Financial Markets

Special Report

HighlightsEuropean fiscal stimulus will not drive European equity outperformance – Europe needs China to open the stimulus taps.Our mega-theme of European integration continues – the continent is politically stable.The U.S.-China trade war is an opportunity for Europe. Any Sino-American trade deal is unlikely to resolve tech disputes. Go long European tech stocks versus American.The euro has room to grow as a global reserve currency given the dollar’s mounting structural flaws. Look for an opportunity to go long EUR/USD on a strategic basis within the near future.FeatureTalk of European fiscal stimulus is accelerating as investors look for reasons to take advantage of depressed European valuations (Chart 1) and traditional late-cycle outperformance relative to the U.S. (Chart 2). We are skeptical of the thesis. Chart 1European 'Cheapness' An Obvious Inducement  Chart 2Euro Stocks Outperform Late In The Cycle Europe is a price taker, not a price maker, when it comes to global growth. In order for investors to generate alpha from an overweight Europe position, the rest of the world needs to pick up the slack and reverse the current decline in economic fundamentals. That will require policy action on the behalf of the Fed, the Trump administration, and – most relevant to Europe – Chinese fiscal policy.That said, long-term investors should start thinking about increasing exposure to Europe. Not only is the continent well priced relative to the rest of the world, but it may have two more things going for it. First, political risks remain low. Second, Europe stands to gain in any prolonged China-U.S. confrontation. The flipside risk is that it stands to lose enormously in any temporary resolution as well.Europe Is A Derivative – Not A Source – Of Global Growth…Despite accounting for 16% of global GDP, the Euro Area generates an ever-shrinking proportion of the annual incremental change in global GDP (Chart 3). This is not surprising, given that the world has undergone significant transformation due to China’s industrialization and the growth of EM economies. Chart 3Europe’s Contribution To Global Growth Declining China’s imports today drive Euro Area manufacturing PMI broadly and Chinese retail sales drive German manufacturing orders specifically (Chart 4). As such, it is critically important to watch Chinese total social financing (TSF) impulse, which closely leads Europe’s exports to China by six months (Chart 5). Chart 4Europe And Germany Rely On China  Chart 5China's Credit Cycle Drives EU Exports  The problem is that the Chinese credit impulse has only tepidly recovered and implies more downside to European exports ahead. In addition, hopes of a rebound in Chinese retail sales have been dashed (Chart 6). The jump in auto sales in June was the result of heavy discounts offered by manufacturers and dealers to clear inventory before new emission standards came into effect on July 1. Due to the frontloading, car sales are now declining in what is traditionally an off-season for car purchases in China. While the worst may be over, weakness could linger for months. Chart 6China's Retail Sales Flashing Red The bottom line is that without an upturn in global growth, Europe will remain in the doldrums. The good news is that BCA’s Chief Strategist Peter Berezin expects precisely such a development in the second half of 2019.1 The bad news is that Chinese credit stimulus appears to be weighed down by a combination of impaired transmission mechanisms and policymaker unwillingness to launch an old-school credit orgy (Chart 7). This is creating a highly unusual – for this cycle – development where China is not playing its usual counter-cyclical role amidst the global manufacturing cycle (Chart 8). Chart 7China's Credit Stimulus Restrained Thus Far  Chart 8Beijing Goes On Strike As Global Spender Without more Chinese stimulus, European fiscal spending won’t be that meaningful.As such, it is difficult to get excited about European growth. As we discussed in last week’s missive, Europe is moving gingerly towards more fiscal spending. However, it has already done so this year, with fiscal thrust at 0.46% of GDP, the highest figure since 2009 (Chart 9). Did anyone notice? Not really. Chart 9Headwinds Overpower EU's Strong Fiscal Thrust Moreover Euro Area countries have to submit their 2020 budgets in early Q4 to the European Commission. It is unlikely that these proposals will be meaningful, given that there is not yet enough panic to spur massive stimulus.Bottom Line: Yes, Europe will provide more fiscal spending in 2020. But it will remain at the mercy of global growth given its high-beta nature.…But At Least It Is Not Falling Apart!   That said, not all is disappointing on the Old Continent. For one, the aforementioned fiscal thrust at least prevented a deeper slowdown this year – and the drop-off in thrust next year will be less dramatic as budgets turn more accommodative.Meanwhile political risk is falling. Anti-establishment parties are either cleaning up their act, putting on a tie, and becoming part of the establishment, or they are losing power. Our long-held thesis that European integration would persist into the next decade remains well-supplied with empirical evidence.2On the Euroskepticism front, much of the hype today surrounds the collapse of the Five Star Movement (M5S) coalition with the League in Italy. The formerly Euroskeptic M5S has shed its critique of European integration and has decided to partner with the center-left and pro-establishment Democratic Party (PD).This is merely the tip of the iceberg. Several key developments throughout 2019 have signaled to investors that the Euroskeptic moment has passed. For a plethora of data and polling to support this view, please refer to our May report on the European Parliament (EP) election. Here we merely survey the latest developments:European Parliament Election: As expected in our EP election forecast, the May contest was a non-event. Support for the euro and the EU is trending higher (Chart 10 and 11), and 73% of Euroskeptic seats are held by Eastern European or U.K. MEPs (Chart 12), both irrelevant for EU policy.3  Chart 10Even Italy Swings In Favor Of Euro  Chart 11Public Opinion Supports The Union  Chart 12Euroskepticism Overstated Random Elections: We rarely cover politics in Denmark or Finland, but the two Nordic countries have been at the forefront of the anti-establishment, right-wing, evolution in Europe. As such, the elections in Denmark (in June) and Finland (in April) were relevant. The Danish People’s Party (DPP) – one of the original “People’s Parties,” founded in 1995 – was massacred, losing 21 seats in the 179-seat legislature.In Finland, the moderately Euroskeptic Finns similarly saw a disappointing – if not as disastrous – performance.Finally, Austrian election on September 29 will likely see the other Europe’s prominent right-wing, Euroskeptic, party – the Freedom Party of Austria (FPO) – decline below 20% for the first time since 2008. Chart 13Macron Recovering In Polls France: Our high conviction view in February that the Yellow Vest protest would ultimately dissipate proved correct. President Emmanuel Macron has also seen a recovery in polling. Although tepid, at least he appears to be diverging from the trajectory of his disastrously unpopular predecessor François Hollande (Chart 13).The good news for Macron is that he continues to lead Marine Le Pen by double digits in the theoretical 2022 second round. While this represents a considerable improvement for Le Pen from her 2017 performance, the fact is that she has had to adjust her policies and rebrand the National Front in order to close the gap with Macron. The party is now called the National Rally and has publicly revised its stance towards both the EU and the euro.4The events in France, Denmark, Finland, and Austria have largely gone unnoticed amidst the China-U.S. trade war, attacks against Federal Reserve independence, and general breakdown in global institutions and paradigms. But they reveal that Euroskepticism in Europe is evolving from a definitive one – in or out – to a much more nuanced position.For students of history, this is not a surprise. European integration has always been a push-pull process. Charles de Gaulle famously caused a total breakdown in integration during the 1965 “Empty Chair Crisis” when France recalled its representative in Brussels and refused to take its seat on the Council.De Gaulle was a Euroskeptic in so far as he believed that European integration was a national, not a supra-national process.5 It could proceed apace, but only if controlled by national capitals. As such, he warred with the Commission all the time. However, de Gaulle did not want to eliminate European integration as he understood its geopolitical and economic imperative. He simply wanted to shape the process to fit French interests.Absolutist Euroskepticism – the idea that all European institutions ought to be replaced by national ones – is an alien idea to the post-World War Two continent, one imported from the nineteenth century. The irony of Brexit, therefore, is that the most vociferous supporters of an absolute end to the EU integrationist project are now abandoning their fellow absolutists on the continent.Geopolitical and structural factors are also pushing European Euroskeptics to evolve from absolutists to modern-era Gaullists. We have identified most of these factors before, but they are worth repeating:Europe has a geopolitical imperative to integrate. In a multipolar world dominated by global powers like the U.S. and China – and with Russia, India, Japan, Iran, and Turkey playing an increasingly independent role – European states are not large enough on their own to defend their economic and geopolitical interests. Chart 14Geopolitical Forces Behind Integration The purpose of integration is to aggregate the geopolitical power of Europe’s individual states amidst rising global multipolarity. Chart 14 is a stylized visualization of what European integration is attempting. It illustrates that the average BCA Geopolitical Power Index (GPI) score of an EMU-5 country is well below that of a BRIC state.6 By aggregating their geopolitical power, European states retain some semblance of relevance in the world.Obviously this is merely a thought experiment as European integration is not aggregation and never will be. Not only is aggregation politically unfeasible, but there is also a lot of double counting in simply adding GPI scores of European states. Nonetheless, the point is that European countries are asymptotically moving from the average to the aggregate score. Chart 15No Basis For Fascism In Great Recession No, the Nazis are not coming. Europe has managed to recover from a generational financial crisis. Pessimists point to the depth of the crisis to explain why Europe is unsustainable, with angst matching the severity of the downturn. However, analogizing to the 1930s is folly. First, Europe’s shared memories of the ravages of populism act as antibodies preventing precisely the same infection from breaking out on the continent.7 Second, the European financial crisis was simply nowhere close to the depth of the Great Depression that rocked Germany as it descended into National Socialism (Chart 15). As for the argument that the European Central Bank fed populism through unorthodox policy easing, the tide of populism would have been much more formidable if Europe had been allowed to sink into deeper recession and deflation.Europeans are just not that desperate. Europe scores much better than the U.S. (or the U.K.) when it comes to the balance between the median income and middle-income share of total population. Chart 16 shows that most Euro Area economies have around 70% of their population in the middle-income bracket. Those that fall short nonetheless hug the line of best fit closely (Italy, Spain, Greece, and the Baltic States). The U.S., on the other hand, has one of the highest median income levels, but with barely 50% of the population considered in the middle-income. Meaning that a lot of the people below the median line are far below it. This is a recipe for actual populist political outcomes (President Trump), as opposed to artificial ones (Italy). Chart 16U.S. At Greater Risk Of Populism Than EU European populism is artificial, U.S. populism is actual.What of the risks in Europe? For example, investors are concerned about mounting Target2 imbalances. Here we agree with our colleague Dhaval Joshi, who has pointed out that growing imbalances in Europe’s monetary system will only further constrain centrifugal forces among the nations.Target2 has seen a steady outflow of Italian cash to German banks as the ECB’s QE saw respective central banks purchase domestic bonds (Chart 17). This means that the Bank of Italy holds assets – BTPs – denominated in Italian euros, while the Bundesbank has a new liability to German banks denominated in German euros. EMU dissolution would be too painful due to this mismatch. Target2 is therefore not a threat to the EMU, but rather a Gordian Knot that can only be unraveled with immense pain and violence.That said, there may be an upcoming headline risk in Europe: the end of Chancellor Merkel’s reign. In our view, Merkel’s role in stabilizing Europe is greatly overstated. Her dithering and lack of conviction caused several crises to descend into chaos amidst the sovereign debt imbroglio. As such, an infusion of new blood will be positive for Europe. The populist threat is also overstated, with the Alternative for Germany (AfD) performing relatively tepidly in the polls. In fact, the liberal, Europhile, Greens are starting to gain votes (Chart 18). As such, an early election in Germany would create volatility and uncertainty but would not undermine our secular thesis on Europe. Chart 17Gordian Knot Supports Integration  Chart 18Germany Not Falling To Populism Bottom Line: There is an ever-strengthening case for the sustainability of the Euro Area and European integration well into the next decade.From Geopolitical Gambit To A Geopolitical Safe-Haven?At this point, we have built a strong case for why Europe will remain a high-beta play on global growth that is unlikely to collapse. As such, investors should plow into Europe when the rest of the world is doing well with confidence that the continent will not descend into chaos.The U.S.