Asset Allocation

Highlights The global manufacturing cycle is likely to bottom soon, and consumption and services remain robust. The risk of recession over the next 12 months is low. This suggests that equities will continue to outperform bonds. But the risks to this optimistic scenario are rising. A denting of consumer confidence and worsening of geopolitical tensions could hurt risk assets. We hedge this by overweighting cash. China remains reluctant for now to use aggressive monetary easing. Until it does, the less cyclical U.S. equity market should outperform. We may shift into EM and European equities when China ramps up stimulus and the manufacturing cycle clearly bottoms. To hedge against this upside risk, we go tactically overweight Financials, and reiterate our overweight on Industrials and neutral on Australia. Bond yields should continue their rebound. We recommend an underweight on duration and favor TIPS. Credit should outperform on the cyclical horizon, but high corporate debt is a risk – we recommend a neutral position. Recommendations   Feature Overview Hedges All Around This is a particularly uncertain time for the global economy – and so a tricky one for asset allocators. Will manufacturing activity bottom soon, or will it drag down the services sector and consumption with it? Will bond yields continue their strong rebound? Is the Fed done cutting rates? Will China now ramp up monetary stimulus? Will Iran escalate a confrontation with Saudi Arabia? What will President Trump tweet about next? This is the sort of environment in which portfolio construction comes into its own. We have our view on all these questions, but our level of conviction is somewhat lower than usual. The way for investors to react is to plan asset allocation in such a way that a portfolio is robust in all the most probable scenarios. We expect the global manufacturing cycle to bottom soon. The Global Leading Economic Indicator is already picking up, and the Global PMI shows some signs of bottoming (Chart 1). The shortest-term lead indicator, the Citigroup Economic Surprise Index, has recently jumped in every region except Europe (Chart 2). (See also What Our Clients Are Asking on page 7 for some more esoteric indicators of cycle bottoms.) The bottoming-out is due to easier financial conditions over the past nine months, a stabilization in Chinese growth, and simply time – the down-leg in manufacturing cycles typically last 18 months, and this one peaked in H1 2018. Chart 1First Signs Of Bottoming Chart 2Surprisingly Strong Surprises     At the same time, government bond yields should have further to rise. The Fed may cut rates once more but, given the resilient U.S. economy, no more than that. This is less than the 59 basis points of cuts over the next 12 months priced in by the Fed Fund futures. The recent pick-up in economic surprises suggests that the 10-year U.S. Treasury yield should return at least to where it was six months ago, 2.3-2.4% (Chart 3). This might be delayed, however, if there is an increase in political tensions, for example a break-up of the U.S./China trade talks (Chart 4). Chart 3Long-Term Rates To Rebound Further... Chart 4...But Geopolitical Tensions Remain A Risk This implies that equities are likely to continue to outperform bonds over the next few quarters, and so we remain overweight global equities and underweight global bonds on the 12-month investment horizon. However, the risks to this rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II, usually about 18 months in advance (Chart 5). The 3-month/10-year curve inverted in the middle of this year. We also worry that the weakness in the manufacturing sector may dent consumer confidence. There are some signs of this in Europe and Japan – but none significant yet in the U.S. (Chart 6). Accordingly last month, as a hedge against an economic downturn, we went overweight cash, which we see as a more attractive hedge, from a risk/reward point-of-view, than bonds. Chart 5Can We Ignore The Message From The Yield Curve? Chart 6Some Signs Of Weaker Consumer Confidence     We also remain overweight U.S. equities, which are lower-beta and have fewer structural headwinds than equities in other regions. However, we continue to look for an entry point into the more cyclical equity markets which would also be beneficiaries of bolder China stimulus. China’s monetary easing remains more tepid than in previous stimulus episodes. It has probably been enough to stabilize domestic activity (Chart 7) but not to trigger a rally in industrial commodity prices, EM assets, and euro area equities, as it did in 2016. A pick-up in global PMIs and signs of stronger Chinese credit growth would clearly help EM and Europe (Chart 8) but we need higher conviction that these things are indeed happening before making that move. In the meantime, we are hedging the upside risk by raising the global Financials sector tactically to overweight, since it would likely do well if euro area stocks started to outperform. Earlier this year, we raised the Industrials sector to overweight and Australian equities to neutral, also to hedge against the upside risk from more aggressive Chinese stimulus. Chart 7Chinese Stimulus Has Merely Stabilized Growth Chart 8Europe And EM Are The Most Cyclical Markets     Chart 9Oil Price Spikes Often Precede Recessions The biggest geopolitical risk to our sanguine scenario is the situation in the Middle East, after the attacks on Saudi oil refineries. Every recession in the past 50 years has been preceded by a 100% year-on-year spike in the crude oil price (though note that Brent would need to rise to over $100 a barrel by year-end, from $61 today, for that to eventuate (Chart 9)). A short-term oil shortage is not the problem since strategic reserves are ample. But the attack demonstrates the vulnerability of the Saudi installations. And a reprisal attack on Iran could lead it to block the Strait of Hormuz, through which more than 20% of global oil passes. We have an overweight on the Energy sector, partly as a hedge against these risks. BCA’s oil strategists expected Brent crude to rise to $70 this year, and average $74 in 2020, even before the recent attack. They argue that the risk premium in the oil price (the residual in Chart 10) is too low, given not only tensions with Iran, but also other potential supply disruptions in Iraq, Libya, Venezuela and elsewhere.   Chart 10Is The Oil Risk Premium Too Low?   Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com     What Our Clients Are Asking Which Leading Indicators Should Investors Watch To Time The Rebound In Global Growth? Chart 11Positive Signals For Global Growth During 2019, the global growth decline was a key driver of the bond rally and the outperformance of defensive assets. Thus, timing when this decline will reverse will be crucial, since it would also result in a change of leadership from defensive to cyclical assets. But how can this be done? Below we list three of our favorite indicators that have provided reliable leading signals on the global economy in the past: Carry-trade performance: The performance of EM currencies with very high carry versus the yen tends to be a leading indicator for global growth (Chart 11, panel 1). In general, carry trades distribute liquidity from countries where funds are plentiful but rates of return are low (like Japan), to places with savings shortfalls and high risk, but where prospective returns are high. Positive performance of these currencies tends to signal a positive shift in global liquidity, which usually fuels global growth. Swedish inventory cycle: The Swedish new-orders-to-inventories ratio is a leading indicator of the global manufacturing cycle (panel 2). Why? Sweden is a small open economy that is very sensitive to global growth dynamics. Moreover, Swedish exports are weighted towards intermediate goods, which sit early in the global supply chain. This makes the Swedish inventory cycle a good early barometer of the health of the global manufacturing cycle. G3 monetary trends: G3 excess money supply – measured as the difference between money supply growth and loan growth – is a leading indicator of global industrial production (panel 3). As base money and deposits become more plentiful in the banking system relative to the pool of existing loans, the liquidity position of commercial banks improves. This provides banks with the necessary fuel to generate more loan growth, a development which eventually provides a boon to economic activity. Importantly, all these leading indicators are sending a positive signal on the global economy. This confirms our view that rates should go up as global growth strengthens. Therefore, investors should remain overweight equities and underweight bonds in their portfolios.   