasurys, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the gold/dollar link in the early ‘70s, bullion has stood as a viable threat to dollar liabilities. With the Fed about to embark on a renewed expansion of its balance sheet, we may have just triggered one of the necessary catalysts for a selloff in the U.S. dollar. This means that holding gold in dollars may become more profitable compared to other currencies (Chart I-11). Given that being long Treasurys and the dollar remains a consensus trade, international investors run the risk of a potential blindside from a sharp drop in the dollar.  The one tectonic shift that has happened over the past decade is that central banks have become net gold buyers, holding 20% of all gold that has ever been mined. If that number were to rise to say 25% or even 30%, it could have the potential to propel the gold price up towards $2800/oz (Chart I-12). If you think such an idea is far-fetched, just ask the Swiss, who a few years ago called a referendum to increase their gold holdings from 7% of total reserves to 20%, or Russia that has seen its gold holdings rise from 2% to over 20% of total reserves. Chart I-11Watch Gold In ##br##USD Terms Watch Gold In USD Terms Watch Gold In USD Terms Chart I-12What If Central Banks Bought Gold More Aggressively? What If Central Banks Bought Gold More Aggressively? What If Central Banks Bought Gold More Aggressively?   Bottom Line: Reserve diversification out of U.S. dollars is a trend that has been underway for a while now, and unlikely to change anytime soon. Gold will be a big beneficiary of this tectonic shift. A Few Trade Ideas If the dollar eventually weakens, the more export-dependent economies should benefit the most from a rebound in global growth, and by extension their currencies should be the outperformers. Within the G-10 universe, there would notably be the European currencies led by the Swedish krona, the Norwegian krone and the pound. The countries currently experiencing the steepest rise in interest rate differentials vis-à-vis the U.S. could be a prelude to which currencies will outperform (previously mentioned Chart I-7A). We expect commodity currencies to also hold firm, but this awaits further confirmation of more pronounced Chinese stimulus, which so far has not yet materialized. The Canadian dollar should also be a beneficiary from dollar weakness, with a technical formation that looks categorically bearish USD/CAD (Chart I-13). Should the 1.30 level be breached, the next level of support is around the 2017 lows of 1.20. The BoC left rates unchanged this week, but the dovish tone from Governor Stephen Poloz was a big reminder that no central bank wants to tolerate a more expensive currency for now. Looser fiscal policy and rising oil prices will eventually become growth tailwinds. Chart I-13A USD/CAD Breakout Or Breakdown? A USD/CAD Breakout Or Breakdown? A USD/CAD Breakout Or Breakdown? Chart I-14Canadian House Prices Canadian House Prices Canadian House Prices However, we will favor the Aussie over the loonie since the downturn in the Australian housing market appears much further advanced compared to Canada. And with macro-prudential measures already implemented in Vancouver and Toronto, there is a rising risk that Montreal could follow suit (Chart I-14). Historically, policy divergences between the Reserve Bank of Australia and the BoC have followed the relative growth profiles of their biggest export markets, and the message so far is that the RBA is well ahead of the curve in its dovish bias (Chart I-15). Go long AUD/CAD for a trade. Chart I-15Buy AUD/CAD Buy AUD/CAD Buy AUD/CAD Finally, the Bank Of Japan left interest rates unchanged but signaled it was willing to ease should the path towards their 2% inflation target be in question. As the central bank that has been pursuing the most aggressive monetary stimulus over the last few years, it is fair to say this week’s policy meeting was a non-event. The yen will continue to be buffeted by powerful deflationary tailwinds that are holding the Japanese economy hostage, as well as global economic uncertainty. In the event that global growth picks up, the yen will depreciate at the crosses, but can still rise versus the dollar. This puts long yen bets in a “heads I win, tails I don’t lose much” scenario. Bottom Line: Go long AUD/CAD and stay short USD/JPY. Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Arvind Krishnamurthy and Hanno Lustig, “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor,” Stanford University, August 29, 2019. Currencies U.S. Dollar Chart II-1USD Technicals 1 USD Technicals 1 USD Technicals 1 Chart II-2USD Technicals 2 USD Technicals 2 USD Technicals 2 Recent data in the U.S. have been mixed: Preliminary GDP growth slowed to 1.9% quarter-on-quarter from 2% in Q3. PCE slowed to 1.5% quarter-on-quarter in Q3. Core PCE, on the other hand, increased to 2.2%. New home sales contracted by 0.7% month-on-month in September, while pending home sales grew by 1.5% month-on-month. The trade deficit narrowed marginally by $2.7 billion to $70.4 billion in September. Initial jobless claims increased by 5K to 218K for the week ended October 25th. The DXY index fell sharply after the Fed's press conference, ending with a loss of 0.6% this week. On Wednesday, the Fed cut interest rate by 25 bps for the third time this year to 1.75%, as widely expected. The fading interest rate differential will continue to be a headwind for the U.S. dollar. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 EUR Technicals 1 EUR Technicals 1 Chart II-4EUR Technicals 2 EUR Technicals 2 EUR Technicals 2 Recent data in the euro area have been firm: GDP growth in the euro area slowed marginally to 1.1% year-on-year in Q3, down from 1.2% in the previous quarter. On a quarter-on-quarter basis, the growth was unchanged at 0.2%. Headline inflation in the euro area slowed slightly to 0.7% year-on-year in October. Core inflation however, increased to 1.1% year-on-year. Retail sales in Germany grew by 3.4% year-on-year in September, up from 3.1% in the previous month. EUR/USD increased by 0.5% this week amid broad dollar weakness. The current debate among central bankers in the Eurozone is whether ultra accommodative monetary policy is still warranted. This espouses the view that at least, to some members of the ECB, the neutral rate of interest in the Eurozone is higher than perceived. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-6JPY Technicals 1 JPY Technicals 1 JPY Technicals 1 Chart II-6JPY Technicals 2 JPY Technicals 2 JPY Technicals 2 Recent data in Japan have been mostly positive: Headline inflation was unchanged at 0.4% year-on-year in October. Core inflation however, increased marginally to 0.7% year-on-year in October. Retail sales soared by 9.1% year-on-year in September in anticipation of the consumption tax hike. Industrial production grew by 1.1% year-on-year in September, compared to a contraction of 4.7% year-on-year the previous month. Consumer confidence increased marginally to 36.2 from 35.5 in October. The yen appreciated by 0.5% this week against the U.S. dollar. The BoJ left its policy rate unchanged this Thursday, while reassuring markets that more stimulus could be added if needed in the future. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 GBP Technicals 1 GBP Technicals 1 Chart II-8GBP Technicals 2 GBP Technicals 2 GBP Technicals 2 Recent data in the U.K. have been mixed: On the housing front, nationwide house prices increased by 0.4% year-on-year in October. Mortgage approvals increased marginally to 65.9K in September. Money supply (M4) grew by 4% year-on-year in September, up from 3.3% in the previous month. GfK consumer confidence fell further to -14 in October. The pound appreciated by almost 1% against the U.S. dollar this week. The E.U. has agreed on yet another Brexit extension until January 31st. An earlier exit is also possible if the U.K. so chooses. Meanwhile, the U.K. economy is holding up quite well despite the cloud of uncertainty. We remain tactically long GBP/JPY. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 AUD Technicals 1 AUD Technicals 1 Chart II-10AUD Technicals 2 AUD Technicals 2 AUD Technicals 2 Recent data in Australia have been mostly positive: Headline inflation increased to 1.7% year-on-year in Q3, up from 1.6% in the previous quarter. HIA new home sales grew by 5.7% month-on-month in September. Building permits contracted by 19% year-on-year in September. However on a monthly basis, it grew by 7.6% in September. AUD/USD surged by 1.2% this week. During a speech this Monday, RBA Governor Philip Lowe ruled out the possibility of negative interest rates in Australia, and urged businesses to start investing given historically low interest rates. Going forward, we expect the Aussie dollar to rebound amid a global growth recovery.  New Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 NZD Technicals 1 NZD Technicals 1 Chart II-12NZD Technicals 2 NZD Technicals 2 NZD Technicals 2 Recent data in New Zealand have been mixed: Building permits increased by 7.2% month-on-month in September. Business confidence came in at -42.4 in October. This was an improvement from -53.5 in the previous month. The activity outlook fell further to -3.5 from -1.8 in October. The New Zealand dollar soared by 0.9% against the USD this week. While we expect the kiwi to outperform the USD amid global growth recovery, it will likely underperform its pro-cyclical peers. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 CAD Technicals 1 CAD Technicals 1 Chart II-14CAD Technicals 2 CAD Technicals 2 CAD Technicals 2 Recent data in the Canada have been firm: GDP grew by 0.1% month-on-month in August. Bloomberg Nanos confidence index fell marginally to 57.4 for the week ended October 25th. The Canadian dollar has depreciated by 0.7% against the U.S. dollar, making it the worst performing G-10 currency this week. The BoC decided to keep interest rates on hold this Wednesday, with relatively strong domestic growth and inflation on target. While growth in Canada has surprised to the upside, it might not prove sustainable. We are shorting the Canadian dollar this week against the Australian dollar. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15HF Technicals 1 CHF Technicals 1 CHF Technicals 1 Chart II-16CHF Technicals 2 CHF Technicals 2 CHF Technicals 2 Recent data in Switzerland have been mixed: KOF leading indicator increased to 94.7 in October, up from 93.9 in the previous month. ZEW expectations fell further to -30.5 in October. The Swiss franc has increased by 0.7% against the U.S. dollar this week. Domestic fundamentals remain strong in Switzerland, but are at risk from the global growth slowdown. As a safe-haven currency, a rising gold-to-oil ratio points to a higher franc. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 NOK Technicals 1 NOK Technicals 1 Chart II-18NOK Technicals 2 NOK Technicals 2 NOK Technicals 2 Recent data in Norway has been positive: Retail sales increased by 0.8% year-on-year in September. USD/NOK is flat this week amid broad dollar weakness. The Norwegian krone has diverged from the ebb and flow of energy prices, and is currently trading around two standard deviations below its fair value. While energy prices have recently been soft, the selloff in the Norwegian krone is exaggerated. We are looking to short CAD/NOK. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 SEK Technicals 1 SEK Technicals 1 Chart II-20SEK Technicals 2 SEK Technicals 2 SEK Technicals 2 Recent data in Sweden have been positive: Consumer confidence rebounded to 92.7 in October. Retail sales increased by 2.6% year-on-year in September. Trade balance of goods shifted back to a surplus of SEK 2 billion in September, following the deficit of SEK 5.5 billion in August. Both imports and exports increased by SEK 6.6 billion and SEK 14.1 billion month-on-month, respectively. USD/SEK fell by 0.6% this week. The Swedish krona is much undervalued. A cheap krona should help to improve the balance of payments dynamics in Sweden. We expect the krona to bounce back sharply once global growth shows more signs of recovery amid a U.S.-China trade war détente. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

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

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

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

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

Highlights The U.S. and China are moving toward formalizing a trade ceasefire that reduces geopolitical risk in the near term. The risk of a no-deal Brexit is finished – removing a major downside to European assets. Spanish elections reinforce our narrative of general European political stability. Go long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Geopolitical risks will remain elevated in Turkey, rise in Russia, but remain subdued in Brazil. A post-mortem of Canada’s election suggests upside to fiscal spending but further downside to energy sector investment over the short to medium term. Feature After a brief spike in trade war-related geopolitical risk just prior to the resumption of U.S.-China negotiations, President Trump staged a tactical retreat in the trade war. Chart 1Proxy For Trade War Shows Falling Risk Proxy For Trade War Shows Falling Risk Proxy For Trade War Shows Falling Risk Negotiating in Washington, President Trump personally visited the top Chinese negotiator Liu He and the two sides announced an informal “phase one deal” to reverse the summer’s escalation in tensions: China will buy $40-$50 billion in U.S. agricultural goods while the U.S. will delay the October 15 tariff hike. More difficult issues – forced tech transfer, intellectual property theft, industrial subsidies – were punted to later. The RMB is up 0.7% and our own measures of trade war-related risk have dropped off sharply (Chart 1). We think these indicators will be confirmed and Trump’s retreat will continue – as long as he has a chance to save the 2020 economic outlook and his reelection campaign. Odds are low that Trump will be removed from office by a Republican-controlled senate – the looming election provides the republic with an obvious recourse for Trump’s alleged misdeeds. However, Trump’s approval rating is headed south. While it is around the same level as President Obama’s at this point in his first term, Obama’s started a steep and steady rise around now and ended above 50% for the election, a level that is difficult to foresee for Trump (Chart 2). So Trump desperately needs an economic boost and a policy victory to push up his numbers. Short of passing the USMCA, which is in the hands of the House Democrats, a deal with China is the only way to get a major economic and political win at the same time. Hence the odds of Presidents Trump and Xi actually signing some kind of agreement are the highest they have been since April (when we had them pegged at 50/50). Trump will have to delay the December 15 tariff hike and probably roll back some of the tariffs over next year as continuing talks “make progress,” though we doubt he will remove restrictions on tech companies like Huawei. Still, we strongly believe that what is coming is a détente rather than the conclusion of the Sino-American rivalry crowned with a Bilateral Trade Agreement. Strategic tensions are rising on a secular basis between the two countries. These tensions could still nix Trump’s flagrantly short-term deal-making, and they virtually ensure that some form of trade war will resume in 2021 or 2022, if indeed a ceasefire is maintained in 2020. Both sides are willing to reduce immediate economic pain but neither side wants to lose face politically. Trump will not forge a “grand compromise.” Our highest conviction view all along has been – and remains – that Trump will not forge a “grand compromise” ushering in a new period of U.S.-China economic reengagement in the medium or long term. China’s compliance, its implementation of structural changes, will be slow or lacking and difficult to verify at least until the 2020 verdict is in. This means policy uncertainty will linger and business confidence and capex intentions will only improve on the margin, not skyrocket upward (Chart 3). Chart 2Trump Needs A Policy Win And Economic Boost How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Chart 3Sentiment Will Improve ... Somewhat Sentiment Will Improve ... Somewhat Sentiment Will Improve ... Somewhat The problem for bullish investors is that even if global trade uncertainty falls, and the dollar’s strength eases, fear will shift from geopolitics to politics, and from international equities to American equities (Chart 4). Trump, hit by impeachment and an explosive reaction to his Syria policy, is entering into dangerous territory for the 2020 race. Trump’s domestic weakness threatens imminent equity volatility for two reasons. Chart 4American Outperformance Falls With Trade Tensions bca.gps_wr_2019_10_25_c4 bca.gps_wr_2019_10_25_c4 Chart 5Democratic Win In 2020 Is Market-Negative Democratic Win In 2020 Is Market-Negative Democratic Win In 2020 Is Market-Negative First, if Trump’s approval rating falls below today’s 42%, investors will begin pricing a Democratic victory in 2020, i.e. higher domestic policy uncertainty, higher taxes, and the re-regulation of the American economy (Chart 5). This re-rating may be temporarily delayed or mitigated by the fact that former Vice President Joe Biden is still leading the Democratic Party’s primary election race. Biden is a known quantity whose policies would simply restore the Obama-era status quo, which is only marginally market-negative. Contrary to our expectations Biden's polling has not broken down due to accusations of foul play in Ukraine and China. Nevertheless, Senator Elizabeth Warren will gradually suck votes away from fellow progressive Senator Bernie Sanders and in doing so remain neck-and-neck with Biden (Chart 6). When and if she pulls ahead of Biden, markets face a much greater negative catalyst. (Yes, she is also capable of beating Trump, especially if his polling remains as weak as it is.) Chart 6Warren Will Rise To Front-Runner Status With Biden How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Second, if Trump becomes a “lame duck” he will eventually reverse the trade retreat above and turn into a loose cannon in his final months in office. Right now we see a decline in geopolitical risk, but if the economy fails to rebound or the China ceasefire offers little support, then Trump will at some point conclude that his only chance at reelection is to double down on his confrontation with America’s enemies and run as a “war president.” A cold war crisis with China, or a military confrontation with Iran (or North Korea, Venezuela, or some unexpected target) could occur. But since September we have been confirmed in believing that Trump is trying to be the dealmaker one last time before any shift to the war president. Bottom Line: The “phase one” trade deal is really just a short-term ceasefire. Assuming it is signed by Trump and Xi, it suggests no increase in tariffs and some tariff rollback next year. However, as recessionary fears fade, and if Trump’s reelection chances stabilize, U.S.