- China trade war offers an intriguing opportunity for Europe.This is largely underwhelming as an investment thesis. Could there be something more exciting to the story given a slew of well-known headwinds to European growth from demographics, low productivity, and regulatory malaise?The trade war between the U.S. and China does offer an intriguing opportunity for Europe.There appears to be an interesting development where European equities outperform those of the U.S. during periods of trade war turbulence (Chart 19). The outperformance is not major, but it is highly counterintuitive. Chart 19Europe Outperforms Amid Trade War Shocks As is understood, Europe is a high-beta play on global growth. Presumably, investors should abandon high-growth derivative plays when trade war accelerates. It is one of the reasons that EM equities and EM FX suffer whenever trade war accelerates.So why is Europe different? Because European exporters generally compete with their American counterparts (and Japanese and South Korean) for Chinese market share. And if China retaliates against U.S. companies, European companies stand to benefit, potentially massively.Take Boeing and Airbus. Boeing expects China to demand 7,700 new airplanes over the next two decades, an order valued at $1.2 trillion. It would be disastrous to the U.S. airline industry if the entirety of that order went to Airbus and its subsidiaries.8 According to the latest news reports, China has slowed down its airplane procurement to a crawl as it awaits the outcome of the dispute with the U.S.9 It is predictably using the procurement decision as leverage in the negotiations. Chart 20Europe To Lose If China Strikes U.S. Deal Yet this “substitution effect” thesis is a double-edged sword for Europe. A resolution of the trade war between the U.S. and China would likely include a massive purchase of U.S. agricultural, commodity, and manufacturing goods: the so-called “Beef and Boeings” deal. China bears often point out that such a massive purchase will negatively impact China’s current account, which is barely in surplus thanks to China’s trade surplus with the U.S. (Chart 20). This is false. Chinese policymakers are not suicidal. The last thing China needs is a balance of payments crisis due to a trade deal with the U.S.China would simply rob Peter to pay Paul, pulling its orders of soy from Brazil and Airbus from Europe in order to make a deal with the U.S. As such, it is highly likely that European capital goods exporters would suffer in any trade war resolution between China and the U.S.That said, a substantive trade deal that resolves all U.S.-China tensions is extremely unlikely. The U.S. and China are not just commercial rivals, they are also geopolitical rivals. As such, the tech conflict between the U.S. and China will continue well beyond any resolution of the trade war. This could create an opportunity for Europe’s traditionally beleaguered tech stocks to finally outperform their American counterparts (Chart 21). Chart 21Go Long EU Tech Versus U.S. Tech Bottom Line: A deterioration of the U.S.-China trade relationship would be a boon for European exporters. Short of a total breakdown of U.S.-China trade, however, European tech stocks may finally begin outperforming their U.S. counterparts thanks to the open distrust between U.S. and China.In addition, U.S. technology firms are likely going to face a slew of regulatory challenges over the next decade. While not necessarily negative, these challenges will nonetheless create new headwinds for the sector.10 We are therefore initiating a structural theme of being long European tech relative to U.S.Investment ImplicationsAre there any broader themes to be extracted from the combined geopolitical forecasts presented in this report? Europe will not collapse, and it may benefit from the souring of U.S.-China geopolitical and economic relations.Long euro is an obvious theme. As our colleague Dhaval Joshi has recently pointed out, the chasm between monetary policies of the Fed and the ECB has become a major geopolitical risk. This is because it has depressed the euro versus the dollar by at least 10 percent – based on the ECB’s own competitiveness indicators. The exchange rate distortion stemming from polarized monetary policies is the culprit for the euro area’s huge trade surplus with the United States (Chart 22).In the short term, EUR/USD may have reached its practical (and geopolitically acceptable) lows. Yes, the ECB is readying another round of monetary stimulus on September 12, but the fiscal policy counterpart is likely to be tepid and thus fail to (yet again) take advantage of historically depressed borrowing costs on the continent. The September 12 ECB meeting may therefore be a “sell the rumor, buy the news” event for EUR/USD. Chart 22Monetary Policy Accounts For Bilateral Surplus  Chart 23U.S. Rivals Buying Gold, Ditching Dollar On the more cyclical and secular horizon, we see an opportunity for the euro to reestablish some of its lost reserve currency status due to the geopolitical conflict between China and the U.S. Washington’s willingness to use trade and financial sanctions for geopolitical benefit has given pause to central bank authorities around the world in using dollars as a reserve currency. Purchases of gold for FX reserve have surged, particularly among America’s geopolitical rivals (Chart 23), as our colleague Chester Ntonifor has recently pointed out.As we argued in a report entitled “Is King Dollar Facing Regicide?” the euro has some catch-up potential. In 1990, the combined currencies of the countries that today comprise the Euro Area accounted for 35% of total composition of global currency reserves. Today, the figure is merely 20% (Chart 24). Chart 24Euro Has Plenty Of Room To Grow As Reserve Currency Could Europe supply the world with enough euros to replace USD as a reserve currency? This is highly unlikely. However, at the margin, an expansion of European liquidity is possible, particularly if Germany finally learns to love fiscal expansion and if European policymakers capitulate on the issuance of Eurobonds. However, such a lack of euro liquidity is not negative for the euro. The world could soon experience a situation where the demand for non-USD liquid assets dramatically increases due to the politicization of America’s reserve currency status while the supply of USD-alternatives remains relatively low. This should be positive for the only true alternative to the USD as a global reserve currency: the euro.As such, we will be looking to initiate a strategic long EUR/USD position, potentially sometime this fall as the ECB and FOMC meetings take place and the risk of a no-deal Brexit is averted. We do not expect the massive monetary policy divergence between Europe and the U.S. to continue, while the Euro Area’s political stability, and the broader geopolitical demand for a non-USD reserve currency, create more long-term tailwinds for the euro.Marko PapicConsulting Editor, BCA Research              Chief Strategist, Clocktower GroupHousekeepingOur high-conviction view that no-deal Brexit odds were overrated has been confirmed by the recent events in the U.K. parliament. We are going long GBP-USD with a tight stop-loss of 3%. Since we expect further volatility – with an election likely and the Conservative Party performing well in the polls and monopolizing the Brexit vote in a first-past-the-post system – we will sell at the $1.30 mark.Footnotes1 Please see Global Investment Strategy, “Trade War: The Storm Before The Calm,” dated August 9, 2019, available at gis.bcaresearch.com.2 Please see Geopolitical Strategy, “Europe's Geopolitical Gambit: Relevance Through Integration,” dated November 3, 2011, available at gps.bcaresearch.com.3 The reason we extracted the U.K. Euroskeptics from the calculation is because with Brexit nigh, the U.K. members of European Parliament are no longer policy relevant. As for Central European Euroskeptics, we extracted them because they are irrelevant for EU policy as they hail from member states that – in truth – nobody seriously thinks would ever leave the EU.4 Ahead of the May EP election, National Rally electoral platform focused on “local, ecological, and socially responsible production." The party advocates combining environmentalism with protectionism, creating an ecological custom barrier at the EU’s doorstep which would defend the European market from products manufactured or produced with less environmentally friendly processes. On the matters of EU membership, the party now advocates a more traditionally Euroskeptic line, a purely Gaullist form of Euroskepticism that seeks to curb – or, at best, abolish – the EU Commission and replace its legislative prerogative by giving the Council of the EU all legislative powers. 5  Please see Julian Jackson, De Gaulle (Cambridge, MA: Harvard UP, 2018).6 We chose to use EMU-5 in the chart because it focuses on the top-five economies in the Euro Area: France, Germany, Italy, Spain, and the Netherlands. If we focused on the overall average EMU score, even one we weighed by population, the results would be even more stark in terms of loss of importance.7 And, worryingly, the U.S. lacks precisely the same shared memory of how wild pendulum swings of polarization can descend into extreme nationalism or left-wing extremism.8 Airbus would not have the capacity to fulfill that entire order today. However, demand creates its own supply, giving Airbus a reason to surge capex and reap the profits.9 Please see Reuters, “Exclusive: Boeing CEO eyes major aircraft order under any U.S.-China trade deal.”10 Please see Geopolitical Strategy, “Is The Stock Rally Long In The FAANG?,” dated August 1, 2018 and “Surviving A Breakup: The Investor’s Guide To Monopoly-Busting In America,” dated March 20, 2019, available at gps.bcaresearch.com.

Highlights The lingering global manufacturing recession and the substantial drop in U.S. bond yields have been behind the decoupling between both EM stocks and the S&P 500, and cyclical and defensive equities. Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to indicate either further bifurcation in global markets or a risk-off period. We review some of our long-standing themes and associated recommendations. Feature Global financial markets have become bifurcated. On one hand, numerous segments of global financial markets leveraged to global growth, including EM stocks, have already sold off (Chart I-1). On the other hand, share prices of growth companies, defensive stocks and global credit markets have remained resilient. Chart I-2 shows that a similar divergence has taken place within EM asset classes: EM share prices have plummeted while EM corporate credit excess returns have not dropped much. Chart I-1Bifurcated Equity Markets Chart I-2Bifurcated Markets In EM   How to explain this market bifurcation? Financial markets sensitive to global trade and manufacturing cycles have been mirroring worsening conditions in global trade and manufacturing. Some of the affected segments include: Global cyclical equity sectors. Emerging Asia manufacturing-related currencies (KRW, TWD and SGD) versus the U.S. dollar (Chart I-3). EM and DM commodity currencies (Chart I-4). Chart I-3Total Return (Including Carry): KRW, TWD And SGD Vs. USD Chart I-4EM And DM Commodity Currencies   Industrial and energy commodities prices. U.S. high-beta stocks as well as U.S. small caps (Chart I-5). Chart I-5U.S. High-Beta Stocks DM bond yields.  Crucially, the current global trade and manufacturing downturns have taken place despite robust U.S. consumer spending. In fact, our theme for the past several years has been that a global business cycle downturn would occur despite ongoing strength in American household spending. The rationale has been that China and the rest of EM combined are large enough on their own to bring down global trade and manufacturing, irrespective of strength in U.S. consumer spending. At the current juncture, one wonders whether such a market bifurcation is justified. It is not irrational. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Corporate bonds have also done well, given the background of a falling risk-free rate. Will the current market bifurcation continue? Or will these segments in global financial markets recouple and in which direction? What To Watch China rather than the U.S. has been the epicenter of this slowdown, as we have argued repeatedly in the past. Hence, a major rally in global cyclical equities and EM risk assets all hinge on a recovery in the Chinese business cycle. The basis for decoupling between cyclical and defensive equities has been U.S. bond yields. The substantial downshift in U.S. interest rate expectations has led to a re-rating of non-cyclicals and growth company stocks. Even though Caixin’s PMI for China was slightly up in August, many other economic indicators remain downbeat: The latest hard economic data out of Asia suggest that global trade/manufacturing continues to contract. Korea’s total exports in August contracted by 12.5% from a year ago, and its shipments to China plunged by 20% (Chart I-6). The import sub-component of China’s manufacturing PMI is not showing signs of amelioration (Chart I-7). The mainland’s import recovery is very critical to a revival in global trade and manufacturing. Chart I-6Korean Exports: No Recovery Chart I-7Chinese Imports To Remain Weak Chart I-8German Manufacturing Confidence German manufacturing IFO business expectations and current conditions both suggest that it is still early to bet on a global trade recovery (Chart I-8). Newly released August data points reveal that U.S., Taiwanese, and Swedish manufacturing new export orders continue to tumble. To gauge whether bifurcated markets will recouple and whether it will occur to the downside or the upside, investors should watch the relative performance of China-exposed markets, global cyclicals and high-beta plays – the ones that have already sold off substantially. The notion is as follows: These markets’ relative performance will likely bottom before their absolute performance recovers. If so, their relative performance will likely foretell the outlook for their absolute performance. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. In other words, they could sell off even if a global recession is avoided. Concerning share prices of growth companies, defensive equity sectors and credit markets, these segments are at risk because of expensive valuations and crowded investor positioning. To assess the outlook for global cyclicals and China-related plays, we are monitoring the following financial market indicators: The Risk-On/Safe-Haven currency ratio is the average of high-beta commodity currencies such as the CAD, AUD, NZD, BRL, CLP and ZAR total return (including carry) indices relative to the average of JPY and CHF total returns (including carry). This ratio is dollar-agnostic. This ratio is making a new cyclical low (Chart I-9). Hence, it presently warrants a negative view on global growth, China’s industrial sector and commodities. Global cyclical equity sectors seem to be on the edge of breaking down versus defensives (Chart I-10). This ratio does not signal ameliorating global growth conditions. Chart I-9The Risk-On/Safe-Haven Currency Ratio Chart I-10Global Cyclicals Versus Defensives Chart I-11U.S. High-Beta Stocks Versus S&P 500 Finally, U.S. high-beta stocks continue to underperform the S&P 500 (Chart I-11). This is consistent with overall U.S. growth deceleration. Bottom Line: Neither the most recent economic data, nor the relative performance of global cyclicals, China-related plays and high-beta markets herald a broad-based and lasting risk-on phase in global markets. On the contrary, economic and market signposts continue to foreshadow either further bifurcation in global markets or a risk-off period. Continue trading EM stocks and currencies on the short side, and underweighting EM risk assets versus DM. Our Investment Themes And Positions Some of our open positions often run for years because they reflect our long-standing themes. Our core theme has for some time been that a global trade/manufacturing recession will be generated by a growth relapse in China. To capitalize on this theme, we have been recommending a short EM stocks / long 30-year U.S. Treasurys strategy since April 2017. This recommendation has produced a 25% gain since its initiation (Chart I-12). Continue betting on lower local interest rates in emerging economies where the central bank can cut rates despite currency depreciation. To implement this theme, we have been recommending receiving swap rates in Korea and Chile for the past several years. Our reluctance to recommend an outright buy on local bonds stems from our bearish view on both currencies – the Korean won and Chilean peso. In fact, we have been shorting both the KRW and the CLP against the U.S. dollar. Chart I-13 shows that swap rates in Korea and Chile have dropped substantially since our recommendations to receive rates in these countries. More rate cuts are forthcoming in these economies, and we are maintaining these positions. Chart I-12EM Stocks Have Massively Underperformed U.S. Bonds Chart I-13Continue Receiving Rates In Korea And Chile   We have been bearish on EM banks in general and Chinese banks in particular. We have expressed these themes in a number of ways: Short EM and Chinese / long U.S. bank stocks. Short EM banks / long EM consumer staples (Chart I-14). Within Chinese banks, we have been short Chinese medium and small banks / long large ones. All these strategies remain valid. In credit markets, we have been favoring U.S. corporate credit versus EM sovereign and corporate credit. Ability to service debt is better among U.S. debtors than EM/Chinese borrowers. We have been playing this theme in the following ways: Underweight EM sovereign and corporate credit / overweight U.S. investment-grade corporates (Chart I-15). Chart I-14Short EM Banks / Long EM Consumer Staples Chart I-15Underweight EM Credit / Overweight U.S. Investment-Grade Corporates   Underweight Asian high-yield corporate credit / overweight emerging Asian investment-grade corporates. As a bet on a deteriorating political and business climate in Hong Kong, in our Special Report on Hong Kong SAR from June 27, we reiterated the following positions: Short Hong Kong property stocks / long Singapore equities. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Mexico: Crying Out For Policy Easing The Mexican economy is heading into a full-blown recession. Most segments of the economy are in contraction, and leading indicators point to further downside. Both manufacturing and non-manufacturing PMIs are well below 50 (Chart II-1). Monetary policy remains too restrictive: Nominal and real interest rates are both very high and plunging narrow money (M1) growth is signaling  further downside in economic activity (Chart II-2). Chart II-1The Economy Is Deteriorating Chart II-2Narrow Money Points To Negative Growth   An inverted yield curve signifies that the central bank is behind the curve and foreshadows growth contraction (Chart II-3). Fiscal policy has tightened as the government has remained committed to achieving a primary fiscal surplus of 1% of GDP in 2019 (Chart II-4, top panel). Consequently, nominal government expenditures have been curbed (Chart II-4, bottom panel). The government’s fiscal stimulus has not been large and has been implemented too late. Chart II-3A Message From The Inverted Yield Curve Chart II-4Fiscal Policy Has Tightened A Lot   Finally, business confidence is extremely low due to uncertainty over President Andrés Manuel López Obrador’s (AMLO) policies towards the private sector. The president is attempting to revive business confidence, but it will take time. Chart II-5Mexico Versus EM: Domestic Bonds And Sovereign Credit Our major theme for Mexico has been that both monetary and fiscal policies are very tight. Consequently, we have been recommending overweight positions in Mexican domestic bonds and sovereign credit relative to their respective EM benchmarks. (Chart II-5). Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Meanwhile, we have been favoring the Mexican peso relative to other EM currencies due to the fact that AMLO is not as negative for the country as was initially perceived by markets. With inflation falling and the Federal Reserve cutting rates, Banxico will ease further. Yet, it will likely cut rates slower than warranted by the economy. The longer the central bank takes to ease, the lower domestic bond yields will drop. Concerning sovereign credit, investors should remain overweight Mexico within an EM credit portfolio. Mexico’s fiscal position is healthier, and macroeconomic policies will be more prudent relative to what the market is currently pricing. We continue to believe concerns about Pemex’s financing and its impact on government debt are overblown, as we discussed in detail in our previous Special Report. In July, the government released an action plan for Pemex financing. We view this plan as marginally positive. To supplement this plan, the government can use the $14.5 billion federal budget stabilization fund to fill in financing shortfalls in the coming years. Importantly, the starting point of Mexican public debt is quite low, which will allow the government to finance Pemex in the years to come by borrowing more from markets. Recessions are bad for share prices, but in tandem with prudent macro policies, they can be positive for fixed-income markets. Lastly, our overweight recommendation in Mexican stocks has not played out. However, we are maintaining it for the following reasons: Chart II-6 illustrates that when Mexican domestic bond yields decline relative to EM ones (shown inverted on Chart II-6), Mexican share prices usually outperform their EM counterparts in common currency terms. Consistent with our view that Mexican local currency bonds will outperform their EM peers, we expect Mexican stocks to outpace the EM equity benchmark. The Mexican bourse’s relative performance against EM often swings with the relative performance of EM consumer staples versus the EM equity benchmark. This is due to the large share of consumer staples stocks in Mexico (34.5%) compared to that in the EM benchmark (7%). Consumer staples stocks are beginning to outpace the EM equity index, raising the odds of Mexican equity outperformance versus its EM peers (Chart II-7). Chart II-6Local Bond Yields And Relative Stocks: Mexico Versus EM Chart II-7Consumer Staples Have A Large Weight In Mexican Bourse   We do not expect a major rally in this nation’s stock market given the negative growth outlook. Our bet is that Mexican share prices - having already deflated considerably - will drop less in dollar terms than the overall EM equity index. Bottom Line: We continue to recommend an overweight stance on Mexican sovereign credit, domestic bonds and equities relative to their respective EM benchmarks. The main risk to the Mexican peso stems from persisting selloff in EM currencies. Traders’ net long positions in the MXN are elevated posing non-trivial risk (Chart II-8). We have been long MXN versus ZAR but are taking profit today. This trade has generated a 9.7% gain since March 29, 2018. A plunging oil-gold ratio warrants a caution on this cross rate in the near term (Chart II-9). Chart II-8Investors Are Long MXN Chart II-9Take Profits On Long MXN / Short ZAR Trade   Juan Egaña, Research Associate juane@bcaresearch.com Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Coincident measures of economic activity suggest that China’s economy continued to slow in July. The August manufacturing PMIs were positive, but they more likely reflect tariff front-running activity than a genuine improvement in the export outlook. The decline in the RMB will have a positive reflationary effect for Chinese producers, but it will not likely be enough to prevent a further slowdown in activity if the export outlook continues to deteriorate (as we expect). Our investment strategy recommendations remain unchanged: underweight Chinese stocks over a tactical (i.e. 0-3 month) time horizon, but overweight cyclically (6-12 months) on the basis that policymakers will ultimately act on the need to ease further. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident measures of economic activity suggest that China’s economy continued to slow in July. The August manufacturing PMIs were positive (especially the Caixin PMI), but the absence of a pickup in manufacturing outside of China suggests that the August improvement (and the recent trend in China’s export data) reflects the same kind of tariff front-running activity that has occurred on more than one occasion over the past 18 months (and which sharply unwound in late-2018 / early-2019). On the housing front, July’s update saw a narrowing in the gap between lofty housing construction and depressed sales volume, suggesting that housing-related activity is unlikely to provide a ballast to counter a weakening external demand outlook absent further policy support for the sector. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, the continued decline in the RMB is the most noteworthy development, with USD-CNH having risen roughly 4.5% since we initiated our long position in mid-May. The still-controlled decline is likely to have a reflationary effect for Chinese producers, but not likely enough to prevent a further slowdown in activity if the export outlook continues to deteriorate in Q4 (as we expect). Consequently, our investment strategy recommendations remain unchanged: the near-term outlook remains bearish for China-related assets, but Chinese policymakers will be forced over the coming 3-6 months to recognize the need to ease further. Investors should remain overweight Chinese stocks over a 6-12 month horizon, but should continue to hedge RMB exposure by being long USD-CNH. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Chart 1The Chinese Economy Continues To Slow Based on coincident activity indicators such as the Li Keqiang index (LKI), China’s economy continued to slow in July (Chart 1). While the pace of growth remains stronger today than it did during the depths of the 2015/2016 slowdown, momentum is clearly negative and a further deceleration is likely over the coming few months. In short, Chinese growth has not yet bottomed. Our leading indicator for the LKI remains in a shallow uptrend, but slowed in July. The sequential decline occurred in nearly all of the components of the indicator; credit was particularly disappointing, with adjusted total social financing growth having decelerated nearly a half a percentage point on a YoY basis. Our indicator underscores that more easing will ultimately be needed in order to stabilize economic activity, even though we acknowledge that it will only likely arrive in piecemeal fashion until policymakers are pressured with a further significant slowdown in growth. The July housing data update was significant, as it featured a narrowing of the gap between lofty housing construction and depressed sales volume (Chart 2). While both the pace of pledged supplementary lending as well as sales volume growth marginally improved in July, floor space started decelerated to mid-single-digit territory (from 10+%). We have noted in several reports that the gap between starts and sales is unsustainable, suggesting that housing-related activity is unlikely to provide a ballast to counter a weakening external demand outlook absent further policy support. At first blush, China’s August PMIs were surprisingly positive. While the official manufacturing PMI slightly declined, the new export orders component improved as did the overall Caixin manufacturing PMI. The improvement in the latter was particularly significant, as it brought the index back into expansionary territory. However, our view of the pickup is less sanguine, and we expect it to reverse over the coming few months. August’s trade data has yet to be released, but the divergence between export and import growth in July provides a clue that the pickup in manufacturing/export sentiment is likely to be temporary. Ex-China, the global PMI has not meaningfully improved (Chart 3), which implies that the acceleration in Chinese export growth is indicative of the same kind of tariff front-running activity that has occurred on more than one occasion over the past 18 months (and which sharply unwound in late-2018 / early-2019). As a result, investors should view the near-term improvement in Chinese export-related data as a sign of an impending slowdown in trade activity, rather than an indication that the underlying trade situation is improving. Chart 2The Unsustainable Pace Of Housing Starts Is Slowing Chart 3China's August PMI Likely Reflects Tariff Front-Running Chart 4A-Shares Are Trading More Off Domestic Stimulus Odds Than Investable Stocks The most relevant high-level insight emanating from China’s equity markets continues to be the divergence in performance between investable and domestic stocks over the past three months. While investable stocks have trended lower due to the strong focus of foreign investors on the trade war, domestic stocks have moved sideways versus the global benchmark in US$ terms (Chart 4). To us, this suggests that domestic stocks are acting as a better barometer of domestic reflation than their investable peers and, for now, A-shares are acting as if reflationary efforts will just offset weak external demand. The likelihood of a further growth slowdown coupled with the reluctance of Chinese policymakers to aggressively stimulate implies that the domestic market is at risk of a near-term relapse, but global investors should watch closely for a breakout