Is It Time To Buy Euro Area Banks? In a Special Report on euro area banks in December 2018, we noted that “Historically, when the relative P/B discount hits the lower band and the relative dividend yield hits the upper band, a rebound in relative return performance could be expected”.1 Our recommendation back then was that “long-term investors should avoid banks in the region, but investors with a more tactical mandate and much nimbler style could use the valuation indicators to ‘time’ their entry into and exit out of banks as a short-term trade.” Since then, banks have continued to underperform the overall market by over 10%, further pushing down relative valuation metrics. Currently, both relative P/B and relative dividend yield are at extreme levels that have historically heralded at least a short-term bounce. The euro area PMI is still below 50, but there are signs that the euro area economy could rebound later this year, which should be positive for banks’ relative earnings. Already, forward EPS growth has been stabilizing relative to the broad market (Chart 12, panel 4). In addition, two of the key concerns back in December 2018 were Italian government debt and the unwinding of QE. Now Italian debt is no longer in crisis and the ECB has relaunched QE. As such, investors with a tactical mandate and a nimble style should buy (overweight) banks in the euro area. Long-term investors should still avoid such a short-term trade because structural issues remain. Chart 12Tactically Upgrade Euro Area Banks   Is The Gold Rally Over? Spot gold prices have increased 17% year-to-date, on the back of global growth weakness, dovish central banks, and rising political tensions. Should investors now pare back their gold exposure? Common sense would suggest they should. However, these are not ordinary times. In the short term, gold prices might suffer from some profit-taking due to overbought technicals and excessively positive sentiment (Chart 13, panel 1). Moreover, gold prices have moved this year due to increased market expectations of central bank easing (panel 2). We expect that markets will be disappointed going forward by only limited rate cuts, which could put downward pressure on gold. On the other hand, with approximately 27%, or $14.9 trillion, of global debt with negative yields at the moment, investors will continue to shift to the next best asset – zero-yielding gold (panel 3). This is clear from the rise in holdings of gold over the past few years by both central banks and investors (panels 4 & 5). We expect this trend to persist as investors continue their search to avoid negative yields and focus on capital preservation. Geopolitical tensions have intensified since the beginning of the year: ongoing yet inconclusive trade negotiations between the U.S. and China, implementation of further tariffs, Brexit uncertainty, and the recent military attacks in the Middle East (panel 6). This environment should also continue to push gold prices higher. We continue to recommend gold as a hedge against inflation – which we see picking up over the next 12 months – as well as against any further deterioration in global growth and the geopolitical situation. Chart 13Gold: Sell Or Hold? Risks to the rosy scenario are rising. We remain concerned about the inverted yield curve, which has accurately forecast every recession since World War II. How Low Can Rates Go? The zero lower bound is a thing of the past. Last month, Denmark’s central bank cut rates to -0.75%, and 10-year government bonds in Switzerland hit a historic low for any major country, -1.12%. In the next recession, how much further could interest rates theoretically fall? For individuals, cash rates might be limited by the cost of storing paper currency, which has a zero yield (unless governments find a way to ban cash or charge an annual fee on it). A bank safety deposit box costs about $300 a year, and a professional-quality safe big enough to store $1 million (which would be a pile of $100 bills 31 x 55 cms, weighing 10 kg) costs $2,000 with installation costs. Amortize the latter over 10 years, and the cost of storing $1 million is about 0.2%-0.3% a year. Swiss franc bills – maximum denomination CHF1,000 – would cost less to store. But storage costs for physical gold are around 2% a year. Since rates have fallen below this, there must be other constraints. Individuals would find storing money in cash possibly dangerous and certainly very inconvenient (imagine having to transport the cash to a bank to pay a tax bill). And the cost for a rich individual or company of storing, say, $1 billion (weighing 10 tonnes) would be much higher. Given the history in even low-rate countries (Chart 14, panel 1), we suspect around -1% is the level at which cashholders would seek alternatives to bank deposits of government bills. Chart 14How Low Can They Go? Chart 15Yield Curves When Rates Are At Zero Or Below   At the long end, the yield curve does not typically invert much when short-term rates are zero or negative (Chart 15). The biggest 3-month/10-year inversion was in Switzerland earlier this year, -0.05%. This points then to the absolute lowest level for 10-year bonds anywhere, even in the middle of a nasty recession, at around -1.1%. That is a worry for asset allocators. It means that the maximum mathematical upside for Swiss government bonds from their current level (-0.8%) is 3% while it is 5% for German bonds (currently -0.5%). This is not much of a hedge. Only the U.S. looks better: if the 10-year Treasury yield falls to 0%, the total return is 18%.   Global Economy Chart 16U.S. Growth Remains Solid Overview: Industrial-sector growth globally has been weak, with the manufacturing PMI in most countries falling below 50. But consumption and services almost everywhere have remained resilient, even in the manufacturing-heavy euro area. And there are tentative signs of a bottoming-out in manufacturing. However, a full-scale rebound will depend on further monetary stimulus in China, where the authorities still seem cautious about rolling out easing on the scale of what was done in 2016. U.S.: U.S. manufacturing has now followed the rest of the world into contraction, with the ISM manufacturing index slipping below 50 in August (Chart 16, panel 2). However, consumption and services are holding up well. Employment continues to expand (albeit at a slightly slower pace than last year, perhaps because of a lack of jobseekers), there is no sign of a rise in layoffs, and consumer confidence remains close to a historical high (though it slipped slightly in September). Housing has recovered after last year’s slowdown, and the recent congressional budgetary agreement means fiscal policy will be mildly expansionary over the coming 12 months. Only capex (panel 5) has slowed, as companies postpone investment decisions due to uncertainty surrounding the trade war. The consensus expects U.S. real GDP growth of 2.2% this year, above most estimates of trend growth. Euro Area: Given its higher concentration in manufacturing, European growth is weaker than in the U.S. The manufacturing PMI has been below 50 since February, and fell further to 45.6 in August. Industrial production is shrinking by 2% year-on-year. Italy has experienced two negative quarters of growth, and Germany may also enter a technical recession in Q3 (GDP shrank by 0.1% in Q2). However, there are some tentative signs that manufacturing is bottoming: the ZEW survey in September, for example, surprised on the upside. And, like the U.S., consumption remains strong. Even in manufacturing-heavy Germany, employment continues to grow, and retail sales in July were up 4.4% year-on-year. In the U.K., however, uncertainty surrounding Brexit has damaged business investment, though employment has been strong.2 Chart 17First Signs Of A Rebound In The Rest Of The World? Japan: Consumption has already slipped, even before the consumption tax hike scheduled in October. Retail sales in July fell 2% year-on-year, due to negative wage growth and consumer sentiment falling to a five-year low. Manufacturing continues to suffer from China’s slowdown and the strong yen (up 6% over the past 12 months), with exports falling 6% and industrial production down 2% year-on-year over the past three months. The effect of the consumption tax hike may be cushioned by government measures (lowering taxes on autos and making high-school education free, for example). And a pickup in Chinese growth would boost exports. But there are scant signs yet of a bottoming in activity. Emerging Markets: China’s growth appears to have stabilized, with both manufacturing and non-manufacturing PMIs above 50 (Chart 17, panel 3). But confidence remains fragile, with retail sales growth slowing to a 20-year low and car sales down 7% in August, despite the introduction of cars compliant with new emissions standards. The authorities have responded with further easing measures (including a further cut in the reserve requirement in September) but seem reluctant to launch a full-scale monetary stimulus, similar to what they did in 2016. Elsewhere in EM, growth has slowed in countries with structural issues (latest year-on-year real GDP growth in Argentina is -5.7%, in Turkey -1.5% and in Mexico -0.8%) but remains fairly resilient elsewhere (India 5%, Indonesia 5%, Poland 4.2%, Colombia 3.4%). Interest Rates: Central banks almost everywhere have turned dovish, with the Fed cutting rates for a second time, the ECB restarting asset purchases, and the Bank of Japan signaling it will ease in October. But further monetary accommodation will probably be less than the market expects. The Fed signaled that its cuts were just a mid-cycle correction and that further easing is unlikely. And the ECB and BoJ have little ammunition left. With signs of growth bottoming, and the market understanding that central banks’ dovish turn is reaching its end, long-term rates, which have already risen in the U.S. from 1.45% to 1.72% in September, are likely to move higher. Investors should also carefully watch U.S. inflation, which is showing signs of underlying strength, with core CPI inflation rising 2.4% year-on-year in August (and as much as 3.4% annualized over the past three months).   