-China tensions on a range of issues will revive – and there is no getting around the longer-term conflict between the two powers. For this and other reasons, we remain strategically short RMB-USD, as the flimsy ceasefire will only briefly see RMB appreciation. BoJo's Brexit Bluff Is Finished Our U.K. indicator captured a sharp decline in political risk in the past two weeks and our continental European indicators mirrored this move (Chart 7). The risk that the U.K. would fall out of the EU without a withdrawal agreement has collapsed even further than in September, when parliament rejected Prime Minister Boris Johnson’s no-deal gambit and we went long GBP-USD. We have since added a long GBP-JPY trade. Chart 7Collapse In No-Deal Risk Will Echo Across Europe Collapse In No-Deal Risk Will Echo Across Europe Collapse In No-Deal Risk Will Echo Across Europe Chart 8Unlikely To See Another Tory/Brexit Rally Like This Unlikely To See Another Tory/Brexit Rally Like This Unlikely To See Another Tory/Brexit Rally Like This The risk of “no deal” is the only reason to care about Brexit from a macro point of view, as the difference between “soft Brexit” and “no Brexit” is not globally relevant. What matters is the threat of a supply-side shock to Europe when it is already on the verge of recession. With this risk removed, sentiment can begin to recover (and Trump’s trade retreat also confirms our base case that he will not impose tariffs on European cars on November 14). Since Brexit was the only major remaining European political risk, European policy uncertainty will continue to fall. The Halloween deadline was averted because the EU, on the brink of recession, offered a surprising concession to Johnson, enabling him to agree to a deal and put it up for a vote in parliament. The deal consists of keeping Northern Ireland in the European Customs Union but not the whole of the U.K., effectively drawing a new soft border at the Irish Sea. The bill passed the second reading but parliament paused before finalizing it, rejecting Johnson’s rapid three-day time table. The takeaway is that even if an impending election returns Johnson to power, he will seek to pass his deal rather than pull the U.K. out without a deal. This further lowers the odds of a no-deal Brexit as it illuminates Johnson's preferences, which are normally hidden from objective analysis. True, there is a chance that the no-deal option will reemerge if Johnson’s deal totally collapses due to parliamentary amendments, or if the U.K. and EU have failed to agree to a future relationship by the end of the transition period on December 31, 2020 (which can be extended until the end of 2022). However, the chance is well below the 30% which we deemed as the peak risk of no-deal back in August. Johnson created the most credible threat of a no-deal exit that we are likely to see in our lifetimes – a government with authority over foreign policy determined to execute the outcome of a popular referendum – and yet parliament stopped it dead in its tracks. Johnson does not want a no-deal recession and his successors will not want one either. After all, the support for Brexit and for the Tories has generally declined since the referendum, and the Tories are making a comeback on the prospect of an orderly Brexit (Chart 8). All eyes will now turn toward the impending election. Opinion polls still show that Johnson is likely to be returned to power (Chart 9). The Tories have a prospect of engrossing the pro-Brexit vote while the anti-Brexit opposition stands divided. No-deal risk only reemerges if the Conservatives are returned to power with another weak coalition that paralyzes parliament. Chart 9Tory Comeback As BoJo Gets A Deal Tory Comeback As BoJo Gets A Deal Tory Comeback As BoJo Gets A Deal Chart 10Brexit Means Greater Fiscal Policy Brexit Means Greater Fiscal Policy Brexit Means Greater Fiscal Policy Whatever the election result, we maintain our long-held position that Brexit portends greater fiscal largesse (Chart 10). The agitated swath of England that drove the referendum result will not be assuaged by leaving the European Union – the rewards of Brexit are not material but philosophical, so material grievances will return. Voter frustration will rotate from the EU to domestic political elites. Voters will demand more government support for social concerns. Johnson’s own government confirms this point through its budget proposals. A Labour-led government would oversee an even more dramatic fiscal shift. Our GeoRisk indicator will fall on Brexit improvements but the question of the election and next government will ensure it does not fall too far. Our long GBP trades are tactical and we expect volatility to remain elevated. But the greatest risk, of no deal, is finished, so it does make sense for investors with a long time horizon to go strategically long the pound. The greatest risk, of a no deal Brexit, is finished. Bottom Line: Brexit posed a risk to the global economy only insofar as it proved disorderly. A withdrawal agreement by definition smooths the process. Continental Europe will not suffer a further shock to net exports. The Brexit contribution to global policy uncertainty will abate. The pound will rise against the euro and yen and even against the dollar as long as Trump’s trade retreat continues. Spain: Further Evidence Of European Stability We have long argued that the majority of Catalans do not want independence, but rather a renegotiation of the region's relationship with Spain (Chart 11). This month’s protests in Barcelona following the Catalan independence leaders’ sentencing are at the lower historical range in terms of size – protest participation peaked in 2015 along with support for independence (Table 1). Table 1October Catalan Protests Unimpressive How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Our Spanish risk indicator is showing a decline in political risk (Chart 12). However, we believe that this fall is slightly overstated. While the Catalan independence movement is losing its momentum, the ongoing protests are having an impact on seat projections for the upcoming election.  Chart 11Catalonians Not Demanding Independence Catalonians Not Demanding Independence Catalonians Not Demanding Independence Chart 12Right-Wing Win Could Surprise Market, But No Worries Right-Wing Win Could Surprise Market, But No Worries Right-Wing Win Could Surprise Market, But No Worries Since the April election, the right-wing bloc of the People’s Party, Ciudadanos, and Vox has been gaining in the seat projections at the expense of the Socialist Party and Podemos. Over the course of the protests, the left-wing parties’ lead over the right-wing parties has narrowed from seven seats to one (Chart 13). If this momentum continues, a change of government from left-wing to right-wing becomes likely. However, a right-wing government is not a market-negative outcome, and any increase in risk on this sort of election surprise would be short-lived. The People’s Party has moderated its message and focused on the economy. Besides pledging to limit the personal tax rate to 40% and corporate tax rate to 20%, the People’s Party platform supports innovation, R&D spending, and startups. The party is promising tax breaks and easier immigration rules to firms and employees pursuing these objectives. Chart 13Spanish Right-Wing Parties Narrow Gap With Left How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Another outcome of the election would be a governing deal between PSOE and Podemos, along with case-by-case support from Ciudadanos. After a shift to the right lost Ciudadanos 5% in support since the April election, leader Albert Rivera announced in early October