to the upside as an indication that policy is becoming considerably easier (and that investable stocks may soon follow the domestic market higher). Over the past month, sector performance within the investable equity market has mostly been along cyclical/defensive lines, with the former underperforming the latter. One notable exception is the investable consumer discretionary sector, which has risen more than 7% over the past month in absolute US$ terms, and has been rising in relative terms since the beginning of the year. Alibaba now accounts for a sizeable portion of the investable consumer discretionary sector, and its outperformance may be signaling a stable outlook for domestic consumer spending. China’s interbank and government bond market has been little changed over the past month. After having declined roughly 20 bps from late-July to early-August, Chinese government bond yields remain at a nearly 3-year low as part of ongoing investor expectations that monetary policy in China will remain easy. The PBOC’s mid-August reform of the loan prime rate (LPR) was a small step in the direction of further easing, but was not likely large enough to have a material impact on credit growth. More fiscal spending remains the most likely avenue for significant additional stimulus, but we do not expect it to materialize before economic activity slows further. Chart 5Onshore Corporate Bond Returns: Negligant Impact Of Defaults Chinese onshore corporate bond spreads fell slightly over the past month, reversing part of a modest uptrend in spreads that had begun in May. Abstracting from the day-to-day changes in spreads, the bigger story is that acute concerns over the potential for widespread corporate defaults have not led to any material impact on onshore corporate bond performance at any point over the past 18 months (which is in line with what we argued several times last year). In RMB terms the ChinaBond Corporate Bond Total Return Index has risen nearly 8% over the past year, or roughly 2.6% in unhedged US$ terms using spot exchange rates (Chart 5). While we would not advise an unhedged currency position in onshore corporate bonds at this time given our long stance towards USD-CNH, the bottom line for investors is that onshore corporate bond spreads already account for rising defaults, and probably overstate the risk. China’s controlled but very significant currency depreciation has continued over the past month, with USD-CNH having nearly reached 7.2 this week. Our earnings recession model for the MSCI China index suggests that the depreciation is likely to have a stimulative effect; holding the current pace of credit growth and the outlook for new export orders constant, the decline in the RMB has probably cut the odds of an ongoing contraction in EPS from roughly two-thirds to slightly over one-half over the past month. However, we noted above that the modest improvement in China’s manufacturing PMIs likely reflects unsustainable trade frontrunning, signaling that further stimulus will likely be required. This will have to come either through a more intense pace of credit growth, or meaningful further currency depreciation (or both). As such, investors should stay long USD-CNH for now, despite the significant rise over the past month. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Jing Sima China Strategist jings@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights An inevitable and imminent U.K. general election will be one of the most unpredictable and ‘non-linear’ elections ever. This non-linearity makes it difficult to take a high-conviction view on sterling’s direction because a tiny vote swing in one direction or another could be the difference between a no-deal Brexit – and the pound below parity against the euro – or a solid coalition for remain – and the pound at €1.30. Instead, a good strategy is to buy sterling volatility on the announcement of the election. The easiest way to implement this is simultaneously to buy at-the-money call and put options (versus either the euro or dollar). In a soft Brexit or remain, the U.K. equity sectors most likely to outperform the overall market are real estate and general retailers. In a hard Brexit, a U.K. sector likely to outperform the overall market is clothing and accessories. Feature Chart of the WeekSterling Volatility Could Go Up A Lot Lyndon B Johnson famously said that that the first rule of politics is to learn to count. A government is a lame duck if it does not have a majority of legislators to drive and set its policy. Fifty years on, LBJ’s namesake is learning this first rule of politics. Boris Johnson is running a minority U.K. government. The irony is that this makes it impossible for a pro-Brexit Johnson to pass legislation for the Brexit process itself! Ending the free movement of EU citizens was supposedly one of the biggest ambitions of the Brexit vote. But astonishingly, even after a no-deal Brexit, free movement would not end – because EU law continues to apply until its legal foundation is repealed. The U.K. government wanted to end free movement through a new law, the immigration bill, but the proposed legislation, along with several other key new laws, cannot make it through parliament. The Most Non-Linear Election Looms The only way out of the impasse is to change the parliamentary arithmetic via a snap general election. The trouble is that the outcome of such an election is near impossible to predict. This is because the U.K.’s first past the post electoral system is designed for a head-to-head between two dominant parties. But right now, there are four parties in play – from left to right: Labour, Liberal Democrat, Conservative, and Brexit. While in Scotland, the SNP is resurgent. Making the next U.K. general election one of the most unpredictable and ‘non-linear’ elections ever. The outcome of a snap general election is near impossible to predict. For example, in the recent Brecon and Radnorshire by-election, the 10 percent of votes that went to the Brexit party syphoned just enough ‘leave’ votes from the Conservatives to hand the seat to the Lib Dems. Repeated nationwide, such a swing could inflict mortal damage to the Conservatives. On the other hand, the staunchly pro-remain Lib Dems could also syphon crucial votes from a Labour party that is prevaricating on its Brexit policy. Understanding this, Johnson isn’t using the next election to resolve Brexit; quite the opposite, he is using Brexit to resolve the next election – in his favour – with the ancient strategy of ‘divide and rule’. Unite ‘leave’ by tacking to the hard right, and divide ‘remain’ between Labour, Lib Dem, Green, SNP, and Plaid Cymru. However, it is a very risky strategy. A small but critical rump of Brexit party voters are diehard anti-establishment rather than pure leave votes; furthermore, remainers almost certainly will vote tactically as they did in 2017 when they obliterated the Conservatives’ overall majority. For U.K. investments, the inevitable imminent election dominates all other considerations, as its outcome will determine the U.K.’s ultimate trading relationship with the EU and rest of the world, as well as establish the U.K’s overarching economic policy and strategy. But to reiterate, the outcome is highly non-linear. A tiny vote swing in one direction or another could be the difference between a no-deal Brexit – and the pound below parity against the euro – or a solid coalition for remain – and the pound at €1.30, as sterling’s ‘Brexit discount’ is unwound (Chart I-2 and Chart I-3). Chart I-2Sterling's Brexit Discount Is 15 Percent, Based On Real Interest Rate Differentials... Chart I-3...And Expected Interest Rate ##br##Differentials The non-linearity makes it difficult to take a high-conviction view on sterling’s direction. Instead, as soon as an election is announced, a good strategy is to buy sterling volatility. Although it has risen recently, sterling volatility is only in the foothills relative to the heights of 2016, meaning plenty of upside (Chart I-1). The easiest way to implement this is simultaneously to buy at-the-money call and put options (versus either the euro or dollar). Brexit Investments  A common question we get is what are the most Brexit-impacted investments, in both directions? As mentioned, the most obvious is sterling. Relative to the established relationship with interest rate differentials prior to the Brexit vote in 2016, the pound now carries a Brexit discount of around 15 percent. For U.K. investments, the inevitable imminent election dominates all other considerations. Related to this, the FTSE100 has outperformed the Eurostoxx600. This is exactly as theory would suggest. The FTSE100 and Eurostoxx600 are just a collection of global multi-currency earning companies quoted in pounds and euros respectively. So when sterling weakens, the multi-currency earnings increase more in FTSE100 index terms than in Eurostoxx600 index terms, resulting in FTSE100 outperformance (Chart I-4). Chart I-4The FTSE100 Outperforms When Sterling Weakens Turning to U.K. equity sectors, those most likely to outperform the overall market in a soft Brexit are real estate and general retailers (Chart I-5 and Chart I-6). Chart I-5U.K. Real Estate Outperforms In A Soft Brexit Chart I-6U.K. General Retailers Outperform In A Soft Brexit While a sector likely to outperform the overall market in a hard Brexit is clothing and accessories (Chart I-7). Chart I-7U.K. Clothing And Accessories Could Outperform In A Hard Brexit Four Disruptors Revisited The final section this week revisits the wider context for Brexit and other recent examples of populism. Specifically, they are backlashes to four structural disruptors to economies and financial markets. Disruptor 1: Protectionism. Since the Great Recession, an extremely polarised distribution of economic growth has left many people’s standard of living stagnant – despite seemingly decent headline economic growth and job creation (Chart I-8). Chart I-8Disruptor 1: Income Inequality Leads To Protectionism Looking to find a scapegoat, economic nationalism and protectionism have resonated very strongly with voters in several major economies: the U.S., U.K., Italy, and Brazil. Other voters could follow in the same vein. But history teaches us that protectionism ends up hurting many more people than it helps. Disruptor 2: Technology. The bigger danger is that the malaise is being misdiagnosed. Many middle-income job losses are not due to globalization, but due to technology. A polarised distribution of economic growth has left many people’s standard of living stagnant. Specifically, Artificial Intelligence (AI) is replacing secure middle-income jobs and displacing workers into insecure low-income manual jobs – like bartending and waitressing – which AI cannot (yet) replace (Table I-1). And AI’s impact on middle-income jobs is only in its infancy.1 The worry is that by misdiagnosing the illness as globalization and wrongly responding with protectionism, the illness will get worse, rather than improve. Table I-1Disruptor 2: Technology Disruptor 3: Debt super-cycles have reached exhaustion. Protectionism carries a further danger. Just like developed economies did a decade ago, major emerging market economies are now coming to the end of structural credit booms and need to wean themselves off their credit addictions (Chart I-9). At this point of vulnerability, aggressive protectionism risks tipping these emerging economies into a sharp slowdown.  Chart I-9Disruptor 3: Debt Super-Cycles Have Reached Exhaustion Disruptor 4: Financial markets are richly valued. Disruptors one, two and three come at a time when equities are valued to generate feeble total nominal returns over the next decade (Chart I-10). Extremely compressed risk premiums are justified so long as bond yields remain ultra-low. Otherwise, the rich valuations will come under pressure.  Chart I-10Disruptor 4: Financial Markets Are Richly Valued The long-term investment message is crystal clear. With the four disruptors in play, we strongly advise long-term investors not to follow passive (equity) index-tracking strategies. Instead, we advise long-term investors to follow bespoke structural investment themes as shown in our structural recommendations section. Please note that owing to my travelling there is no fractal trading system this week. Normal service will resume next week.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Please see the European Investment Strategy Special Report ‘The Superstar Economy: Part 2’ January 19, 2017 available at eis.bcaresearch.com Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Bank Credit Analyst