Global Equities Chart 18Has Earnings Growth Bottomed? Still Cautious, But Adding An Upside Hedge: Global equities registered a small loss of 8 basis points in Q3 (Chart 18) despite all the headline risks from geopolitics and weakening economic data. Overall, our defensive country allocation worked well in Q3, since DM equities outperformed EM by 4.5%, and the U.S. outperformed the euro area by 2.8%. Our sector positioning did not do as well since underweights in Utilities and Consumer Staples and overweights in Industrials, Energy and Health Care all went in the wrong direction, even though the underweight in Materials did help to offset the loss. During the quarter, however, both sector and country rotations were evident within the global equity universe, in line with the wild swings in bond yields. September saw some reversals in DM/EM, U.S./euro area and cyclical/defensives. Going forward, BCA’s House View remains that global economic growth will begin to recover over the coming months, albeit a little later than we previously expected. As such, our defensive country allocation remains appropriate. We did put euro area and EM equities on upgrade watch in April,3 but the delay in the global recovery also implies that it is still not the time to trigger this call. With our view that bond yields have hit bottom,4 we are making one adjustment in our global sector allocation by upgrading Financials to overweight from neutral. We are financing this by cutting in half the double overweight in Health Care to overweight (see next page for more details). This adjustment also acts as a hedge against two possible outcomes: 1) that the euro area outperforms the U.S., and 2) that Elizabeth Warren wins in the upcoming U.S. presidential election.5   Upgrade Global Financials To Overweight From Neutral Chart 19Upgrade Global Financials The relative performance of global Financials to the overall equity market has been hugely affected by the movements in global bond yields (Chart 19, panel 1). As bond yields made a sharp reversal in September, so did the relative performance of Financials, even though it is barely evident on the chart given how much Financials have underperformed the broad market over recent years. It’s not clear how sustainable the sharp reversal in bond yields will be, but BCA’s House View is that bond yields will move higher over the next 9-12 months. As such, we are upgrading Financials to overweight from neutral, for the following additional reasons: Valuations are extremely attractive as shown in panel 2. More importantly, the relative valuation is now at an extreme level that historically heralded a bounce in Financials’ relative performance. Loan quality has improved. The U.S. non-performing loan (NPL) ratio is nearing the lows reached before the Global Financial Crisis (GFC). Even in Spain and Italy, NPL ratios have fallen significantly, though they remain higher than they were prior to the GFC (panel 3). U.S. consumption has been strong, housing has rebounded, and demand for loans is getting stronger (panel 4), in line with data such as the Citi Economic Surprise Index, suggesting that economic data may have hit bottom. To finance this upgrade, we cut the double overweight of Health Care to overweight, as a hedge against Elizabeth Warren winning next year’s U.S. presidential election and tightening rules on drug pricing. Government Bonds Maintain Slight Underweight On Duration. Our below-benchmark duration call was severely challenged by the global bond markets in the first two months of the third quarter. The U.S. 10-year Treasury yield hit 1.43% on September 3 in response to the weaker-than-expected ISM manufacturing index in the U.S., 57 bps lower than the level at the end of previous quarter, and just a touch higher than the historical low of 1.32% reached on July 6, 2016. The rebound in bond yields since September 5, however, was driven not only by the ebb and flow in the U.S./China trade policy dynamics, but also by the positive surprises in economic data releases, as shown in Chart 20. BCA’s Global Duration Indicator, constructed by our Global Fixed Income Strategy team using various leading economic indicators, is also pointing to higher yields globally going forward. Investors should maintain a slight underweight on duration over the next 9-12 months. Favor Linkers Vs. Nominal Bonds. Global inflation expectations have also rebounded after continuing their downtrend in the first two months of the quarter. This largely reflects the acceleration in August in realized inflation measures such as core CPI, core PCE, and average hourly earnings. In addition, historically, the change in the crude oil price tends to have a good correlation with inflation expectations. The oil price jumped initially by 20% following the attack on the Saudi Arabian oil production facilities. While it’s not clear how the geopolitical tensions will evolve in the Middle East, a conservative assumption of a flat oil price until the end of the year still points to much higher inflation expectations, supporting our preference for inflation-linked bonds over nominal bonds. We also favor linkers in Japan and Australia over their respective nominal bonds (Chart 21). Chart 20Bond Yields Have Hit Bottom Chart 21Favor Inflation Linkers We continue to look for an entry point into more cyclical markets which would benefit from a bolder Chinese stimulus. Corporate Bonds Since we turned cyclically overweight on credit within a fixed-income portfolio, investment-grade bonds and high-yield bonds have produced 220 and 73 basis points, respectively, of excess return over duration-matched government bonds. We remain bullish on the outlook for credit over the next 12 months, as we expect global growth to accelerate before the end of the year. Historically, improving global growth has resulted in sustained outperformance of credit over government bonds. Moreover, default rates should remain subdued over the next year given that lending standards continue to ease (Chart 22, panel 1). How long will we remain overweight credit? High levels of leverage, declining interest coverage ratios, and the high share of Baa-rated debt in the U.S. corporate debt market continue to make credit a risky proposition on a structural basis. However, with inflation expectations still very low, the Fed has a strong incentive to keep monetary policy easy. This dovish monetary policy should keep interest costs at bay, helping credit outperform over the next year. That said, we believe that there are some credit categories that are more attractive than others. Specifically, we recommend investors favor Baa-rated and high yield securities, given that there is still room for further credit compression in these credit buckets (panel 2 and panel 3). On the other hand, investors should stay away from the highest credit categories, as they no longer offer value (panel 4). Chart 22Baa-rated And High-Yield Credit Offer The Most Value   Commodities Chart 23No Supply Shock In The Oil Market Energy (Overweight): September’s drone attack on Saudi crude facilities sent oil prices soaring as much as 20% in the days following, before falling back to pre-attack levels. Initial estimates estimated the supply disruption at 5.7 million barrels a day – approximately 5.5% of global supply – making it the largest crude supply outage in history. However, assuming the Saudis can return 70% of the lost output back online as they claim, OPEC’s spare capacity, approximately 1.8 million barrels a day, should be able to balance the market and cover the remaining lost production.6,7 In the longer-term, a pick-up in global oil demand, as economic growth rebounds, plus supply tightness should keep oil price elevated, with Brent reaching $70 this year and averaging $74 in 2020 (Chart 23, panels 1 & 2). Industrial Metals (Neutral): A combination of half-hearted year-to-date stimulus by Chinese authorities and a stronger USD in the second and third quarters of 2019 have driven industrial metals spot prices lower. However, the Chinese government announced additional stimulus in September, with further bond issuance to finance infrastructure projects and an easing of monetary policy (panel 3). This should give some upside for industrial metal prices over the coming six-to-12 months. Precious Metals (Neutral): We remain positive on gold, despite its strong performance year-to-date, since we see it as a good hedge against recession, inflation, and geopolitical risks. We discuss gold in detail in the What Our Clients Are Asking section on page 9. Silver also looks attractive in the short term. The nature of the use of silver has changed over the past two decades, from being mostly a base metal for industrial fabrication to becoming more of a precious metal viewed as a safe haven. The correlation between gold and silver prices has increased since the Global Financial Crisis from an average of 0.5 pre-crisis to 0.8 post-crisis (panels 4 & 5). Global growth and political uncertainty should support silver prices in the coming months. Currencies U.S. Dollar: The trade-weighted dollar has appreciated by 2.5% since we turned neutral in April. We expect that the steep drop in yields will continue to ease financial conditions and help global growth in the last quarter of the year. Given that the dollar is a counter-cyclical currency, an environment where global growth rallies have historically been negative for the greenback. Euro: Since we turned bullish