that he would be lifting the “veto” on working with the Socialist Party. If the right-wing parties fall short of a majority, then Rivera would be open to talks with Socialist leader Pedro Sanchez. A governing deal between PSOE, Podemos, and Ciudadanos would have 175 seats, as of the latest projections, which is just one seat short of a majority. As we go to press, this is the only outcome that would end Spain’s current political gridlock, and would therefore be the most market-positive outcome. Bottom Line: Despite having a fourth election in as many years, Spanish political risk is contained. This is reinforced by a relatively politically stable backdrop in continental Europe, and marginally positive developments in the U.K. and on the trade front. We remain long European versus U.S. technology, and long EU versus Chinese equities. We will also be looking to go long EUR/USD when and if the global hard data turn. Following our European Investment Strategy, we recommend going long 10-year Italian BTPs / short 10-year Spanish bonos for a trade. Turkey, Brazil, And Russia Chart 14Turkish Risk Will Rise Despite 'Ceasefire' Turkish Risk Will Rise Despite 'Ceasefire' Turkish Risk Will Rise Despite 'Ceasefire' Turkey’s political risk skyrocketed upward after we issued our warning in September (Chart 14). We maintain that the Trump-Erdogan personal relationship is not a basis for optimism regarding Turkey’s evading U.S. sanctions. Both chambers of the U.S. Congress are preparing a more stringent set of sanctions, focusing on the Turkish military, in the wake of Trump’s decision to withdraw U.S. forces from northeast Syria. At a time when Trump needs allies in the senate to defend him against eventual impeachment articles, he is not likely to veto and risk an override. Moreover, Turkey’s military incursion into Syria, which may wax and wane, stems from economic and political weakness at home and will eventually exacerbate that weakness by fueling the growing opposition to Erdogan’s administration and requiring more unorthodox monetary and fiscal accommodation. It reinforces our bearish outlook on Turkish lira and assets. Chart 15Brazilian Risk Will Not Re-Test 2018 Highs Brazilian Risk Will Not Re-Test 2018 Highs Brazilian Risk Will Not Re-Test 2018 Highs Brazil’s political risk has rebounded (Chart 15). The Senate has virtually passed the pension reform bill, as expected, which raises the official retirement age for men and women to 65 and 63 respectively. This will generate upwards of 800 billion Brazilian real in savings to improve the public debt profile. Of course, the country will still run primary deficits and thus the public debt-to-GDP ratio will still rise. Now the question shifts to President Jair Bolsonaro and his governing coalition. Bolsonaro’s approval rating has ticked up as we expected (Chart 16). If this continues then it is bullish for Brazil because it suggests that he will be able to keep his coalition together. But investors should not get ahead of themselves. Bolsonaro is not an inherently pro-market leader, there is no guarantee that he will remain disciplined in pursuing pro-productivity reforms, and there is a substantial risk that his coalition will fray without pension reform as a shared goal (at least until markets riot and push the coalition back together). Therefore we expect political risk to abate only temporarily, if at all, before new trouble emerges. Furthermore, if reform momentum wanes next year, then Brazil’s reform story as a whole will falter, since electoral considerations emerge in 2021-22. Hence it will be important to verify that policymakers make progress on reforms to tax and trade policy early next year. Our Russian geopolitical risk indicator is also lifting off of its bottom (see Appendix). This makes sense given Russia’s expanding strategic role (particularly in the Middle East), its domestic political troubles, and the risks of the U.S. election. The latter is especially significant given the risk (not our base case, however) that a Democratic administration could take a significantly more aggressive posture toward Russia. Political risk in Turkey and Russia will continue to rise. Bottom Line: Political risk in Turkey and Russia will continue to rise. Russia is a candidate for a “black swan” event, given the eerie quiet that has prevailed as Putin devotes his fourth term to reducing domestic political instability. Brazil, on the other hand, has a 12-month window in which reform momentum can be reinforced, reducing whatever spike in risk occurs in the aftermath of the ruling coalition’s completion of pension reform. Canada: Election Post-Mortem Prime Minister Justin Trudeau returned to power at the head of a minority government in Canada’s federal election (Chart 17). The New Democratic Party (NDP) lost 15 seats from the last election, but will have a greater role in parliament as the Liberals will need its support to pass key agenda items (and a formal governing coalition is possible). The NDP’s result would have been even worse if not for its last-minute surge in the polls after the election debates and Trudeau’s “blackface” scandal. Chart 17Liberals Need The New Democrats Now How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 The Conservative Party won the popular vote but only 121 seats in parliament, leaving the western provinces of Alberta and Saskatchewan aggrieved. The Bloc Québécois, the Quebec nationalist party, gained 22 seats to become the third-largest party in the House. Energy investment faces headwinds in the near-term. The Liberal Party will face resistance from the Left over the Trans Mountain pipeline. Trudeau will not necessarily have to sacrifice the pipeline to appease the NDP. He may be able to work with Conservatives to advance the pipeline while working with the NDP on the rest of his agenda. But on the whole the election result is the worst-case scenario for the oil sector and political questions will have to be resolved before Canada can take advantage of its position as a heavy crude producer near the U.S. Gulf refineries in an era in which Venezuela is collapsing and Saudi Arabia is exposed to geopolitical risk and attacks. More broadly, the Liberals will continue to endorse a more expansive fiscal policy than expected, given Canada’s low budget deficits and the need to prevent minor parties from eating away at the Liberal Party’s seat count in future. Bottom Line: The Liberal Party failed to maintain its single-party majority. Trudeau’s reliance on left-wing parties in parliament may prove market-negative for the Canadian energy sector, though that is not a forgone conclusion. Over the longer term the sector has a brighter future.   Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Appendix GeoRisk Indicator TRADE WAR GEOPOLITICAL RISK INDICATOR TRADE WAR GEOPOLITICAL RISK INDICATOR U.K.: GeoRisk Indicator U.K.: GEOPOLITICAL RISK INDICATOR U.K.: GEOPOLITICAL RISK INDICATOR France: GeoRisk Indicator FRANCE: GEOPOLITICAL RISK INDICATOR FRANCE: GEOPOLITICAL RISK INDICATOR Germany: GeoRisk Indicator GERMANY: GEOPOLITICAL RISK INDICATOR GERMANY: GEOPOLITICAL RISK INDICATOR Spain: GeoRisk Indicator SPAIN: GEOPOLITICAL RISK INDICATOR SPAIN: GEOPOLITICAL RISK INDICATOR Italy: GeoRisk Indicator ITALY: GEOPOLITICAL RISK INDICATOR ITALY: GEOPOLITICAL RISK INDICATOR Canada: GeoRisk Indicator CANADA: GEOPOLITICAL RISK INDICATOR CANADA: GEOPOLITICAL RISK INDICATOR Russia: GeoRisk Indicator RUSSIA: GEOPOLITICAL RISK INDICATOR RUSSIA: GEOPOLITICAL RISK INDICATOR Turkey: GeoRisk Indicator TURKEY: GEOPOLITICAL RISK INDICATOR TURKEY: GEOPOLITICAL RISK INDICATOR Brazil: GeoRisk Indicator BRAZIL: GEOPOLITICAL RISK INDICATOR BRAZIL: GEOPOLITICAL RISK INDICATOR Taiwan: GeoRisk Indicator TAIWAN: GEOPOLITICAL RISK INDICATOR TAIWAN: GEOPOLITICAL RISK INDICATOR Korea: GeoRisk Indicator KOREA: GEOPOLITICAL RISK INDICATOR KOREA: GEOPOLITICAL RISK INDICATOR What's On The Geopolitical Radar? How Much To Buy An American President? – GeoRisk Update: October 25, 2019 How Much To Buy An American President? – GeoRisk Update: October 25, 2019 Section III: Geopolitical Calendar