Feature BCA Research (aka The Bank Credit Analyst) published its first report in 1949, a remarkable 70 years ago. This probably makes us the longest-running independent investment research firm in the world. As we age, it is normal to occasionally reflect on how the world has changed over the course of our lives. It is an interesting exercise in the case of BCA. We need to start with a little history. The Bank Credit Analyst began life as a small-circulation newsletter produced by Hamilton Bolton, a Montreal-based money manager. He had been sending out investment commentary to his clients for some time and was encouraged to start catering to a wider audience. Bolton was a visionary because he was one of the few market analysts at that time to understand the importance of money and credit in driving economic and market cycles. In those days, banks were the dominant financial intermediary, so an analysis of flows through the banking system provided accurate and leading signals about economic and market trends. That is why he named his new service “The Bank Credit Analyst”. Bolton developed a series of monetary-based indicators that allowed him to make some great market calls. He passed away in 1967, but his valuable contribution to financial research was acknowledged in 1987 when the CFA Institute posthumously awarded him the prestigious “Outstanding Contribution to Investment Research Award”.1 Hamilton Bolton was a product of his times in that his worldview was influenced heavily by having lived through the Great Depression. Like many of his generation, he had a strong aversion to excessive debt growth, and was highly sensitive to any buildup of financial imbalances that could tip the economy back into a severe downturn. In fact, widespread fears of renewed depression did not really fade until the late 1950s. That psychology helps explain why policymakers were complicit in allowing inflation to take hold in the 1960s because there is a common tendency to fight the last war. As long as depression/deflation is seen as the primary threat, then there will be complacency about inflation risks. Does This Sound Familiar? Let’s look at some of the conditions that existed in 1949, when The Bank Credit Analyst started publication. The U.S. long-term Treasury yield had been capped at 2.5% since April 1942. At the request of the Treasury Department, the Fed had given up control of the money supply by buying whatever bonds were needed to keep yields below 2.5%, in order to support the financing of war-inflated budget deficits. The level of federal debt was down from its wartime peak of 106% of GDP, but was still at a historically high 77.5%. The European and Japanese economies were in a complete mess, having been devastated during the war. As already noted, fears of renewed deflation and depression were prevalent. Inflation was tame with the U.S. personal consumption deflator declining by 0.8% in 1949 and rising by only 1.2% in 1950. There was considerable geopolitical upheaval. Most notably, the Cold War intensified as Russia extended its control over East Europe and other countries. Mao Zedong founded the People’s Republic of China in October 1949 after his communist forces defeated the Kuomintang led by Chiang Kai-shek. There were serious border clashes between North and South Korea in August 1949, a prelude to the North’s invasion in June 1950. It does not require a huge stretch of the imagination to see some parallels with the current environment. We currently are having (or have had): Massive central bank purchases of government debt (i.e. quantitative easing) and the explicit pegging of bond yields by the Bank of Japan. A huge increase in government debt levels, albeit not because of war-related spending. In a remarkable coincidence, U.S. federal debt reached 77.8% of GDP in fiscal 2018, almost exactly the same level as in 1949. The European and Japanese economies are moribund. However, unlike in 1949, this reflects structural forces, not war-related devastation. There are widespread fears about the long-run economic growth outlook, well captured by the secular stagnation thesis, promoted by Larry Summers. Central bankers are concerned that inflation is too low. Geopolitical concerns abound. These include U.S.-China tensions, Brexit, Korea (again), rising populism and Russia’s more aggressive stance on the world stage. In the end, the fears of 70 years ago that the world might slip back into depression proved unfounded. The 1950s and 1960s, for the most part, turned out to be golden decades for consumers, businesses and equity investors. Unfortunately, this does not mean that we can look forward to a repeat experience in the decades ahead, because we must now turn to the major differences between the present and the past. The Past Worked Out Just Fine The conditions for an economic boom in the 1950s and 1960s could hardly have been better. The U.S. armed forces employed more than 12 million men and women at the end of WWII, 7.6 million of whom were stationed overseas. After the war, these people were desperate to get back to a normal life, with civilian jobs, marriage and children. The inevitable result was a population boom and a surge in growth as pent-up demand for housing and consumer goods was unleashed. It was all aided by the 1944 G.I. Bill that provided low-cost mortgages and many other benefits. The improvement in economic growth boosted government tax receipts and, coupled with a drop in defense spending, this kept fiscal finances in check. During the 1950s and 1960s, the federal deficit averaged less than 1% of GDP and debt had fallen to less than 30% of GDP by 1969. This occurred despite a surge in federal infrastructure spending, helped by the Federal Highway Act of 1956 that authorized the construction of an interstate highway system. Meanwhile, the economy did not appear to be impeded by tax rates that were far above current levels. The reconstruction of the European economies was a monumental task that was beyond the financing capabilities of those shattered countries. However, between 1948 and 1951, the U.S. European Recovery Program (The Marshall Plan) transferred $100 billion in 2018 dollars to aid the recovery effort and this helped Europe get back on its feet. There also was a huge amount of U.S. aid to support the rebuilding of Japan. Economic growth in Japan averaged almost 9% a year in the 1950s and more than 10% in the 1960s. In Germany, the comparable figures were 7.7% and 4.2%. The growth of the world economy also was boosted by steady reductions in tariffs during the 1950s and 60s. The most notable was the Kennedy Round of 1964-67 that achieved a 38% weighted average drop in tariffs. Protectionism was in strong retreat in the decades after WWII. Finally, a word on the markets. At the end of 1949, the S&P 500 was trading at seven times trailing earnings while the dividend yield was at 6¾%. The market’s earnings yield of 14% compared to a 2.2% yield on 30-year Treasuries. In other words, stocks were incredibly cheap. Moreover, when the 1951 Treasury-Federal Reserve Accord ended the bond peg, yields inevitably rose steadily over the subsequent years, making bonds a poor investment. In the 1950s, U.S. equities delivered real compound returns of 16.6% a year compared to -3.3% for 30-year bonds. In the 1960s, the annualized real returns were a still-respectable 5.3% for stocks and -1.4% for bonds. In sum, the two decades after the launch of the BCA were a very favorable time and it was largely due to a very depressed starting point. However, the current environment is very different to that of 70 years ago. It’s a Different Picture Now Perhaps the most important difference with the past is the demographic outlook. In contrast to the post-WWII baby boom, the U.S. and most other developed economies face bleak population dynamics. Almost all developed economies – and many emerging ones – have seen the birth rate drop below replacement levels with the result that population growth has slowed dramatically. In many cases, populations are in actual decline – especially in the important working-age segment. That deprives economic growth of its main driver. The annual potential growth of U.S. real GDP averaged 4% in the 1950s and 4.3% in the 1960s. Potential growth in the next decade will average only 1.8% a year, according to the Congressional Budget Office (CBO). And it will be even lower in Europe and Japan. As far as pent-up demand is concerned, the picture also is very different. While the consumer industry works hard to develop new must-have goods and services, the reality is that demand is satiated for a lot of products. For example, in 2017, there were 259 million registered private and commercial autos and trucks in the U.S. compared to only 225 million licensed drivers. In 1950, the number of licensed drivers (62 million) far exceeded the number of registered vehicles (48 million). And it is hard to believe that the ownership penetration of most consumer durables has much upside. Turning to government finances, the current environment of bloated deficits and debt significantly constrains the room for fiscal stimulus. Yes, there is constant talk of the need for more infrastructure spending, but this has proven very difficult to implement without offsetting cuts in other spending or measures to boost revenues. The U.S. is saddled with unprecedented peacetime fiscal deficits and the CBO projects that federal debt will approach 100% of GDP within ten years, even without factoring in another recession. The comparison between the free trade era of the 1950s and 60s and the current situation speaks for itself. It is unclear at this stage just how far the move toward protectionism will go, but one thing seems clear. The rush toward globalization that followed the breakup of the Soviet Union and the entry of China into the global trading system is in retreat. This shows up not only in rising tariffs, but also in declining cross-border direct investment flows and increased antipathy to large-scale international migration. The irony is that the developed world needs more immigration to offset the weak growth in resident populations. What about the markets? The stock market certainly is not cheap, the way it was 70 years ago, with the S&P 500 trading at more than 18 times trailing operating earnings. Low interest rates are providing support, but future returns are likely to be in low single figures in a world where economic growth is moderate and there is little scope for profit margins and/or multiples to expand. Prospects for bonds do look somewhat similar to the situation in the early 1950s. Then, there was only one way for yields to go once the Fed’s peg ended. Today, yields will only fall sustainably if the economy sinks into a protracted downturn. We will get another recession in the next few years and yields could certainly hit new lows at that point. But the resulting policy response – both fiscal and monetary – seems almost certain to lead to higher inflation down the road. That would not bode well for the bond outlook, as was the case between the second half of the 1960s and the early 1980s. Concluding Thoughts Hamilton Bolton was fortunate to launch his new investment service ahead of a powerful economic revival and an almost two-decade bull market in stocks. He did not live long enough to witness the inflation upturn and volatile economic environment of the 1970s and 1980s, but BCA’s monetary focus allowed it to prosper during that period. Under the leadership of Tony Boeckh, the company’s then owner and Editor-in-Chief, BCA was strident in warning investors about the buildup of inflationary pressures and the dangers this posed for markets. During this time, BCA also developed the concept of the Debt Supercycle which helped investors understand the complex forces driving policy and the economic/market cycles. If Bolton was alive today, he would be horrified at the state of the world. He would not be able to understand how investors could be so complacent in the face of record government deficits and debt and by what he would regard as the reckless behavior of central banks. At the same time, he would be able to identify with the renewed focus on weak growth and deflation risks. The bottom line is that he would be advising investors to be extremely cautious. Investors currently are semi-obsessed with the timing of the next recession as that would be the signal to significantly downgrade risk assets. The official BCA stance is that a recession is not imminent and this creates a window for stocks to outperform. This matters for those investors who need to be concerned with relative performance. It is painful to sit on the sidelines if markets keep rising and you underperform your peers. However, for those more concerned with absolute performance, and that was true of most investors in Bolton’s time, the upside potential currently seems unattractive relative to the downside risks. Unfortunately, economists have a poor track record of forecasting recessions and bear markets thus often come as a complete surprise. Yes, low interest rates provide a floor under stocks, with the dividend yield comfortably above the 10-year Treasury yield. But rates are low for a reason: the economy and thus corporate earnings face major downside risks. Against this background, I would tend to side with what I imagine Bolton would say: this is a time to focus on capital preservation rather than taking risks to maximize returns. Let me try to end on a more positive note. As noted earlier, the long-term outlook turned out much better than Bolton probably anticipated 70 years ago. What could make that true this time around? Some things cannot be changed, at least over the next decade: adverse demographic trends, high ownership of consumer goods, and high levels of government debt. Geopolitical developments could go either way – for the better or worse – so I will make no predictions there. The one savior would be a marked revival in productivity because, ultimately, that is the only real source of rising living standards. Technology is changing rapidly and there are lots of exciting innovations. But to make a significant and lasting difference it will require more than developments such as autonomous vehicles or 3-D printing. We will need a new General Purpose Technology (GPT) that has a profound impact on the way economies and societies are structured. Previous examples include the steam engine, electricity and of course the internet. Perhaps Artificial Intelligence will do the trick, but that does not seem likely to be a near-term cure. Chart 1Then (1949) And Now (2019) In closing, we can be sure of one thing. The world changed in ways Hamilton Bolton could not have conceived and that also will be true for us today. BCA will endeavor to evolve with the times as it has done over the past 70 years and we look forward to keep helping our clients prosper in a complex and ever-changing world. 1949 – A Very Momentous Year Hamilton Bolton launches The Bank Credit Analyst The Peoples Republic of China, the Federal Republic of Germany and the German Democratic Republic (East Germany) are founded Indonesia gains independence from the Netherlands The civil war in Greece ends NATO is established The Geneva Convention is agreed The Soviet Union detonates its first atomic bomb Apartheid becomes official policy in South Africa Alfred Jones creates the first hedge fund The first non-stop circumnavigation of the world by an aircraft occurs The first commercial jet airliner, the De Havilland Comet, has its maiden flight EDSAC – the first practicable stored-program computer runs its first program at Cambridge University Products introduced that year included Lego, the 45 rpm record, the first Porsche car and the Xerox photocopier. George Orwell’s dystopian novel 1984 is published People born include Ivana Trump, Jeremy Corbyn, Benjamin Netanyahu, Meryl Streep and Bruce Springsteen 2019 – Not So Much Chaotic politics in the U.K., Italy and many other countries Trade wars   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com Footnotes 1 Previously known as the Nicholas Molodovsky Award  