in April, EUR/USD has depreciated by 2.7%. Overall, we continue to be positive on EUR/USD on a cyclical timeframe. After the ECB cut rates by 10 basis points and announced further rounds of quantitative easing, there is not much room left for the euro area to keep easing relative to the U.S. (Chart 24, panel 1). Moreover, improving expectations of profit growth in the euro area vis-à-vis the U.S. will drive money flows towards Europe, pushing EUR/USD up in the process (panel 2). Emerging Market Currencies: We remain bearish on emerging market currencies for the time being. That being said, they remain on upgrade watch for the end of the year. There are multiple signs that global growth is turning up, a consequence of the easy financial conditions caused by some of the lowest bond yields on record. Moreover, the marginal propensity to spend (proxied by M1 growth relative to M2 growth) in China, the main engine of EM growth, continues to point to further appreciation in emerging market currencies (panel 3). Chart 24Interest Rate And Profit Expectation Differentials Favor The Euro     Alternatives Chart 25Favor Hedge Funds Untill Global Growth Bottoms Return Enhancers: Over the past 12 months, we have recommended investors pare back on private equity and increase allocations to hedge funds – macro hedge funds in particular. This was due to our judgement that we are late in the economic cycle. While we expect growth to pick up over the coming months, this is not yet clear in the data (Chart 25, panel 1). This uncertain macro outlook will prove tough for private equity funds, especially given an environment of rising multiples and increasing competition for deals. We continue to see global macro hedge funds as the best hedge ahead of the next recession and would advise investors to allocate funds now, given the time it takes to move allocations in the illiquid space. Inflation Hedges: In the current environment, TIPS are likely a better inflation hedge than illiquid alternative assets. Our May 2019 Special Report 8 showed that TIPS produce a particularly attractive risk-adjusted return during times when inflation is rising, but still fairly low (below 2.3%). TIPS should do well, therefore, in the environment we expect over the next few months, where the Fed remains dovish, cutting rates perhaps once more, while condoning a moderate acceleration of inflation (panel 2). Volatility Dampeners: Structured products – mostly Mortgage-Backed Securities (MBS) – have had an excellent record of reducing portfolio volatility (panel 3). Despite that, we do not recommend more than a neutral allocation to MBS currently due to a less-than-attractive valuation picture. Despite Treasury yields falling by more than 100 basis points this year and refinancing activity picking up, nominal MBS spreads remained near their all-time lows. However, as Treasury yields bottom, we expect refinancing to slow, putting downward pressure on spreads. Risks To Our View The most likely upside risk comes from the Fed being too dovish and falling behind the curve. Underlying inflation pressures in the U.S. remain strong (with core CPI up 3.4% annualized over the past three months). After two rate cuts, the Fed Funds rate is now comfortably below the neutral rate: 0.1% in real terms compared to a Laubach-Williams r* of 0.8% (Chart 26). Tightness in the money markets have pushed the Fed to start expanding its balance sheet again. If manufacturing growth accelerates next year, and wages and profits begin to rise, a stock market melt-up, similar to that in 1999, would be possible. Eventually, though, the Fed would need to raise rates (perhaps sharply) to kill inflation, which could usher in the next recession. There are a broader range of possible downside risks. As argued throughout this Quarterly, there are various possible triggers of recession: failure of China to stimulate, and a loss of confidence by consumers, in particular. Some models of recession put the risk over the next 12 months as high as 30% (Chart 27). Structurally, the biggest risk is probably the high level of corporate debt in the U.S. (Chart 28). A breakdown in the junk bond market, as seen briefly last December, could lead to companies failing to refinance the large amount of debt maturing over the next 18 months. Geopolitical risks also remain elevated and are, by nature, hard to forecast. The outcome of Brexit remains highly uncertain – though we see low risk of a no-deal exit. We expect trade talks between the U.S. and China to drag on, without a comprehensive deal, while a clear breakdown would be negative. Impeachment of President Trump is probably not a significant market event, but might hurt market sentiment briefly (particularly if it makes the election of Elizabeth Warren more likely). The Iran/Saudi conflict could escalate. Risk premiums may need to rise to take into account these threats. Chart 26Is The Fed Turning Too Dovish? Chart 27What Risk Of Recession? Chart 28Is Corporate Debt The Biggest Risk?   Footnotes 1Please see Global Asset Allocation Special Report, titled "Euro Area Banks: Value Play Or Value Trap?" dated December 14, 2018, available at gaa.bcaresearch.com. 2 Please see Foreign Exchange Strategy Special Report, “United Kingdom: Cyclical Slowdown Or Structural Malaise?”, dated 20 September 2019, available at fes.bcaresearch.com. 3Please see Global Asset Allocation Quarterly, titled "Quarterly - April 2019" dated April 1, 2019, available at gaa.bcaresearch.com. 4Please see Global Investment Strategy Weekly Report, titled "Bond Yields Have Hit Bottom," dated September 6, 2019, available at gis.bcaresearch.com. 5Please see Global Investment Strategy Weekly Report, titled "Elizabeth Warren And The Markets," dated September 13, 2019, available at gis.bcaresearch.com. 6Dmitry Zhdannikov and Alex Lawler “Exclusive: Saudi oil output to return faster than first thought - sources,” Reuters, dated Sepetmber 17, 2019. 7Please see Geopolitical Strategy Special Alert titled, “Attacks On Critical Infrastructure In KSA Raises Questions About U.S. Response,” dated September 16, 2019, available at gps.bcaresearch.com. 8Please see Global Asset Allocation Special Report, titled “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019, available at gaa.bcaresearch.com GAA Asset Allocation

GAA DM Equity Country Allocation Model Update The GAA DM Equity Country Allocation model is updated as of September 30, 2019.  The country model downgraded Australia from overweight to underweight in order to boost Canada and Sweden to a slight overweight. The other overweight countries remain Italy, Spain, Switzerland, Germany, and the Netherlands. Japan and the U.K. are still deep in underweight territory even though they performed very well in September, as shown in Table 1.  Table 1Model Allocation Vs. Benchmark Weights As Table 2 and Charts 1, 2, and 3 all show, the overall model performed in line with the MSCI World benchmark in September, driven by 15 bps of underperformance from the Level 2 model, offset by 5 bps of outperformance from the Level 1 model. Since going live, the overall model has outperformed by 82 bps, with 278 bps of outperformance by the Level 2 model, offset by 44 bps of underperformance from the Level 1 model. Table 2Performance (Total Returns In USD %) 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)   Furthermore, please refer to our 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 as well when making overall recommendations.   GAA Equity Sector Selection Model Chart 4Overall Model Performance The GAA Equity Sector Model (Chart 4) is updated as of September 30, 2019. The model’s relative tilts between cyclicals and defensives have changed compared to last month. The global growth proxies embedded in the model are behind the bearish tilt on cyclical sectors. The only cyclical sector currently overweight by the model – Information Technology – is favored due to positive inputs from both its liquidity and momentum components. The valuation component has triggered a buy signal in the Energy sector. However, negative inputs from the remaining components do not justify an outright overweight position. All remaining sectors, on the other hand, continue to have a muted valuation component. The model is now overweight 4 sectors in total, 1 cyclical and 3 defensive sectors. These are Information Technology, Consumer Staples, Health Care and Utilities. Table 3Model’s Performance (March 1, 2019 - Current) 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 4Current Model Allocations   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com      