Highlights Shifting Trends: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Duration & Country Allocation Strategy: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Credit Allocation Strategy: Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Feature Chart of the WeekBond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? Bond Yields Sniffing A Turn In Global Growth? It has been fifty days (and counting) since the 2019 low for the benchmark 10-year U.S. Treasury yield was reached on September 3. The year-to-date low for the benchmark 10-year German bund yield was seen six days before that on August 28. Yields have risen by a healthy amount since those dates, up +34bps and +37bps for the 10yr Treasury and Bund, respectively. This has occurred despite the significant degree of bond-bullish pessimism on global growth and inflation that can be found in financial media reporting and investor surveys. The fact that yields are now steadily moving away from the lows suggests that the 2019 narrative for financial markets – slowing global growth, triggered by political uncertainty and the lagged impact of previous Fed monetary tightening and China credit tightening, forcing central banks to turn increasingly more dovish – is no longer correct. If that is true, yields have more near-term upside as overbought government bond markets begin to “sniff out” a bottoming out of global growth momentum (Chart of the Week). In this Weekly Report, we take a look at the changing state of the factors that fueled the sharp decline in bond yields in 2019. We follow that up with a review of all our current recommended investment positions on duration, country allocation and spread product allocations in light of recent developments. We conclude that maintaining a below-benchmark duration exposure, while favoring lower-beta countries in sovereign debt and overweighting corporate debt in the U.S. and Europe, is the most appropriate fixed income strategy for the next 6-12 months. The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. Yields Are Rising At The Right Time, For The Right Reasons Chart 2Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning Bond-Bullish Growth & Inflation Factors Are Turning The timing of the bottoming of yields in the major developed markets (DM) should not be surprising, given the more bond-bearish turn of reliable leading directional yield indicators. The diffusion index of our global leading economic indicator (LEI), which leads the real (ex-inflation expectations) component of DM bond yields by twelve months, is at an elevated level (Chart 2). At the same time, the slowing of the annual rate of growth in the trade-weighted U.S. dollar, which leads 10-year DM CPI swap rates by around six months, is signaling that bond yields have room to increase from the inflation expectations side. Finally, the rising trend of positive data surprises for the major DM countries is also pointing to higher yields. Breaking it down at the country level, the pickup in DM 10-year bond yields since the 2019 lows has been widespread (Charts 3 & 4). The range of yield increases is as low as +16bps in Japan, where the Bank of Japan (BoJ) is pursuing a yield target, to +46bps in Canada where the economy and inflation are both accelerating. Chart 3Pricing Out Some Expected Rate Cuts … Pricing Out Some Expected Rate Cuts ... Pricing Out Some Expected Rate Cuts ... Chart 4… Across All Developed Markets ... Across All Developed Markets ... Across All Developed Markets The increase in yields has also occurred alongside reduced expectations for easier monetary policy. Our 12-month discounters, which measure the expected change in short-term interest rates priced into Overnight Index Swap (OIS) curves, show that markets have partially priced out some (but not all) expected rate cuts in all major DM countries. The Three Things That Have Changed For Global Bond Markets So what has changed to trigger a reduction in rate cut expectations and an increase in global yields? The bond-bullish narrative that we refer to in the title of this report can be broken down into the following three elements, which have all turned recently: Slowing global growth (now potentially bottoming) Chart 5Global Growth Bottoming Out Global Growth Bottoming Out Global Growth Bottoming Out Current global growth is still trending lower, when looking at measures like manufacturing PMIs or sentiment surveys like the global ZEW index. Forward-looking measures like our global LEI, however, have been moving higher in recent months, suggesting that a bottom in the PMIs may soon unfold (Chart 5). We investigated that improvement in our global LEI in a recent report and concluded that the move higher was focused almost exclusively within the emerging market (EM) sub-components that are most sensitive to improving global growth.1 This fits with the improvement shown in the OECD LEI for China, a bottoming of the annual growth rate of world exports, and the general acceleration of global equity markets – the classic leading economic indicator. Rising political uncertainty (now potentially fading) The U.S.-China trade war (including the implications for the upcoming 2020 U.S. presidential election) and the U.K. Brexit saga have been the main sources of bond-bullish political uncertainty over the past several months. Yet recent developments have helped reduce the odds of the most negative tail risk outcomes, providing a bit of a boost to global bond yields. The U.S. and China have agreed (in principle) to a “phase one” trade deal that, at a minimum, lowers the chances of a further escalation of the trade dispute through higher tariffs. Meanwhile, the momentum has shifted towards a potential final Brexit agreement between the U.K. and European Union that can avoid an ugly no-deal outcome. Our colleagues at BCA Research Geopolitical Strategy believe that developments are likely to continue moving away from the worst-case scenarios, given the constraints faced by policymakers.2 U.S. President Donald Trump is now in full campaign mode for the 2020 elections and needs a deal (of any kind) to deflect criticism that his trade battle with China is dragging the U.S. economy into recession. Already, there has been a sharp decline in income growth for workers in swing states that could vote for either party’s candidate in next year’s election (Chart 6). Trump cannot afford to lose voters in those states, many of which are in the U.S. industrial heartland (i.e. Ohio, Michigan) that helped put him in the White House. In other words, he is highly incentivized to turn down the heat on the trade war or else face a potential loss next November. While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Meanwhile, China is facing a slowing economy and rising unemployment, but with reduced means to fight the downtrend given high private sector debt that has impaired the typical response between easier monetary conditions and economic activity (Chart 7). While the Chinese government does not want to be seen as caving in to U.S. pressure on trade policy, its desire to maintain social stability by preventing a further rise in unemployment from the trade war provides a powerful incentive to try and ratchet down tensions with the U.S. Chart 6Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade Political Reasons For Trump To Retreat On Trade In the U.K., a no-deal Brexit is an economically painful and politically unpopular outcome that would severely damage the re-election chances of Prime Minister Boris Johnson and his Conservative party. Thus, even a hard-line Brexiteer like Johnson must respond to the political constraints forcing him to try and get a Brexit deal done (Chart 8). Chart 7Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Economic Reasons For China To Retreat On Trade Chart 8Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit Political Reasons To Retreat On A No-Deal Brexit While these political uncertainties have not been fully resolved by these latest developments, the shift in momentum away from worst-case scenarios has likely been enough to reduce the safe-haven bid for DM government bonds, helping push yields higher. Bull-flattening pressure on yield curves (now turning into moderate bear-steepening) The final leg down in bond yields in August had a technical aspect to it, fueled by the demand for duration and convexity from asset-liability managers like European pension funds and insurance companies. Falling yields act to raise the value of liabilities for that group of investors, forcing them to rapidly increase the duration of their assets to match the duration of their liabilities (the technique used to limit the gap between the value of assets and liabilities). That duration increase is carried out by buying government bonds with longer maturities (and higher convexity), but also through the use of interest rate derivatives like long maturity swaps and swaptions. The end result is a bull flattening of yield curves (both for government bonds and swaps) and a rise in swaption volatility (i.e. the price of swaptions). Those dynamics were clearly in play in August after the shocking imposition of fresh U.S. tariffs on Chinese imports early in the month. Bond and swaption volatilities spiked, and bond/swap yield curves bull-flattened, in both Europe and the U.S. (Chart 9). That effect only lasted a few weeks, however, and volatilities have since declined and curves have steepened. This suggests that the “convexity-buying” effect has run its course and is now starting to work in the opposite direction, with asset-liability managers looking to reduce the duration of their assets as higher yields lower the value of their liabilities. This is putting some upward pressure on longer-maturity global bond yields. Chart 9Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Signs