Highlights Portfolio Strategy Intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. The transition from a virtuous to a vicious EPS-to capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating relative balance sheet (b/s) and relative operating metrics compel us to put the cyclicals/defensives portfolio bent on downgrade alert. Recent Changes The cyclicals/defensives portfolio bent is now on our downgrade watch list. Table 1 Feature The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes. Worrisomely, BCA’s Equity Selloff Indicator captures these dynamics and continues to emit a distress signal (Chart 1). Equities have been relatively resilient in the face of these headwinds. Investors are hoping not only for a U.S./China trade deal, but also that the Fed’s cutting cycle will save the day. Chart 1Mind The Gap What caught our attention from all the speeches at the recent Jackson Hole Symposium was RBA Governor Philip Lowe’s speech, especially the section titled “Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity”.1 Lowe highlighted that “When easing monetary policy, all central banks know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don't want to invest because of elevated uncertainty, we can't be confident that changes in monetary conditions will have the normal effect (stress ours).” The perception that the Fed is going to be the savior of the economy is a big risk, and when reality hits that President Trump’s tariffs are a shock to global final demand and presage profit contraction, volatility will skyrocket (please refer to Chart 3 from the August 19 Weekly Report). Importantly, the virtuous capex upcycle that has been in motion since the Trump inauguration when CEOs voted with their feet and started investing, has ground to a halt according to national accounts (Chart 2). U.S. non-residential fixed investment subtracted from GDP growth last quarter, and we doubt the Fed’s fresh interest rate cutting cycle will arrest the fall. Leading indicators of capital outlays point to additional pain in coming quarters (Chart 2). As a reminder, generationally low interest rates and a real fed funds rate near zero hardly restrict expansion plans. Chart 2Free Falling The shift from a virtuous to a vicious capex cycle is a theme that will start gaining traction as the year draws to a close. While pundits are dismissing the recent steep fall in capex as a one off, our indicators suggest otherwise. The middle panel of Chart 3 clearly depicts this emerging dynamic. Profit growth peaked in 2018 on the back of the massive fiscal easing package and capex is following suit, albeit with a slight lag. There are high odds that a looming profit contraction will further shatter frail animal spirits, sabotage the capex upcycle and tilt into a down cycle. Tack on the ongoing trade uncertainty, and CEOs are certain to, at least, postpone deploying longer-term oriented capital. Worryingly, this transition from a virtuous to a vicious capex cycle is not limited to a few cyclical sectors as we would have expected on the back of the re-escalating Sino-American trade tussle. In fact, basic resources’ and non-capital goods producers’ capital outlays are decelerating, warning that corporate America is in the early stages of retrenchment (bottom panel, Chart 3). Chart 3EPS-To-Capex Down Cycle Chart 4Capex… Charts 4, 5 & 6 break down sectorial capex growth using financial statement reported data from Refinitiv. Seven out of eleven sectors are steeply decelerating from near 20%/annum growth to half that; given that these sectors comprise more than 72% of the total capex pie, they will continue to weigh on overall stock market reported investment. Chart 5…Per… Chart 6…Sector Similarly, the news on the cyclicals versus defensives capex profile is grim. Trade uncertainty and the global growth soft patch has dealt a blow to deep cyclical expansion plans and leading indicators signal that the cyclicals/defensives capex will flirt with the contraction zone in the coming quarters (Chart 7). In sum, intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. Chart 7Relative Capex Blues This week we update our cyclicals versus defensives bias (we are currently neutral) and are compelled to put this portfolio bent on our downgrade watch list. Put The Cyclical/Defensive Tilt On Downgrade Alert Roughly two years ago, when nobody was talking about the brewing capex upcycle, we penned a report titled “Underappreciated Capex” and posited that: “It would be unprecedented if the current business cycle ended without a visible capex upcycle. Since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming.” Fast forward to today and as historical empirical evidence had suggested, capex growth peaked near the 20%/annum mark (Chart 3 above). If our assessment is accurate that capex has now likely hit a wall and the virtuous EPS-to-capex cycle reverses to a vicious down cycle as EPS are now contracting, then deep cyclical high-operating leverage sectors are in for a rough ride. This will especially be true if the global recession warnings also morph into an actual recession on the back of the re-escalating Sino-American trade war. More specifically, our capex indicators are firing warning shots. Capex intentions according to a plethora of regional Fed surveys are sinking steadily, which bodes ill for cyclicals versus defensives (Chart 8). One key driver of the capex cycle is China and the emerging markets (EM). News on both fronts is grim. Our real-time indicator that gauges China’s reflation efforts (monetary and fiscal) turning into actual economic activity is Chinese excavator sales that remain in the doldrums (top panel, Chart 9). Chart 8Drop In Capex Will Weigh On Relative Profits Chart 9Elusive Global Growth Granted, global growth remains elusive as we highlighted last week and while softening Chinese economic activity is weighing on global growth, European and Japanese GDP growth is also decelerating with a number of economies already in the contraction zone (bottom panel, Chart 9). Melting global bond yields reflect these growth fears and warn that the relative share price ratio has more downside (middle panel, Chart 9). Export growth is an important indicator that closely tracks the ebbs and flows of global trade. When the trade-weighted U.S. dollar appreciates it dampens trade, the opposite is also true. Currently the Fed’s trade-weighted greenback based on goods has vaulted to cyclical highs, warning that the path of least resistance is lower for trade, thus a net negative for relative export and profit prospects (Chart 10). Similarly, EM capital outflows exacerbate the ongoing global growth blues and put additional strain on EM economies as depreciating currencies sap consumer purchasing power (top panel, Chart 10). The implication is that EM final demand is in retreat. The rising U.S. dollar not only deals a blow to basic resource exports via making them less competitive and leading to market share losses, but it also undermines cyclical sectors' pricing power. The top panel of Chart 11 shows that deflating commodity prices are exerting downward pull on relative share prices. The ISM manufacturing survey’s prices paid subcomponent corroborates this deflationary backdrop. Keep in mind that operating leverage cuts both ways, and now that the pendulum is swinging the opposite way revenue contraction in these high fixed costs industries will fall straight off the bottom line (Chart 11). Chart 10Rising Dollar Dollar Dampens Trade And… Chart 11…Saps Pricing Power Our macro-based cyclicals/defensives EPS growth models do an excellent job in capturing all these moving parts and signal that defensives have the upper hand in the coming quarters (bottom panel, Chart 8). Turning to operating metrics, the inventory buildup in the past few quarters coupled with a softness in overall business sales underscore that relative share prices will continue to trend lower (top panel, Chart 12). On the balance sheet front, relative net debt-to-EBITDA has troughed and widening junk spreads and the inverted yield curve warn that a further relative b/s degrading looms (second & third panels, Chart 12). If our thesis pans out in the coming months, then cash flow growth will come under pressure as the vicious capex cycle flexes its muscles foreshadowing a rise in bankruptcy filings. Already, the news on the profit margin front is disconcerting. Historically, the ISM manufacturing index and relative operating profit margins have been joined at the hip and the recent flirting of the former with the boom/bust line points toward an ominous relative margin squeeze (bottom panel, Chart 12). Chart 12Poor Financial & Operating Backdrop… Chart 13…But Excellent Valuations And Technicals Finally, soft versus hard data surprise oscillations have an excellent track record in forecasting relative share price movements. The current message is to expect additional weakness in relative share prices (second panel, Chart 13). While most of the indicators we track signal that the time is ripe to downgrade this portfolio bent to an underweight stance, bombed out relative valuations, and oversold technicals keep us at bay, at least for the time being (third & bottom panels, Chart 13). However, we are compelled to put the cyclicals/defensives ratio on downgrade alert to reflect the transition from a virtuous to a vicious EPS-to-capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating b/s and operating metrics. The way we will execute this downgrade will be via a downgrade of the S&P tech sector (for additional details on the S&P tech sector's downgrade mechanics please refer to last Friday’s U.S. Equity Strategy Insight Report). Bottom Line: Stay on the sidelines in the S&P cyclicals/S&P defensives ratio, but put it on downgrade alert.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1      https://www.rba.gov.au/speeches/2019/sp-gov-2019-08-25.html Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps

Feature In investment, there are times when your view and your strategy should not be the same. Our view remains that the global economy is likely to avoid recession over the next 18 months, that the Fed will cut rates once or twice more as an “insurance” but not enter a full easing cycle, that global bond yields will rise, and that risk assets will outperform over the next 12 months. But the risks to that view have increased, and so we want to bolster the hedge against our view being wrong. We don’t see Recommended Allocation Chart 1GAA Portfolio Volatility Relative To Benchmark government bonds as an attractive hedge at this level of yield, and so are moving to a “barbell” strategy, with overweights in equities and cash, and an underweight in fixed income. This lowers the volatility of our recommended portfolio to close to that of the benchmark (Chart 1). First, the good news. Although the manufacturing sector globally continues to deteriorate, with many PMIs falling to below 50, services and consumption remain robust almost everywhere (Chart 2). With central banks easing monetary policy, and in some countries (Italy, the U.S., the U.K., maybe even Germany) governments loosening fiscal policy, financial conditions are improving, which will eventually support growth (Chart 3). Intra-cyclical manufacturing downturns typically last around 18 months, and this one is close to its sell-by date (Chart 4). Chart 2Manufacturing Weak, Services Fine So what has changed? First, manufacturing has continued to decline for longer than we expected. In the early summer, there were signs of a bottoming in Europe, but these are no longer evident. The diffusion index of the global manufacturing PMI (i.e. the percentage of countries with a rising versus falling PMI), which typically leads the PMI by six months, suggests the PMI has further to fall (Chart 5). Chart 3Easing Financial Conditions Will Help Chart 4Close To The Bottom?   Chart 5Further Downside For PMIs? Chart 6China's Reluctant Monetary Stimulus   The most likely cause of this is that China has been more reluctant to ramp up monetary stimulus than we expected. It has eased fiscal policy, but monetary policy has been tentative: despite a moderate increase in credit creation this year, M3 money supply growth has barely accelerated (Chart 6). This has been enough to stabilize Chinese growth, but has been insufficient to give the sort of boost to global growth that China provided in 2016. There are two reasons for China’s reluctance to stimulate. The authorities seemingly continue to prioritize debt deleveraging and clamping down on shadow banking. And, also, maybe they do not want to give a boost to the global economy that would help the U.S. avoid recession and increase the probability of President Trump’s being reelected. China has been more reluctant to ramp up monetary stimulus than we expected. The Trade War is an increasing risk. BCA’s geopolitical strategists continue to assign a 40% probability to a resolution by year-end,1 but it is becoming harder to see how (or, indeed, why) President Xi would offer concessions to the U.S. that would lead to a deal. Ultimately, if Chinese growth slows significantly and U.S. stocks fall sharply, China will boost monetary stimulus and President Trump will push for even a superficial trade agreement. But things will need to get worse first. Meanwhile, the rise in global political uncertainty – and the mercurial nature of Trump’s foreign and trade policies – are a risk for markets (Chart 7). Chart 7Global Political Risks Rising Chart 8Consumers (Mostly) Remain Confident   We are also concerned about how long consumption can remain robust in this environment. So far, consumer confidence has remained resilient in the U.S., though it has dipped a little in Europe and Japan (Chart 8). But, if corporate profits remain weak, companies will start to delay hiring decisions and begin to lay off workers. This would be the transmission mechanism for the manufacturing slowdown to spread into the broader economy. So far, fortunately, there are few signs it is happening: German unemployment is at a record low, and U.S. initial claims continue to run at or below last year’s level (Chart 9). Chart 9No Signs Of Weakening Labor Market Table 1GAA Recession Checklist     In the recession checklist we have published for the past two or more years, we are starting to have to tick off more warning signs (Table 1 and Chart 10). Chart 10Some Worrying Signs Chart 11Risk Of Recession No Longer Negligible   For example, the yield curve has inverted both for the 3-month/10 year and 2-year/10-year. Although the yield curve has been an almost infallible predictor of recession in the past 70 years, there are some reasons to argue that it may not be as good this time: for example, central bank purchases have artificially pulled down long-term rates. But inversion is probably a self-fulfilling prophesy. For example, in a recent Fed Senior Bank Loan Officers Survey, 40% of banks said they would tighten credit standards simply because of a moderate inversion of the yield curve. Formal models of recession 12 months ahead that incorporate the yield curve slope, put recession risk now at about 25% (Chart 11).   