Highlights Corporate Bonds: High corporate debt levels will be a problem for corporate bond investors during the next downturn, but spreads will not respond to them until inflationary pressures mount and monetary policy turns restrictive. Maintain an overweight allocation to corporate bonds versus Treasuries, with a preference for the Baa and high-yield credit tiers. MBS: Agency MBS spreads are competitive with high-rated (Aaa, Aa, A) corporate bonds, and look even more attractive on a risk-adjusted basis. We recommend that investors swap the Aaa, Aa and A-rated corporate bonds in their portfolios for agency MBS. Municipal Bonds: Investors should upgrade municipal bonds from neutral to overweight, given the recent back-up in Municipal / Treasury yield ratios. Within munis, investors should retain a preference for long-maturity Aaa-rated bonds, where yields are most compelling. Feature We attended BCA’s annual Investment Conference last week. The event always provides a good opportunity to hear from some expert panelists and find out what issues are front and center in our clients’ minds. More than anything else, two themes kept popping up in the different presentations and in conversations with attendees: Large corporate debt balances Under-priced inflation risk We can’t help but see a strong connection between the two. On Corporate Debt The consensus among panelists and attendees was very much in line with our own view: Highly levered balance sheets will be a problem for corporate bond investors during the next default cycle, but don’t help us determine when that default cycle will occur. Chart 1 shows that, despite the persistent increase in the debt-to-profits ratio, corporate bankruptcies are well contained. We examined the reasons for this divergence in a recent report, concluding that accommodative monetary policy is holding down the default rate by keeping interest costs low and giving banks the confidence to roll over maturing debt.1 Essentially, banks will look through signs of deteriorating corporate balance sheet health until the Fed shifts to a more restrictive policy stance. Chart 1Corporate Balance Sheets Are In Bad Shape, But Defaults Are Low On Inflation This is where inflation becomes important. The Fed is currently running an accommodative monetary policy because many years of low prices have convinced investors that inflation might never return. As a result, the 10-year TIPS breakeven inflation rate is only 1.53%, well below the 2.3% - 2.5% range consistent with the Fed’s target. The Fed must maintain an accommodative policy stance until it achieves its goal of re-anchoring inflation expectations. Only then will monetary policy turn restrictive, raising the risk of a corporate default cycle. We have long held the view that a 10-year TIPS breakeven inflation rate above 2.3% would cause us to turn much more cautious on corporate credit. It might take many months of core inflation printing near the Fed’s target before investors start to believe that it will stay there indefinitely. Many conference panelists thought that inflation risks are currently under-priced, and while we tend to agree that it is premature to declare the death of the Phillips curve, we expect it will still take some time before inflation expectations hit our 2.3% - 2.5% target range. We have shown in prior research that inflation expectations adapt only slowly to changes in the actual inflation data.2  At present, the fair value reading from our Adaptive Expectations Model of the 10-year TIPS breakeven inflation rate is only 1.94% (Chart 2). This fair value will move higher if inflation continues to print near current levels, but that process will take some time. In other words, it might take many months of core inflation printing near the Fed’s target before investors start to believe that it will stay there indefinitely. Chart 2Adaptive Expectations Model Chart 3Inflation Not Far From Target While the adaptive process might take a long time, it’s important to note that inflation is already quite close to the Fed’s target. Trailing 12-month trimmed mean PCE inflation came in at 1.96% in August, while year-over-year core PCE hit 1.77% (Chart 3). Trimmed mean inflation has been more stable than other inflation measures since the financial crisis, and core PCE has tended to drift toward the trimmed mean over time.      On Corporate Debt & Inflation In our view, the two themes of high corporate debt and under-priced inflation risk are tightly linked. It has taken a very long time for the economy to recover from the financial crisis. As a result, inflation has been low for a prolonged period and the Fed has been forced to maintain an accommodative policy stance. That accommodative policy stance encourages banks to extend credit, and encourages firms to issue debt. Eventually, inflation pressures will mount, the Fed’s policy will turn restrictive and weak corporate balance sheets will be exposed. Only then, will corporate spreads widen significantly. Until that time, the pertinent question is whether corporate spreads offer adequate compensation for the risk that inflationary pressures emerge earlier than anticipated. For now, our answer is yes, with the caveat that the risk/reward trade-off is more attractive in the lower credit tiers. The 12-month high-yield breakeven spread is very attractive, well above its historical median (Chart 4). But within investment grade, we view only the Baa-rated credit tier as offering adequate compensation (Chart 4, bottom panel). There are better alternatives to owning Aaa, Aa and A-rated corporate bonds, as discussed in the next section. Chart 4Corporate Bond Valuation Favor Agency MBS Over High-Rated Corporate Credit Chart 5MBS More Attractive Than High-Rated Corporate Bonds As noted above, investment grade corporate bonds rated A or higher don’t offer much expected compensation at current spread levels. In fact, our prior research notes that their spreads are already below our cyclical targets.3 But on the plus side, the average option-adjusted spread (OAS) for conventional 30-year agency MBS has widened in recent months and now looks like an attractive alternative to high-rated corporate credit. We recommend that investors shift out of Aaa, Aa and A-rated corporate credit and into agency MBS for three reasons. 1) Expected Compensation Is Competitive The average OAS for conventional 30-year agency MBS now stands at 52 bps. This is only 6 bps below the average OAS offered by a Aa-rated corporate bond, and 37 bps less than that offered by an A-rated credit (Chart 5). That’s not bad for a Aaa-rated bond with agency backing. 2) Risk-Adjusted Compensation Is Stellar MBS spreads look much more attractive when we consider the risk profile. Specifically, when we consider that the average duration of the MBS index has fallen sharply this year, while the average duration of the investment grade corporate bond index has risen (Chart 5, panel 2). In fact, the average duration of the MBS index is only 2.9, compared to 7.8 for an A-rated corporate bond. This means that the MBS spread needs to widen by 18 bps over the next 12 months for an investor to see losses, while the A-rated spread needs to widen by only 11 bps (Chart 5, bottom panel). We recommend that investors shift out of Aaa, Aa and A-rated corporate credit and into agency MBS. Because MBS exhibit negative convexity, their duration declines when yields fall. By contrast, non-callable investment grade corporate bonds have positive convexity and have seen their durations rise. This means that, all else equal, negatively convex securities start to look more attractive on a risk-adjusted basis after a large decline in bond yields. This is also the main reason why negatively convex high-yield corporate bonds currently look much more attractive than investment grade corporate bonds.4 Interestingly, MBS did not look so attractive relative to corporate bonds in 2015/16, the last time that MBS index duration fell sharply. That’s because corporate bond spreads also widened during that period. This time around, corporate bond spreads have been stable as MBS index duration has plunged. Unless you think that Treasury yields have further downside, which we do not,5 agency MBS look like a good buy. 3) Macro Risks Are Lower While, as discussed above, we are not yet sounding the alarm about the macro risks to corporate bonds, we are even less concerned about the macro risks surrounding agency MBS. Mortgage refinancing activity is the most important macro driver of MBS spreads, and it should stay relatively low for a very long time. At such low mortgage rates, most homeowners have already had an opportunity to refinance, so refi burnout is currently very high. This is obvious when we observe that there was only a small spike in refi activity this year, despite a very large decline in mortgage rates (Chart 6). Chart 6Muted Refi Activity Will Keep Nominal Spreads Low Chart 6 also shows that the nominal MBS spread is highly correlated with refi activity, and that it remains near its historical tights. This spread contains both the OAS – which is a proxy for an MBS investor’s expected return – and the portion of the spread that is expected to be lost as a result of prepayment activity. The fact that the OAS is reasonably elevated compared to history while the overall nominal spread remains low means that MBS are pricing-in very little buffer for prepayment losses. Given the macro back-drop, this seems appropriate. Beyond refi risk, we also note that the credit quality of outstanding mortgages remains very high. The median FICO score on new mortgages has barely come down since the financial crisis (Chart 7). Further, while mortgage lending standards have been easing for the bulk of the post-crisis period, the Fed’s July Senior Loan Officer survey reported that the banks that view lending standards as tighter than the post-2005 average outnumber those that view standards as easier. Stronger housing activity data generally lead to higher mortgage rates, which in turn limit refi activity. Finally, there is very little reason to be concerned about significant weakness in housing activity. Of the six major housing activity data series that we track, all have rebounded sharply since this year’s drop in mortgage rates (Chart 8). Stronger housing activity data generally lead to higher mortgage rates, which in turn limit refi activity. Chart 7Mortgage Lending Standards Are Tight Chart 8Housing Activity Hooking Up   Bottom Line: Agency MBS spreads are competitive with high-rated (Aaa, Aa, A) corporate bonds, and look even more attractive on a risk-adjusted basis. We recommend that investors swap the Aaa, Aa and A-rated corporate bonds in their portfolios for agency MBS. Upgrade Municipal Bonds On July 23, we advised investors to reduce municipal bond exposure from overweight to neutral.6 The rationale was purely valuation driven. We saw no immediate signs of municipal credit distress, but noted that yields were simply too low relative to the alternatives. Today, we similarly see no signs of immediate credit distress. In fact, municipal bond ratings upgrades continue to outpace downgrades, our Municipal Health Monitor remains in “improving health” territory and state & local government interest coverage is strong (Chart 9).7 Chart 9Muni Credit Quality Is Not A Concern The difference, however, is that yield ratios have rebounded dramatically since early August, and municipal bonds have once again become attractive (Chart 10). Chart 10Munis Attractive Once Again Bottom Line: Investors should upgrade municipal bonds from neutral to overweight, given the recent back-up in Municipal / Treasury yield ratios. Within munis, investors should retain a preference for long-maturity Aaa-rated bonds, where yields are most compelling.