Of Reduced Convexity-Related Bond Buying Chart 10Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Bull-Flattening Yield Curve Pressures Easing Up A Bit Chart 11Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves Fed & ECB Actions Should Help Steepen Up Curves The steepening seen so far must be put in context, however, as yield curves remain very flat across the DM world (Chart 10). Term premia on longer-term bonds remain very depressed, although those should start to increase as global growth stabilizes and the massive safe-haven demand for global government debt begins to dissipate. Some pickup in inflation expectations would also help impart additional bear-steepening momentum to yield curves – a more likely result now that the Fed and ECB have both cut interest rates and, more importantly, will start provide additional monetary easing by expanding their balance sheets (Chart 11). Bottom Line: The factors that have driven bond yields lower throughout 2019 – slowing growth, rising uncertainty, demand for safe assets and dovish monetary policy expectations – have all started to turn in a more bond-bearish direction. Reviewing Our Recommended Bond Allocations In light of these shifting global trends described above, the fixed income investment implications are fairly straightforward: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. Duration: A moderate below-benchmark overall duration stance is warranted for global fixed income portfolios, with yields likely to continue drifting higher over at least the next six months. A big surge in yields is unlikely, as central banks will need to see decisive evidence that global growth is not only bottoming, but accelerating, before shifting away from the current dovish bias. Given the reporting lags in the economic data, such evidence is unlikely to appear until the first quarter of 2020 at the earliest. Yet given how flat yield curves are across the DM government bond markets, the trajectory of forward rates is quite stable relative to spot yield levels, making it much easier to beat the forwards by positioning for even a modest yield increase. Country Allocation: Yields are rising around the world, suggesting that the current move is a shift higher driven by non-country-specific factors like more stable future global growth prospects. In that case, using yield betas to the “global” bond yield is a good way to consider country allocation decisions within a fixed income portfolio. We looked at those yield betas in an August report, using Bloomberg Barclays government bond index data for the 7-10 year maturity buckets of individual countries and the Global Treasury aggregate (Chart 12).3 The rolling 3-year betas were highest in the U.S. and Canada, making them good countries to underweight within a global government bond portfolio in a rising yield environment. The yield betas were lowest in Japan, Germany and Australia, making them good overweight candidates. The U.K. was a unique case of having a relatively high historical yield beta prior to the 2016 Brexit referendum and a lower yield beta since then - making the U.K. allocation highly conditional on the resolution of the Brexit uncertainty. Spread Product Allocation: The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. Thus, an overweight stance on overall global spread product versus governments is warranted. The backdrop described in this report, where global growth is bottoming out but where central banks maintain a dovish bias, is a perfect sweet spot for global spread product like corporate bonds and Peripheral European government debt. With regards to our current strategic fixed income recommendations and model bond portfolio allocations, we already have much of the positioning described above in place. We are below-benchmark on overall duration, underweight higher-beta U.S. Treasuries; overweight government bonds in lower-beta Germany, France, Japan and Australia (Chart 13); overweight investment grade corporate bonds in the U.S., euro area and U.K.; and overweight high-yield corporate bonds in the U.S. and euro area. Chart 12Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets Favor Lower-Beta Government Bond Markets There are areas where our positioning could change, however. Chart 13Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform Lower-Beta Laggards Should Start To Outperform In terms of government bonds, we are currently overweight the U.K. and neutral Canada. A final Brexit deal would justify a downgrade of Gilts to at least neutral, if not underweight, as the Bank of England has signaled that rate hikes would be justified if the Brexit uncertainty was resolved. A downgrade of higher-beta Canadian government debt to underweight could also be justified, although the Bank of Canada is not signaling that a change in monetary policy (in either direction) is warranted. For now, we will hold off on any change to our U.K. stance, as it is now likely that there will be another extension of the Brexit deadline beyond October 31. As for Canada, we remain neutral for now but will revisit that stance in an upcoming Weekly Report. With regards to spread product, we are only neutral EM USD-denominated sovereign and corporate debt, as well as Spanish sovereign bonds; and underweight Italian government debt. An EM upgrade to overweight would require two things that are not yet in place: a weaker U.S. dollar and accelerating Chinese economic growth. Chart 14Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe Stay Overweight Corporates In The U.S. & Europe As for Peripheral governments, we have preferred to be overweight European corporate debt relative to sovereign bonds in Italy and Spain. The recent powerful rally in the Periphery, however, has driven the spreads over German bunds in those countries down to levels in line with corporate credit spreads (Chart 14). We will maintain these allocations for now, but will investigate the relative value proposition between euro area Peripheral sovereigns and corporates in an upcoming report. Bottom Line: Maintain a moderate below-benchmark stance on aggregate bond portfolio duration. Favor lower-beta countries with central banks that are more likely to stay relatively dovish as global yields drift higher, like core Europe, Australia and Japan. Stay overweight corporate bonds versus government debt in the U.S. and Europe, both for investment grade and high-yield. Maintain just a neutral stance on EM USD-denominated spread product, but look to upgrade if global growth improves further and the USD begins to weaken. Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com   Footnotes 1 Please see BCA Research Global Fixed Income Strategy Weekly Report, “What Is Driving The Improvement In The BCA Global Leading Economic Indicator?”, dated October 2, 2019, available at gfis.bcaresearch.com. 2 Please see BCA Research Geopolitical Strategy Weekly Report, “Five Constraints For The Fourth Quarter”, dated October 11, 2019, available at gps.bcaresearch.com. 3 Please see BCA Research U.S. Bond Strategy/Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?", dated August 20, 2019, available at usbs.bcaresearch.com and gfis.bcaresearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Cracks Are Forming In The Bond-Bullish Narrative Cracks Are Forming In The Bond-Bullish Narrative Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Housing Activity Summary Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Trade War Worries Affecting Sentiment Trade War Worries Affecting Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections Crisis Of Confidence Crisis Of Confidence As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Crisis Of Confidence Crisis Of Confidence Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Dear Client, In lieu of our regular Weekly Report this week, tomorrow we will be publishing a joint Special Report on the Chinese automobile industry outlook with our Emerging Markets Strategy service, authored by my colleague Ellen JingYuan He. Best regards, Jing Sima China Strategist Feature Chart 1Chinese Economy Likely To Bottom In Q1 Chinese Economy Likely To Bottom In Q1 Chinese Economy Likely To Bottom In Q1 President Trump announced last Friday the first phase of a potential trade agreement with China. For now, the most concrete aspect of the announcement has been the deferral of an increase in tariffs that had been scheduled to occur this week, in exchange for agriculture purchase commitments from China. Market participants initially reacted with caution to the news, given the U.S. administration’s about-face in early-May and given signs from Beijing that China “needs time” to finalize a deal. However, Chinese policymakers have subsequently played up the progress made during the negotiations, and characterized both sides as being on “the same page”. We noted in last week’s report that China’s economy was likely to stabilize in Q1 of next year (Chart 1), but that a further shock to China’s external