Chart 1218 Months Of Ups And Downs Given all this, we think it is appropriate to take some risk off. As far back as February 2018, we argued that “investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now”.2 Given the ups and down of markets in the past 18 months, we suspect that those risk-averse investors would not have been unhappy with that advice (Chart 12), although they would also have missed some nice equity rallies over that time, if they had been nimble enough to time entry and exit points. Since a majority of the subscribers to this service are rather conservative, we are now extending that advice to all clients. On a 12-month time horizon, we raise cash to overweight. We are also reducing somewhat both our equity overweight and bond underweight. In this period of increased uncertainty, a portfolio closer than usual to benchmark makes sense. (BCA’s House View is a little more bullish, remaining neutral on cash and overweight equities on the 12-month horizon). Fixed Income: Absent recession, we see little room for rates to fall further. The U.S. 10-year Treasury yield (now 1.5%) should stay above its July 2016 historic low of 1.37%. The Fed is unlikely to cut rates by 100 basis points over the next 12 months, as futures imply. We would expect only two 25 bp rate cuts: in September and either October or December. Yields are likely eventually to move up over the next 12 months (particularly given that inflation continues to trend higher). But they may not move much for a while, and so we move from underweight to neutral on duration for now. Eventually, we see investors understanding that government bonds are no longer an attractive hedge at current yields. Even if German 10-year yields fell to -1.2% (probably around the lowest possible), one-year total return would only be 5% (Table 2). The U.S. looks a little better, though. One could imagine the yield falling to zero in the next recession, which would give a return of 16%. On credit, we remain neutral: it represents a low-beta play on equities. So far this year, both investment-grade and high-yield bonds have eked out a small positive excess return (Chart 13). Table 2Not Much Room For Positive Returns Chart 13Credit Returns Have Not Been Bad Chart 14Downside For Cyclicals?   Equities: To offset our overweight on equities, we continue with a low-beta country/regional tilt. We recommend an overweight on the U.S., and underweight on Emerging Markets. The key for upside to U.S. equities remains earnings. Analysts have a pessimistic forecast of only 2.5% EPS growth in 2019 for the S&P500. A rough proxy for earnings growth (nominal GDP growth of 4.5%, wage growth of 3.5% leading to some margin expansion, 2% buybacks) points to EPS growth of around 7-8%. Q3 earnings (where analysts forecast -2% year-on-year) are likely to surprise on the upside, as did Q1 and Q2, though the strong dollar and weak overseas growth are risks. In our next Quarterly, to be published on October 1, we may make some adjustments to further dial down risk, for example in our equity sector recommendations, which currently have a slight cyclical tilt. The relative performance of cyclicals has started to wobble, and the message from bond markets is that cyclicals have further to fall in relative terms (Chart 14). Investors will come to understand that government bonds are no longer an attractive hedge at current yields. Currencies: The trade-weighted dollar has broadly moved sideways in the past year (Chart 15), weakening against the yen, but strengthening against the euro and EM currencies. We remain neutral on the dollar. It will continue to be pulled by two opposing forces: weak global growth is a positive, but the Fed has more room to cut rates than the rest of the world and so interest rate differentials will shift against the dollar. The renminbi is likely to continue to weaken, as the Chinese use currency policy as the least painful offset against U.S. tariffs. The latest  set of tariffs suggests that the CNY needs to fall to around 7.5-7.6 to the USD to offset their impact but, if Trump implements all the tariffs he has threatened, it could fall as far as 8.0 (Chart 16). This would pull other EM currencies down further. GBP will continue to be buffeted by Brexit scenarios. A no-deal Brexit could bring it down to 1.00 against the USD, whereas Remain or a very soft Brexit would take it back to PPP, 1.43. The current level is a probability weighted average of the two. Chart 15Dollar Has Moved Broadly Sideways Chart 16CNY Could Fall Much Further     Commodities: The oil price has been hurt by a slowing of demand in developed economies (Chart 17). Supply, however, remains tight, and our energy strategists have cut their forecast for Brent this year only modestly to an average of $66 a barrel (from an earlier forecast of $70, and from a current spot price of $60).3 Industrial commodities continue to struggle because of China’s slowdown (Chart 18) and are unlikely to recover until China’s stimulus is beefed up. Gold remains a good insurance for investors worried about geopolitical risk, recession, and inflation.   Chart 17EM Oil Demand Has Been Weak   Chart 18Industrial Commodities Hurt By China       Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com 1      Please see Geopolitical Strategy Weekly, “Big Trouble In Greater China,” dated August 23, 2019, available at gps.bcareseach.com 2      Please see Global Asset Allocation, “GAA Monthly Portfolio Update,” dated February 1, 2018, available at gaa.bcaresearch.com. 3      Please see Commodity & Energy Strategy, “USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl,” dated August 22, 2019, available at ces.bcaresearch.com Recommended Asset Allocation  

The GAA DM Equity Country Allocation model is updated as of August 31, 2019.   Currently, the model still favors Spain, Italy, Germany, the Netherlands, Switzerland, and Australia at the expense of the U.S., Japan, the U.K., France and Canada, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) As shown in Table 2 and Chart 1,  Chart 2 and  Chart 3, the overall model underperformed the MSCI World benchmark by 6 bps in August, driven by 1 bp of outperformance from Level 2 model, and 6 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 82 bps, with 290 bps of outperformance by Level 2 model, offset by 51 bps of underperformance from Level 1. Chart 1GAA DM Model Vs. MSCI World Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations.   GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of August 31, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The model continues to favor a mixed bag of sectors, given the current increased level of uncertainty, and continued lack of evidence that global growth is bottoming. Despite the current liquidity phase tilting the model to favor high-beta sectors, weak growth and momentum inputs offset that. The valuation component continues to remain muted across all sectors. The model is now overweight five sectors in total, two cyclical versus three defensive sectors. The overweight sectors are Consumer Discretionary, Information Technology, Consumer Staples, Healthcare and Utilities. For more details on the model, please see the Special Report “Introducing the GAA Equity Sector Selection Model,” dated July 27, 2016, as well as the Sector Selection Model section in the Special Alert “GAA Quant Model Updates,” dated March 1, 2019 available at https://gaa.bcaresearch.com. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com              

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

Highlights Four ghosts of 2016 are knocking at the door: Brexit, Trump, Brazil, Italy. President Trump and U.S. trade policy are keeping uncertainty high. Upgrade the odds of a no-deal Brexit to about 33%. Expect limited stimulus from Italy and Germany – for now. Brazil’s pension reform is entering its final stretch – buy the rumor, sell the news. Feature Four major political events of 2016 are returning to affect the global investment landscape this fall – though only two of these ghosts are truly frightening. In order of market relevance: Trump: The election of Donald J. Trump as U.S. president, November 8, 2016 Brexit: The U.K. referendum to leave the European Union, June 23, 2016 Italy: The Italian constitutional referendum, December 4, 2016 Brazil: The removal of Brazilian President Dilma Rousseff, August 31, 2016 Italy and Brazil are producing market-positive political results in the short run. Brexit and Trump pose substantial and immediate risks to the global bull market. A pivot by Trump is the headline risk to our view that no trade agreement will be concluded by November 2020, as we outlined in a Special Report last week. At the moment tensions are still escalating. President Trump has ordered an increase in tariffs (Chart 1) and threatened to invoke the International Economic Emergency Powers Act of 1977, which would give him the ability to halt transactions, freeze funds, and appropriate assets. China is retaliating proportionately and virtually incapable of softening its tone prior to its National Day celebration on October 1. The next round of negotiations, slated for Washington in September, could be a flop like the talks in July, or it could be canceled. Investors should stay defensive. The equity market will have to fall to force Trump to stage a tactical retreat. Meanwhile China could intervene violently in Hong Kong SAR. That possibility, the nationalist military parade on October 1, and U.S. actions toward the South China Sea and Taiwan, show that sabers are rattling, causing additional market jitters. Chart 1Trump's Latest Tariff Salvo U.S.-China tensions underpin our tactical safe-haven trade recommendations. But we are not shifting to a cyclically bearish stance until we get clarity on Trump’s and Xi’s handling of their immediate predicament. Brexit is the other acute short-term risk. This was true even before Prime Minister Boris Johnson opted to prorogue parliament from September 10 to October 14, shortening the time that parliament has to either pass a law forbidding a no-deal exit or bring down Johnson’s government in a vote of no confidence. We are upgrading the odds of “no deal” to no higher than 33%, using a conservative decision-making process (Diagram 1). No-deal is not our base case because parliament, the public, and even Johnson himself want to avoid a recession, which is the likely outcome, even granting that the Bank of England will not stand idly by. We are upgrading the odds of “no deal” Brexit to about 33%. Diagram 1Brexit Decision Tree (Revised August 29, 2019) From a bird’s eye point of view, the pound is very attractive (Chart 2). But in the near-term the twists and turns of Britain’s political struggle imply that we will see wild volatility. Our foreign exchange strategists expect that a no-deal Brexit would cause GBP/USD to collapse to 1 after October 31. Assuming our one-in-three odds of such an outcome, the probability-weighted average of cable is about 1.2. Hence investors should not short sterling from here, unless they strongly believe we are underrating the odds of no-deal exit. In the worst-case scenario, a no-deal Brexit will cause an economic shock at a time when Europe is on the brink of recession – Italy and Germany are virtually there. This means there is a substantial risk of additional deflationary pressure piling onto German bunds and sustaining the global bond rally. This pressure will be sharply reduced if Johnson loses an early no confidence vote, but that is a 50/50 call so we would not call time on this rally yet. Stay cautious. Chart 2Pound Can Only Go So Low   Italy: Stimulus … Without A Bruising Brussels Battle Italy has avoided a new election by producing an unusual tie-up between the establishment Democratic Party and the anti-establishment Five Star Movement (M5S). The coalition still needs to clear some internal hurdles and an online vote by Five Star members, but an agreement is to be presented to President Sergio Mattarella as we go to press. This is the most market-friendly outcome that could have been expected, as is clear through the sharp drop in Italian government bond yields (Chart 3). Our GeoRisk indicator for Italy is also collapsing. Chart 3Markets Cheer New Italian Coalition This development marks the climax of a story line that we outlined in 2016, when Prime Minister Matteo Renzi lost a constitutional referendum that aimed to strengthen Italian governments to enable deeper structural reforms (he subsequently resigned). At that time we argued that Italy would emerge as a market-relevant political risk due to rampant anti-establishment sentiment, but that this risk would subside when Italy’s populists were shown to be pragmatic at heart, i.e. unwilling to push their conflicts with Brussels to a point that truly reignited European break-up risk. This view is now vindicated – and not only for the short-term. The new coalition comes at the nick of time, with Europe teetering on recession and the risk of a no-deal Brexit rising. The new government will have to deliver the 2020 budget to the European Commission by October 15. The budget will aim to provide fiscal support, including a delay of the legislatively mandated hike in the Value Added Tax from 22% to 24.2%, already rolled over from 2019. The Five Star Movement will demand as a price for its participation in the coalition that social spending go up; the Democratic Party will have learned a lesson while out of power and will be more fiscally permissive and strike a tougher tone with Brussels. The Italian budget talks will be a non-issue: the coalition will cooperate with Brussels. The episode demonstrates that the Italian risk to financial markets is overrated. This point goes beyond the fact that the Democrats and Five Star were able to cooperate. Italy’s leading populist parties have already shown that they are pragmatic and will play the game with Brussels to avoid a financial breakdown. In May 2018, the newly formed populist coalition proposed a gigantic “wish list” budget that would have increased the budget deficit to roughly 7.3% of GDP in 2019. They also appointed a euroskeptic economy minister who almost prevented government formation. The ensuing conflict with Brussels triggered considerable turmoil (Chart 4). Ultimately, however, the populists did precisely what we expected: they bowed to the severe financial constraint on Italy’s banking system. They agreed to a 2019 and 2020 deficit of 2.04% and 2.1%, respectively (Chart 5). Chart 4Italian Populists Prove Pragmatic Chart 5Even Salvini Compromised On Budget Clash At present, the market is relieved that an election was avoided that might have seen Salvini and the League form a government with a much smaller right-wing party (Fratelli D’Italia) (Chart 6) – but the truth is that Salvini had already capitulated to the EU, both on budget matters and the euro