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Weekly Report, “Corporate Bond Investors Should Not Fight The Fed”, dated September 17, 2019, available at usbs.bcaresearch.com 4 The high-yield bond index is negatively convex because most high-yield credits carry embedded call options. Investment grade corporate bonds tend to be non-callable. 5 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Municipal Health Monitor please see U.S. Bond Strategy Special Report, “Trading The Municipal Credit Cycle”, dated October 18, 2016, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The world remains mired in a manufacturing recession. As such, it is still too early to put on fresh pro-cyclical trades. Focus on the crosses rather than outright U.S. dollar bets. Two new trade ideas: sell EUR/NOK and buy GBP/JPY. Also consider selling the gold/silver ratio. Feature Currency markets tend to trade into and out of various regimes. This means that to be an effective FX manager, you have to be extremely fluid. For example, interest rate differentials might dominate FX moves during a particular period, pivoting your job to a central bank monitor. Other times, flows dominate, perhaps even equity flows, like when a disruptive technology is developed in a specific market. The outperformance of U.S. equities, specifically technology stocks, is a case in point. Balance-of-payments dynamics usually matter mostly at critical turning points, making them not very useful as timing indicators. The exorbitant privilege of the U.S. dollar we discussed a fortnight ago is also a case in point. But more often than not, being able to identify whether the investment climate is about to become more hostile or not could be the key difference between being a successful FX manager or a relic. There has been no shortage of news for investors to digest over the last few days, from the Brexit imbroglio, to the Fed, to the drone attacks in Saudi Arabia and finally to U.S. President Donald Trump’s possible impeachment. But the most perplexing (and perhaps the most important) has been the German manufacturing flash PMI print for the month of September of 41.4, the lowest in over a decade (Chart I-1). If the country with the “cheapest currency” cannot manage to pull itself out of a manufacturing recession, then the message to the periphery is clearly that they have an impending problem. In short, our contention that the euro was close to a bottom might be offside by a few months, based on the latest manufacturing data release (Chart I-2). Chart I-1A Eurozone Manufacturing Recession Chart I-2The Euro Needs Stronger Growth Which FX Regime? Chart I-3A Recession Will Be Dollar Bullish The performance of the dollar since the 10/2 yield curve inverted is instructive. So far, we are tracking both the 2005 and 1998 roadmaps, meaning the window for cautious optimism on risk assets could still pan out (Chart I-3). Specifically, the dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long. In both 2006 and 1998, the dollar eventually catapulted higher, but it took longer than 12 months. Having an accurate recession probability-timing model is therefore crucial for strategy. Historically, domestic flows have been a very timely indicator, since repatriation by residents occurs during episodes of severe capital flight. In 2005, domestic individuals were deploying funds outside the U.S., which suggested patience before positioning for dollar strength. This made sense, since the return on capital was higher outside the U.S. with the EM and commodity bull market in full swing. More often than not, FX markets tend to favor regions with the highest return on capital. These tend to be the most difficult to bet against, but potentially the most potent blindside at turning points. If economic data continues to deteriorate due to much larger endogenous factors, a defensive strategy is clearly warranted. One way to tell will be an emerging divergence between our leading indicators and actual underlying data as is occurring so far in September. On the flip side, any specter of positive news could light a fire under sectors, currencies and countries that have borne the brunt of the slowdown. Both are highly risky bets. For now, we prefer to focus on the crosses rather than outright U.S. dollar bets. Sell EUR/NOK Sometimes, the best ideas are the simplest ones. The Norges bank is the most hawkish G-10 central bank, while the European Central Bank restarted QE at its latest meeting. This is a powerful catalyst for a short EUR/NOK trade: The dollar tends to rally during recessions but the window before the dollar bull market takes hold can be quite long.  The slowdown in the euro zone has been concentrated in the manufacturing sector, but the deflationary impulse is starting to shift to other parts of the economy. Euro area overall core CPI continues to blast downwards, which has historically been a bad omen for the euro (Chart I-4). We expect euro zone inflation expectations to eventually rise, in part helped by the recovery in oil prices (Chart I-5), but this will also benefit the Norwegian krone. EUR/NOK has historically tracked the performance of relative stock prices between Europe and Norway, but a gaping wedge opened up in 2018 (Chart I-6). This divergence is unsustainable. In short, it is a bet on oil fields in Norway versus European banks. The ECB’s tiering of reserves might prevent euro zone banks from teetering over the edge, but unless the manufacturing recession ends soon and firms start to borrow to invest, banks will continue to have a demand problem. Meanwhile, the flareup in the Middle East means that oil prices will remain bid in the near term. This should favor Norwegian equities over those in the euro zone, and be negative for EUR/NOK (Chart I-7). 10-year German bunds are yielding -0.57% while the yield pickup on Norwegian bonds is a positive carry of 1.8%, despite liquidity concerns. In their latest policy meeting, Central Bank Governor Øystein Olsen stressed that Norway had much more fiscal room to maneuver in the event of a downturn, meaning the supply of Norwegian paper could increase, easing the liquidity premium. Chart I-4Deflation Remains Predominant In The Eurozone Chart I-5A Rise In Oil Prices Will Help Inflation Expectations Chart I-6Stocks And Currencies: An Unsustainable Divergence Chart I-7Higher Oil is Negative ##br##For EUR/NOK Bottom Line: Sell EUR/NOK at 9.937. Buy GBP/JPY Last week’s Special Report made the case for a cyclical recovery in the U.K., even though structural factors remain a headwind. This week, we are re-attempting to buy cable versus the yen: Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance. Real interest rate differentials favor a stronger pound. Most importantly, the Bank of England stood pat at its latest policy meeting while the Bank of Japan is likely to introduce more stimulus or stronger guidance (Chart I-8). Chart i-8A Tactical Bounce In GBP/JPY Is Likely Chart I-9The Benefit Of A Weaker Pound Speculators are very short the pound while they have been covering their short bets on the yen, as the investment environment has become more uncertain. The fall in the pound should begin to improve the U.K.’s balance-of-payment dynamics relative to Japan (Chart I-9). Bottom Line: Buy GBP/JPY at 132.6. Concluding Thoughts We continue to track various indicators for the dollar, from interest rate differentials, balance-of-payment dynamics, valuations, portfolio flows and positioning – and none of them are sending a bullish signal at the moment. Global growth remains in a funk, which has been supercharging dollar bulls. However, long-dollar bets remain susceptible should global growth stabilize. Our strategy is to continue focusing on the crosses until categorical evidence emerges that global growth has bottomed.  In our trading portfolio, we continue to favor the NOK, SEK, petrocurrencies and the AUD. So far, these trades have been implemented at the crosses to limit downside risk, should our view on the dollar be offside. We intend to eventually start placing outright dollar bets once evidence emerges that global growth has bottomed and the world has skidded a recession.