sector and/or internal policy missteps could easily tip the Chinese economy into a deeper growth slowdown.1 This, to us, justified a tactically bearish stance towards Chinese stocks, despite our positive cyclical bias. Indeed, following our tactical underweight call initiated on July 24,2 relative to global stocks, Chinese investable stocks dropped nearly 3% in the months of August and September in reaction to intensified trade tension. Chart 2Chinese Stocks Have Been Underperforming Since Late April Chinese Stocks Have Been Underperforming Since Late April Chinese Stocks Have Been Underperforming Since Late April While it is not yet clear how substantive the final deal between the U.S. and China will be, it is our judgment that the odds of a further escalation in the trade war have legitimately fallen over the past week. Both sides of the negotiating table have strong incentives to reach a deal (particularly the U.S.), and both U.S. and Chinese policymakers may finally be acting in a way that is consistent with each side’s respective constraints. As such, we no longer feel that a tactical underweight stance is warranted, and we recommend that clients maintain a neutral stance towards Chinese stocks over the near term. The potential for the talks to collapse once again is keeping us from recommending an outright overweight tactical stance, as well as the small but still non-trivial chance that the final deal is not meaningful enough to help revive economic activity. Cyclically, a substantive trade deal would be bullish for Chinese stocks, as the relative performance of both the investable and domestic markets are meaningfully below their late-April highs (Chart 2). The stimulus that policymakers have already provided should be enough to stabilize Chinese domestic demand, and a trade deal should help reinforce a stabilization in sentiment and activity over the coming year. However, one risk to our cyclical positioning is that the removal of uncertainty for China’s exporters strengthens the will of Chinese policymakers to curb “excess” credit growth. For now, this remains “a story for another day”, as investors will almost certainly bid up Chinese stocks (particularly the investable market) in reaction to a deal. But the behavior of China’s credit impulse following the surge in Q1 of this year underscores that policymakers are very serious about preventing another significant rise in the macro leverage ratio. This could lead to a less optimistic outlook over the coming 6-12 months than we originally expected when we recommended upgrading Chinese stocks earlier this year, and is a risk that we will be continually monitoring over the coming months. Stay tuned!   Jing Sima China Strategist JingS@bcaresearch.com   Footnotes 1      Please see China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing”, dated October 9, 2019, available at cis.bcaresearch.com 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?”, dated July 24, 2019, available at cis.bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights Portfolio Strategy The trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. A tentative tick up in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Recent Changes Initiate a long S&P Industrials/short S&P Tech pair trade on a tactical three-to-six month time horizon, today. Initiate a long S&P Machinery/short S&P Semiconductors pair trade on a tactical three-to-six month time horizon, today. Follow The Profit Trail Follow The Profit Trail Feature The S&P 500 oscillated violently again last week, as the barrage of declining economic data, heightened trade war-related volatility and political upheaval dominated the news flow. While the Fed remains the backstop of last resort, we doubt additional interest rate cuts, which are already aggressively priced in the bond market, will boost lending and entice CEOs to invest in capital expenditure projects. Investors have to stay patient and disciplined, let this economic slowdown play out and allow for the natural healing of the economy. As a reminder, the ISM manufacturing index has been decelerating for twelve months and only been below the boom bust line for two. If history is an accurate guide, an additional three-to-six months of manufacturing pain are in store before a definitive bottom is in place (bottom panel, Chart 1). Such a macro backdrop, still warrants caution on the prospects of the broad equity market. Chart 1Allow Time For Economic Healing Allow Time For Economic Healing Allow Time For Economic Healing Beginning in August, a number of BCA publications became a tad more cautious on risk assets. Following our October editorial view meeting last week, this cautiousness was cemented with a tactical downgrade of global equities to neutral from previously overweight in the BCA House View matrix. While this marks a clear shift toward this publication’s less sanguine view of the U.S. equity market adopted during the summer, BCA's cyclical 12-month House View remains overweight global equities. Worryingly, the majority of the indicators we track continue to emit distress signals and warn that the SPX has further downside (Chart 2), especially absent profit growth. Importantly, we first correctly posited last May that the back half of the year global growth reacceleration was in jeopardy and would go on hiatus courtesy of rising policy uncertainty.1 Such a backdrop would boost the U.S. dollar and simultaneously take a bite out of SPX EPS.2 Chart 2Soft Data Red Flag Soft Data Red Flag Soft Data Red Flag Last week we highlighted that the U.S. dollar is the most important indicator to monitor given its global deflationary/reflationary properties. Were the greenback to maintain its year-to-date gains, it will continue to dent SPX profitability via P&L translation loss effects and likely sustain the profit recession into early 2020 (trade-weighted U.S. dollar shown inverted, bottom panel, Chart 3). Chart 3Greenback Weighing On Profits Greenback Weighing On Profits Greenback Weighing On Profits U.S. Equity Strategy’s S&P 500 four-factor macro EPS growth model remains downbeat (middle panel, Chart 4). Were we to isolate the U.S. dollar as a single variable and re-run the regression it is clear that additional greenback appreciation will further weigh on SPX profit growth (bottom panel, Chart 4). Meanwhile, the easing in financial conditions and drubbing of the 10-year Treasury yield since the Christmas Eve lows is already reflected in the 23% jump in the forward PE multiple, which explains over 90% of the SPX’s rise since the Dec 24, 2018 trough (top & middle panels, Chart 5). In other words, for multiples to expand anew, financial conditions would have to further ease, which in our view is a tall order (bottom panel, Chart 5). Chart 4EPS Model Warrants Caution EPS Model Warrants Caution EPS Model Warrants Caution Chart 5Financial Conditions Are The Forward P/E Financial Conditions Are The Forward P/E Financial Conditions Are The Forward P/E This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe.  Thus, we would lean against the narrative that easy financial conditions are not fully reflected into stocks. In contrast, our worry is that junk spreads are on the verge of a breakout and such a backdrop would tighten financial conditions and aggravate an SPX drawdown (junk OAS shown inverted, Chart 6). Adding it all up, the trade-weighted U.S. dollar’s appreciation along with the still souring manufacturing data are weighing on SPX profit growth, at a time when heightened geopolitical uncertainty and a looming reversal in financial conditions has the potential to wreak havoc on stock prices. Stay cautious on the prospects of the broad equity market on a cyclical 9-12 month time horizon. This week we are initiating two related pair trades to exploit the mispricing of the trade war within the deep cyclical sector universe. Chart 6Watch Junk Spreads Watch Junk Spreads Watch Junk Spreads Initiate A Long Industrials/Short Tech Pair Trade… Ever since the Sino-American trade war started in March 2018, the market has punished industrials, but tech has escaped unscathed. While the global growth soft patch preceded the U.S./China trade spat, courtesy of the Fed’s tightening cycle and Chinese policymakers’ slamming on the brakes, the trade war has served as a catalyst to aggressively shed deep cyclical equities except for tech stocks (Chart 7). We think this misalignment presents a playable opportunity to generate alpha by going long industrials/short tech, irrespective of the trade war’s outcome. In other words, this market neutral trade will be in the black either because the trade spat gets resolved or because there will effectively be no “real” deal including intellectual property and the tech sector. If the two sides manage to iron out their differences and strike a deal, industrials stocks should benefit from a greater catch-up phase because they have been depressed over the past two years, while tech stocks are near relative all-time