currency. He was hardly likely to push for a budget more aggressive than that of the initial proposal in 2018. The clash with Brussels would have been a flash in the pan; the result would have been greater fiscal thrust, which would have been market-positive in the current environment. Chart 6Election Would Have Meant More Stimulus ... And More Political Risk M5S will also push for more spending and has also moderated their stance on the euro. A coalition with the Democrats will not work if the purpose is to push a euroskeptic agenda. There will be a focus on counter-cyclical fiscal policy, pragmatic reforms that the two can agree on, and fighting corruption. The budget talks will be a non-issue: the Democratic Party is an establishment party and the coalition will cooperate with Brussels. Furthermore, the context has changed since 2018 in a way that will reduce budget frictions. There is a need for countercyclical fiscal policy in light of the global slowdown, so the European Commission will have to be more flexible on the budget. This is particularly true if Germany itself loosens its belt on a cyclical basis. The risk to the above is that the coalition shaping up between the Democrats and Five Star is an alliance of convenience that will break down over time. Five Star will remain hard-line on immigration, which is driving anti-establishment sentiment. Italian elections are a frequent affair. Salvini and the League will be waiting in the wings, especially if Brussels proves too tight-fisted or if the Democrats do not toughen their stance on immigration. But as outlined above, Salvini’s own evolution on the euro, on northern Italy, and on the budget and financial stability shows that the economy will have to get a lot worse before Italian euroskepticism presents a renewed systemic risk. Bottom Line: The tentative coalition taking shape in Italy will produce a modest increase in fiscal thrust with minimal frictions with Brussels. As such it is the most market-friendly outcome that could have occurred from Salvini’s push to seize power. Beneath this episode of government change is the political arrangement taking shape in Italy, and across Europe, which calls for a commitment to the European project and currency. The price of this commitment is a tougher line on immigration from European leaders. Germany: Fiscal Loosening, But Not For The States (Yet) Our GeoRisk indicator for Germany is pointing to an increase in risk in recent weeks. Germany is threatened by a potential technical recession and while fiscal stimulus is in preparation, there will not be a fiscal game-changer until Merkel steps down in 2021 – barring a total collapse in the economy that forces her hand in the meantime. The outlook is not improving (Chart 7, top panel). The economy shrank by 0.1% in Q2 2019, exports are falling, and passenger car production is at the lowest level ever recorded (Chart 7, bottom panels). Chart 7German Economy Gets Pummeled Chart 8Germany: Expect Orthodox Stimulus For Now Finance Minister Olaf Scholz has announced that Germany could increase government spending by $55 billion within the context of European and German budget constraints. Split proportionally between 2019 and 2020, this additional spending would not put Germany in violation of the “black zero” rule – a commitment to a balanced budget that limits the federal structural deficit to 0.35% of GDP – even without any additional revenue (Chart 8).   There will not be a fiscal game-changer in Germany until Merkel steps down – barring a crisis. The German Chancellery reports that it does not see the need for stimulus in the short term – as long as trade tensions do not escalate and there is no hard Brexit. At present, however, trade tensions are escalating and the odds of a no-deal Brexit are increasing. Moreover China’s economy and stimulus efforts continue to disappoint. In this context Germany’s ruling coalition is putting together a climate change package that would entail additional spending (while stealing some thunder from the increasingly popular Green Party). Given the European Commission’s forecast of Germany’s 2020 budget surplus, 0.8% of GDP, the government could ultimately go further than Scholz’s ~$50bn. This is because the black zero rule provides for exceptions in case of recession (or natural disasters or other crises out of governmental control) with a majority vote in the Bundestag. Hence we are not so much concerned about the magnitude of the stimulus as its timing. First, Merkel and her coalition typically move slower than the market would like in the face of financial and economic challenges. Second, according to the black zero rule, which is transcribed in the German constitution (the Basic Law), the Länder cannot run budget deficits from 2020. Amending the constitution to delay this deadline requires a two-thirds majority in the Bundestag and the Bundesrat – a much taller order than the simple majority needed to boost federal deficits. The governing coalition currently holds 56% of the seats in the Bundestag. If the Greens were brought on board, which they would be inclined to do, this number falls just short of two-thirds at 65.6%. In order to obtain a two-thirds majority in the Bundesrat, the Social Democrats, Christian Democrats, and the Greens would need the support of another party, either the Left or the Free Democrats. This could be done but it would require political will, which is only likely to be sufficient if the German and global economy get worse from here. Meanwhile financial markets will have to settle for the gradual implementation of a stimulus package on the order of 1% of GDP – the one the government is planning. Bottom Line: While Germany will likely roll out a stimulus package by Q4, if third quarter GDP data confirm that the country is in a technical recession, Merkel’s hesitation and budget limits mean that this stimulus will likely be moderate. A marginal upside surprise is possible but it will not represent a true “game changer” on fiscal policy in Germany. The game changer is more likely after Merkel steps down in 2021. The Green Party is surging in Germany and could possibly lead the next government. Even if it doesn’t, its success and Europe-wide developments are pushing German leaders to become more accommodative. Brazil: Reform Or Bust Political turmoil in Brazil over the past five years has ultimately resulted in a right-wing populist government under President Jair Bolsonaro. Bolsonaro is pursuing a pension reform that is universally acknowledged as necessary to straighten out Brazil’s fiscal books, but that the previous government tried and failed to pass. On this front the news is market-positive: having cleared the lower Chamber of Deputies, the pension reforms are now likely to pass the senate. This will lift investor confidence and give Bolsonaro an initial success that he may then be able to translate into additional economic reforms. The Brazilian economy and financial markets are moving in opposite directions. The currency and equities staged a mid-year rally despite negative data releases – shrinking retail sales and industrial production amid high unemployment (Chart 9). More recently these assets relapsed despite tentative signs of improvement on the economic front (Chart 10). All the while, chaos and controversies surrounding Bolsonaro’s government have weighed on his approval rating, ending the honeymoon period after election (Chart 11). Chart 9Brazil: Signs Of Improvement   Chart 10Brazil: Markets Sold Despite Pension Progress Chart 11Bolsonaro’s Honeymoon Is Long Gone The mid-year equity re-rating was driven by an improvement in sentiment on the back of the government’s pension reform. The relapse occurred despite the passage of the pension reform bill in the lower house, indicating that global economic pessimism has dominated. The bill’s next step goes to the senate where it faces two rounds of voting before enactment (Diagram 2). It should clear this hurdle by a large margin, though we expect delays. Diagram 2Brazil: Pension Reform Timeline In the second round vote in the lower house on August 6 – which had a smaller margin of victory than the first round – deputies voted largely in line with party alliances (Charts 12A & 12B). Assuming legislators in the senate behave in the same way, the reform should gain the support of 64 of the 81 senators – easily surpassing the 49 votes needed. Even in a more pessimistic scenario where all opposition parties and all independent parties vote against the bill – along with two defecting senators from government-allied parties – the reform would pass by 56-25. Chart 12APension Bill Sailed Through Lower House ... Chart 12B... And Should Pass Senate In Time This favorable outlook is also supported by popular opinion, which indicates that the majority of those polled agree that pension reforms are necessary (Chart 13). This leaves two questions: How soon will the bill clear the senate? According to senate party leaders’ proposed timetable, the bill will undergo its first upper house vote on September 18 with the second round slated for October 2. This is ambitious. The strategy of Senator Tasso Jereissati – who has been appointed senate pension reform rapporteur – is to approve the text in its current form and create a parallel proposed amendment to the constitution (PEC) which will bring together the amendments that senators make to the original text. Dozens of amendments have been filed with the Commission on Constitution and Justice. These will prolong the enactment of the final bill and dilute its impact. We doubt the senate will let Jereissati have his way entirely and hence expect delays and dilution. Chart 13Brazil: Public Now Favors Pension Reform Chart 14Brazil: Pension Reform Not Enough How much savings will the bill generate? Will the reforms be sufficient to improve public debt dynamics in Brazil? The Independent Fiscal Institute of the senate estimates that the reform will generate BRL 744 billion of savings. This is significantly less than the BRL 1.2 trillion initially proposed, and lower than the BRL 860 billion that Economy Minister Paulo Guedes has indicated as the minimum fiscal savings required. Our Emerging Markets strategists argue that the bill falls short of what is needed. While the plan will reduce the fiscal deficit and slow debt accumulation, it will be insufficient to generate primary surpluses over the coming years (Chart 14).1 Moreover, estimated savings in the final bill will likely be further revised down as the bill undergoes more amendments in the senate. What comes after pension reform? The market has focused almost exclusively on this issue to the neglect of Bolsonaro’s wider economic reform agenda. The agenda includes privatization, trade liberalization, tax reforms, and deregulation. Here we are more skeptical. First, Bolsonaro will have spent a lot of political capital on pensions. Second, while the economy and unemployment are always important, they are not the foremost concern for Brazilians (Chart 15). Chart 15Bolsonaro Will Lose Political Capital After Pension Bill Third, the economic agenda is often at odds with Bolsonaro’s social, foreign, and environmental policies: The new Mercosur-European Union trade agreement and ongoing trade negotiations between Mercosur and Canada are positive developments. However the G7 summit in France highlighted that the deal with the EU is at risk due to dissatisfaction with Bolsonaro’s response to the Amazon fires. France and Ireland have threatened to withhold support of the ratification. With world leaders concerned about the political risks of trade liberalization, and with Trump having issued a license to foreign leaders for trade weaponization, an escalation of tensions between the Europeans and Bolsonaro could lead to punitive measures even beyond the delay to the Mercosur-EU deal. Brazil’s China problem: Bolsonaro has been cozying up to President Donald Trump while striking a more aggressive tone with China. This is a risky strategy as it may undermine Brazil’s economic interests. The country’s exports are much more leveraged to China than to the U.S. and have been benefitting on the back of the trade war as China substitutes away from the U.S. (Chart 16). The president’s planned trip to China in October reveals an attempt to mend ties after having accused China of dominating key Brazilian sectors during his election campaign. But it is not clear yet that Bolsonaro will stage a retreat. And if President Trump backtracks on his trade war in order to clinch a deal, Bolsonaro may have lost some goodwill with China without receiving the benefit of China’s substitution effects. Hence Bolsonaro will have to soften his approach to China to make progress on the trade aspect of the reform agenda. Chart 16Brazil: Time To Mend Ties With China Bottom Line: We expect the passage of a diluted pension reform bill that will slow the growth of public debt to some extent. However global headwinds are persisting. And any success on pensions should not be extrapolated to other items on the economic reform agenda. Bolsonaro’s trade liberalization faces difficulties on the surface. Other domestic reforms are even more difficult to achieve in the wake of painful pension cuts. Reforms that enjoy public support and do not require a complicated legislative process are the most likely to be implemented, but even then, legislation and implementation are likely to be long-in-coming in Brazil’s highly fractured congress. As a result we share the view with our Emerging Markets Strategy that the pension reform is a “buy the rumor, sell the news” phenomenon. Housekeeping We are booking gains on our long BCA global defense basket for a 17% gain since inception in October 2018. The underlying thesis for this trade remains strong and we will reinstitute it at an appropriate time, though likely on a relative basis to minimize headwinds to cyclical sectors. We are also finally throwing in the towel on our long rare earth / strategic metals equity trade. The logic behind the trade is intact but it was very poorly timed and the basket has depreciated 24% since inception.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy RoukayaI@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      Please see BCA Research’s Emerging Markets Strategy Weekly Report “On Chinese Banks And Brazil,” dated July 18, 2019, available at ems.bcaresearch.com. France: GeoRisk Indicator U.K.: GeoRisk Indicator Germany: GeoRisk Indicator   Italy: GeoRisk Indicator Spain: GeoRisk Indicator Russia: GeoRisk Indicator   Korea: GeoRisk Indicator Taiwan: GeoRisk Indicator Turkey: GeoRisk Indicator Brazil: GeoRisk Indicator What's On The Geopolitical Radar? Geopolitical Calendar