highs. In contrast, a “no deal” scenario, should also re-concentrate investors’ minds and lead to a relative selling in tech stocks versus their already beaten-down deep cyclical peers: industrials. Chart 7Bifurcated Deep Cyclicals Market Bifurcated Deep Cyclicals Market Bifurcated Deep Cyclicals Market Chart 8Lots Of Bad Trade War News Reflected In Prices Lots Of Bad Trade War News Reflected In Prices Lots Of Bad Trade War News Reflected In Prices Chart 8 shows the drubbing in relative share prices as three key macro drivers have felt the trade war’s wrath. In more detail, were a deal to get struck, growth expectations will reverse course and a bond market sell-off will almost immediately reflect such an improvement in the global macro backdrop. Rising interest rates on the back of a reflationary/inflationary impulse are a boon for industrials and a bane for high growth tech stocks (top panel, Chart 8). Similarly, the middle panel of Chart 8 highlights that the ISM manufacturing survey should climb above the boom/bust line and outshine the San Francisco Fed’s Tech Pulse Index (that comprises “coincident indicators of activity in the U.S. information technology sector”3) on news of a successful deal. Finally, relative capital expenditure outlays should also veer in favor of industrials as previously mothballed infrastructure projects will come out of hibernation (bottom panel, Chart 8). In contrast, tech capex has been resilient of late with analytics, security and cloud computing being the most defensive capex corner, leaving little room for additional relative capex gains. Taking the opposite side i.e. a “no deal”, we doubt the metrics we depict in Chart 8 would sink that much further. If anything we believe that there is an element of exhaustion and relative share prices would jump on news of a breakdown in trade talks as tech sector fire sales would trump the sell-off in already depressed industrials. Meanwhile, the U.S. dollar and relative share prices have been steeply diverging recently and this gap will likely narrow via a catch-up phase in the latter (top & middle panels, Chart 9). According to Factset’s latest data the S&P industrials sector garners 37% of its sales from abroad, whereas the S&P information technology sector’s foreign exposure stands at 57% of total revenues.4 Therefore, given this 20% delta, a rising greenback should be beneficial to the more domestically geared industrials stocks (bottom panel, Chart 9). On the operating front, industrials also have the upper hand. The relative wage bill is sinking like a stone (shown inverted, middle panel, Chart 10) at a time when relative selling price inflation is holding its own (top panel, Chart 10). The upshot is that a relative profit margin jump is in store in the coming months which should boost the relative share price ratio (bottom panel, Chart 10). Chart 9Unsustainable Divergence Unsustainable Divergence Unsustainable Divergence Chart 10Industrials Have The Upper Hand Industrials Have The Upper Hand Industrials Have The Upper Hand U.S. Equity Strategy’s proprietary relative Cyclical Macro Indicators and relative profit growth models capture all these drivers and both signal that an industrials versus tech earnings-led outperformance phase looms into year end (Chart 11). Chart 12 shows that the relative earnings breadth and relative net earnings revisions are both deep in negative territory. In terms of technicals, the relative percentage of groups trading with a positive 52-week rate of change has hit the lowest level in the past two decades (second panel, Chart 12) and our composite relative technical indicator is roughly one standard deviation below the historical mean (bottom panel, Chart 11). Chart 11Profit Models And...  Profit Models And...  Profit Models And...  Chart 12...Washed Out Breadth Say Buy Industrials At The Expense Of Tech ...Washed Out Breadth Say Buy Industrials At The Expense Of Tech ...Washed Out Breadth Say Buy Industrials At The Expense Of Tech Finally, relative valuations are also bombed out. Our relative valuation indicator has been in a six-year uninterrupted drop, falling from two standard deviations above the mean to one standard deviation below the mean (fourth panel, Chart 11). Such entrenched bearishness in relative value is unwarranted. Bottom Line:  Firming operating metrics, the resilient U.S. dollar, compelling valuations and depressed technicals, all signal that there is an exploitable tactical trading opportunity in a long S&P industrials/short S&P tech pair trade, irrespective of the trade war outcome. …And A Long Machinery/Short Semis Pair Trade A more speculative and higher octane vehicle to explore this trade war-related mispricing is via a long S&P machinery/short S&P semiconductors pair trade. Most of the drivers mentioned above also hold true in this subsector market-neutral trade. However, in this section we will drill deeper in the China/EM drivers. The Emerging Asia leading economic indicator (EALEI) has plummeted to levels last hit around the 1998 LTCM bailout (top panel, Chart 13). While more pain is likely in the coming months as global trade has ground to a halt, we doubt the carnage in the EALEI can continue indefinitely. In fact, a tentative trough in the Emerging Markets (EM) manufacturing PMI heralds a brighter outlook for relative share prices (bottom panel, Chart 13). Chart 13Same Trade War Theme, Different Vehicles To Play It Same Trade War Theme, Different Vehicles To Play It Same Trade War Theme, Different Vehicles To Play It Chart 14China...  China...  China...  Encouragingly, China’s fiscal and credit impulse also signals that a bottom in relative share prices is likely already in place. If this leading indicator proves accurate in the coming months, then relative share prices can spike 20% near the late-2018 highs (Chart 14).   Chinese money supply growth is showing some signs of life and capital committed to infrastructure spending is coming out of hibernation. Goldman Sachs’ China current activity indicator is on a similar upward trajectory, underscoring that the path of least resistance is higher for relative share prices (Chart 15). Chart 15...Holds The Key ...Holds The Key ...Holds The Key Chart 16Firming Final Demand... Firming Final Demand... Firming Final Demand... On the operating front, relative new orders and relative shipment growth have both ticked higher (top & middle panels, Chart 16). Importantly, our relative demand proxy suggests that the relative end-demand backdrop is also firming. Using Caterpillar’s global sales to dealers data compared with global chip sales reveals that a wide gap has formed between relative share prices and our relative demand gauge (bottom panel, Chart 16). If our thesis pans out in the upcoming three-to-six months then machinery will trounce semis. Finally, relative pricing power corroborates that machinery demand has the upper hand versus semiconductor final demand. The Commodity Research Bureau’s raw industrials index is climbing relative to Asian DRAM prices. The upshot is that the compellingly valued relative share price ratio will gain steam in the months ahead (Chart 17). In sum, a tentative up-tick in EM and China data along with improving relative operating metrics signal that the time is ripe to initiate a long machinery/short semis pair trade. Bottom Line: Initiate a long S&P machinery/short S&P semiconductors pair trade today. The ticker symbols for the stocks in the S&P machinery and S&P semis indexes are: BLBG – S5MACH – CAT, DE, ITW, IR, CMI, PCAR, PH, SWK, FTV, DOV, XYL, IEX, WAB, SNA, PNR, FLS, and BLBG – S5SECO – INTC, TXN, NVDA, AVGO, QCOM, MU, ADI, AMD, XLNX, QRVO, MCHP, MXIM, SWKS, respectively. Chart 17...Is A Boon To Relative Pricing Power ...Is A Boon To Relative Pricing Power ...Is A Boon To Relative Pricing Power Key Risk To Monitor One important risk to both of our newly recommended market-neutral trades is China. We recently touched base with our ex-Chief Geopolitical Strategist and currently Chief Strategist at the Clocktower Group, Marko Papic. He warned us that all bets would be off because: “I think we will look back at the recession of 2020 and it will be known as the “China recession”. Basically, China just decided to stop playing, pick up its toys, and go home”. If Marko’s wise words were to ring true, then such a Chinese policy shift will truly be a game changer with negative global economic growth implications. With regard to our pair trades, they would both be offside.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Consolidation” dated May 21, 2019, available at uses.bcaresearch.com. 2      Please see BCA U.S. Equity Strategy Weekly Report, “On Edge” dated May 13, 2019, available at uses.bcaresearch.com. 3      https://www.frbsf.org/economic-research/indicators-data/tech-pulse/ 4      https://www.factset.com/hubfs/Resources%20Section/Research%20Desk/Earnings%20Insight/EarningsInsight_100419A.pdf Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)