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been relatively strong: The Markit flash manufacturing PMI rebounded to 51 in September from 50.3. Flash services PMI increased to 50.9. The Chicago Fed national activity index increased to 0.1 from -0.4 in August. The Richmond Fed manufacturing index fell to -9 in September from 1. The Conference Board consumer confidence fell to 125.1 in September from 135.1. On the housing front, home prices grew by 0.4% month-on-month in July. Mortgage applications decreased by 10% for the week ended September 20th, but new home sales increased by 7% month-on-month in August. Initial jobless claims increased to 213,000 for the week ended September 20th. Annualized GDP growth was unchanged at 2% quarter-on-quarter in Q2. Trade deficit of goods was little changed at $72.8 billion. Headline and core PCE increased to 2.4% and 1.9% quarter-on-quarter, respectively in Q2. The DXY index appreciated by 0.6% this week. The recent data from the U.S. have been holding up quite well compared with the rest of the world. Net speculative positions on the greenback remain elevated due to U.S. relative strength. While we see dollar resilience in the near term, declining net foreign purchases of U.S. securities, diminishing interest rate differentials and the plunging bond-to-gold ratio all suggest the path of least resistance for the dollar is down. Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area continue to deteriorate: The Markit flash manufacturing and services PMIs for the euro area both fell to 45.6 and 52, respectively in September. In France, the Markit flash manufacturing PMI fell to 50.3; services PMI decreased to 51.6. In Germany, the manufacturing PMI collapsed to 41.4; services PMI fell to 52.5. German IFO current assessment increased to 98.5 in September. However, the IFO expectations fell to 90.8. Monetary supply (M3) grew by 5.7% year-on-year in August. German Gfk consumer confidence nudged up to 9.9 in October. The EUR/USD fell by 0.8% this week. The recent data from the euro area has unfortunately showed no signs of global growth bottoming. The manufacturing PMI in Germany is now at its lowest level since the Great Financial Crisis. A major concern faced by investors is that weak activity in manufacturing may have already begun to infiltrate the service sectors. That said, the services PMIs in major economies, though falling, still remain in expansionary territory above 50. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japense Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: National headline inflation fell from 0.5% year-on-year to 0.3% year-on-year in August. Core inflation was unchanged at 0.6% year-on-year. The Markit flash manufacturing PMI fell to 48.9 in September from 49.3. Services PMI also fell to 52.8 from 53.3. The leading index and coincident index were both little changed at 93.7 and 99.7, respectively, in July.  The USD/JPY has been flat this week. Japanese exports have been weak, weighed by the global trade war and manufacturing slowdown. However, accordingly to the BoJ, domestic demand has remained firm, and capex also continues to increase. Moreover, the consumption tax hike next month will probably have a marginal impact compared with previous tax hikes. In a speech this week, BoJ Governor Haruhiko Kuroda emphasized that the central bank will ease without hesitation if the economy loses momentum. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 There is little data from the U.K. this week: Mortgage approvals decreased slightly to 42,576 in August from 43,303 in July. The GBP/USD fell by 1.4% this week. British Prime Minister Boris Johnson has now lost his majority in Westminster after large profile defections from the so-called rebels, thus another election is highly likely by year-end. Besides, a further delay of Brexit is almost certain. We have downgraded the probability for a no-deal Brexit. We remain positive on the pound and are buying GBP/JPY this week. Report Links: United Kingdon: Cyclical Slowdown Or Structural Malaise? - September 20, 2019 Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: The preliminary commonwealth manufacturing PMI fell to 49.4 in September from 50.9 in August. On the other hand, the services PMI rebounded to 52.5 from 49.1, back to above-50 expansionary territory. Consumer confidence increased to 110.1 from 109.3 this week. The AUD/USD fell by 1% this week. Reserve Bank of Australia Governor Philip Lowe commented on Tuesday that the Australian economy is picking up, and is now at a “gentle turning point.” The previous rate cuts have allowed the property markets in big cities like Sydney and Melbourne to regain some strength, but will likely take longer to flow through the whole economy. In terms of monetary policy, Governor Lowe reiterated his commitment to ease monetary conditions when needed, though he did not signal an imminent move for next week. Australia has a large beta to global shifts as a small, open economy. Should the global manufacturing recession come to an end, the positive fundamentals will continue to lift the Australian economy through the rest of the year and into 2020. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Imports increased by NZ$30 million to NZ$5.69 billion in August, while exports fell by NZ$830 million to NZ$4.13 billion. The total trade deficit widened from NZ$700 million to NZ$1.57 billion. The NZD/USD appreciated by 1% initially, then plunged after the Reserve Bank of New Zealand’s policy meeting, returning flat this week. As widely expected, the RBNZ kept its official cash rate unchanged at 1% this Wednesday while signaling that there is more scope to ease if necessary amid a global slowdown. The market is currently pricing an 80% probability of a rate cut for the next policy meeting in November, reflecting weak business confidence. We are playing the kiwi weakness through the Australian dollar and Swedish krona, which are 1.9% and 1.95% in the money, respectively. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been resilient: Bloomberg Nanos confidence increased to 57.4 this week from 56.7. Retail sales increased by 0.4% month-on-month in July, lower than the expectations of a 0.6% monthly growth. The USD/CAD has been flat this week. Oil prices have been on a wild ride this year. Since the drone attack a fortnight ago, Saudi Arabia has claimed that it is recovering faster than expected, beating its own targets. Brent crude oil spot prices have fallen by 6% from their September 16th peak, while Western Canada Select (WCS) oil prices have dropped by 12.3%, dampening the loonie’s upside potential. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: The trade balance narrowed to CHF 1.2 billion in August from CHF 2.6 billion in July.  Credit Suisse survey expectations came in at -15.4 in September, up from the last reading of -37.5 in August. The USD/CHF has been flat this week. As a small, open economy, Switzerland belongs to those countries with highest foreign trade-to-GDP share. The trade balance in August has been the lowest since January 2018, with lower exports of main goods including chemical and pharmaceutical products. Among trading  partners, exports to Germany, Italy, and France all declined, reflecting the recent manufacturing slowdown in Europe. That said, we remain positive on the safe-haven Swiss franc during the risk-off period amid trade war uncertainties, Brexit chaos, Middle-East tensions, and more recently, the Trump Impeachment imbroglio. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is scant data from Norway this week: The unemployment rate increased to 3.8% in July, 0.6 percentage points higher than in April, accordingly to the recent Labour Force Survey. The USD/NOK appreciated by 0.5% this week. The Norges Bank, the one and only hawkish central bank among the G-10, raised its interest rate by 25 basis points to 1.5% last week. Since last September, the Norges Bank has hiked rates four times in total, resulting in a one-percentage-point increase in rates. The central bank stated that “the Norwegian economy has been solid; Employment has risen; Capacity utilization appears to be somewhat above a normal level; Inflation is close to target.” A higher interest rate would also help take the wind out of skyrocketing house prices and household debt levels. In addition, the central bank lowered its projection path for the krone, stating that the factors it outlined, including weaker activity in the petroleum sector, would probably keep weighing on the krone in the years ahead. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been negative: Consumer confidence fell to 90.6 in September. PPI yearly growth fell from 2% in July to 1.4% in August. Trade balance shifted to a deficit of SEK 5.4 billion in August. USD/SEK has been flat this week. We are closely monitoring the Swedish foreign trade as a leading indicator for global growth. The Swedish trade balance has shifted to a deficit for the first time this year. However, compared to last August, the deficit was narrowed by SEK 2.6 billion. Year to date, the Swedish trade surplus amounted to SEK 27 billion. Notably, the trade in goods with non-EU countries resulted in a surplus of SEK 6.6 billion, while the trade with EU resulted in a deficit of SEK 12 billion. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights Portfolio Strategy The contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. It no longer pays to be overweight gold mining equities as sentiment is stretched, the restarting of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on global gold miners. EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Recent Changes Trim the Global Gold Mining index to neutral, today. Downgrade the S&P Materials sector to underweight, today. Table 1 Feature Equities broke out of their trading range last week, but in order for this short-covering rally to become durable, and for volatility to subside, either global growth needs to turn the corner and alleviate recession fears or the trade war needs to de-escalate materially. On the recession front Central Banks (CBs) are doing their utmost to reflate their respective economies, but the early stages of looser monetary policy have been insufficient to change the global growth trajectory. With regard to the trade war, markets cheered the news that talks between the U.S. and China will resume in September and October. The dates for talks are conveniently chosen to follow the September FOMC meeting and the October 1 70th anniversary of the People's Republic of China. The latter date implies that Washington is considering delaying the October 1 tariff hike – and it could imply that Washington does not anticipate any violent suppression of Hong Kong protesters by that time. However, the harsh reality is that the two sides are just “kicking the can down the road”. The longer the Sino-American trade war takes to conclude, the more likely it will serve as a catalyst for a repricing of risk significantly lower (top panel, Chart 1). A technical correction may be necessary to force Trump to reduce the trade pressure significantly. Even if the October 1 tariff hike is postponed it will remain a source of uncertainty ahead of the final tariff tranche slated for December 15. The bond market may offer some clues as to the extent that the escalating trade war will eventually get reflected into stocks (bottom panel, Chart 1). The equity transmission mechanism is through the earnings avenue. Simply put, rising trade uncertainty deals a blow to global trade that boosts the U.S. dollar which in turn makes U.S. exports uncompetitive in global markets, deflates the commodity complex and with a lag weighs on SPX earnings. Chart 1Tracking Trade Uncertainty Speaking of the economically hypersensitive manufacturing sector, last week’s ISM release made for grim reading, further fueling recession fears (the New York Fed now pegs the recession probability just shy of 38% by next August). Not only did the overall survey fall below the boom/bust line (middle panel, Chart 2), but also new orders collapsed. In fact, the drubbing in new orders is worrying and it signals that the economy is going to get worse before it gets better (top panel, Chart 2). Tack on the simultaneous rise in inventories, and the sinking new orders-to-inventories ratio (not shown) warns of additional manufacturing ills in the coming months. Importantly, export orders suffered the steepest losses plunging to 43.3. The last three times that this trade-sensitive survey subcomponent was in such a steep freefall were in 1998, 2001 and 2008, when the SPX suffered peak-to-trough losses of 20%, 49% and 57%, respectively. In fact, since the history of the data, ISM manufacturing export orders have never been lower with the exception of the GFC (Chart 3). Such a retrenchment will either mark the bottom for equities or is a harbinger of a steep equity market correction. We side with the latter as the odds of President Trump striking a real trade deal (including tech) with China any time soon are low. Chart 2Like Night Follows Day Similar to the ISM manufacturing/non-manufacturing divergence (bottom panel, Chart 2), business confidence is trailing consumer conference by a wide mark. Historically this flaring chasm has been synonymous with a sizable loss of momentum in the broad equity market (Chart 4). One plausible explanation is that as business animal spirits suffer a setback, CEOs are quick to prune/postpone capex plans and, at the margin, corporations retrench and short-circuit the capex upcycle. Chart 3Export Carnage Chart 4Mind The Gap Circling back to last week’s capex update, national accounts corroborate the financial statement data deceleration, and in some cases contraction, in capital outlays (Chart 5). As a reminder our thesis is that the EPS-to-capex virtuous upcycle is morphing into a vicious down cycle.1 This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Crucially, tech investment, that comprises almost 30% of total investment according to national accounts, is decelerating, R&D and other intellectual property investment have also hooked down, non-residential structures are on the verge of contraction, and industrial, transportation and other equipment –that have the largest weight in U.S. capex – are also quickly losing steam (Chart 6). Chart 5Capex Blues Chart 6All Capex Segments… In more detail, Charts 7 & 8 further break down capital outlays in the respective categories and reveal that worrisomely the investment spending slowdown is broad based. Chart 7…Have Rolled Over… Chart 8…Except For One Adding it all up, the contracting manufacturing sector that rekindled recession fears, the harsh reality of the Sino-American trade war weighing on profits, downbeat business confidence and mushrooming capex slowdown signals all warn that investors should tread carefully in the historically difficult equity market months of September and October. As a reminder, this is U.S. Equity Strategy service’s view and it contrasts with BCA’s sanguine equity market house view. This week, we downgrade a deep cyclical sector by taking profits in a niche subgroup that has served as a reliable portfolio hedge. Downgrade Materials To Underweight… Heightened economic and trade policy uncertainty has claimed the S&P materials sector as one of its victims (Chart 9). Given that our Geopolitical Strategy service’s base case remains that there will be no Sino-American trade deal by the U.S. November 2020 election, there is more downside for materials stocks and we are downgrading this niche deep cyclical sector to a below benchmark allocation.2 Beyond the U.S./China trade war inflicted wounds that materials stocks have to nurse, there are four major headwinds that they will also have to contend with in the coming months. Chart 9Trade Uncertainty Sinking Materials First, the emerging markets (EM) in general and China in particular are in a prolonged soft patch that predates the Sino-American trade war. EM stocks and EM currencies are both deflating at an accelerating pace warning that relative share prices will suffer the same fate (Chart 10). Nothing epitomizes the infrastructure spending/capex cycle more than China’s insatiable appetite for commodities and the news on that front remains dire. The Li Keqiang index continues to emit a distress signal and that is negative for materials top line growth (bottom panel, Chart 10). Second, global inflation is in hibernation and select EM producer price inflation growth series are on the verge of contraction or already outright contracting. Chinese raw materials wholesale prices are in the deflation zone and warn that U.S. materials sector profits will underwhelm (Chart 11). Chart 10Bearish EM… Chart 11…And China Backdrops Base metal prices are a real time indicator of the wellness of the S&P materials sector. Currently, base metals are deflating both on the back of a firming U.S. dollar and contracting global manufacturing. Such a commodity price backdrop is dampening prospects for a profit-led materials sector relative share price recovery (top & middle panels, Chart 12). Third, the materials exports outlook is darkening. Apart from the deflating effect the appreciating U.S. dollar has on commodities it also clips basic materials companies’ exports prospects. How? It renders materials related exports uncompetitive in international markets leading to market share losses. Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Chart 12Weak Pricing Power And Declining Exports In addition, the latest ISM export order subcomponent plunged to multi-year lows reflecting trade war pessimism and falling global end-demand. The implication is that the export relief valve is closed for materials equities (bottom panel, Chart 12). Finally, materials sector financial statement metrics are moving in the wrong direction. Net debt-to-EBITDA is rising anew and interest coverage has likely peaked for the cycle at a time when free cash flow generation has ground to a halt (Chart 13). U.S. Equity Strategy’s S&P materials sector profit growth model encapsulates all these moving parts and warns that a severe profit contraction phase looms (Chart 14). Chart 13Financial Statement Red Flags Chart 14Model Says Sell Netting it all out, EM and China ills, deflating global producer pricing power, export blues and souring financial statement metrics underscore that materials stocks have ample downside. Bottom Line: The time is ripe to downgrade the S&P materials sector to underweight. …Via Trimming Gold Miners To Neutral The way we are executing this downgrade in the materials sector to an underweight stance is by trimming the global gold mining index to a benchmark allocation. Our thesis that gold stocks serve as a sound portfolio hedge remains intact and underpinned when: economic and trade policy uncertainty are on the rise (top panel, Chart 15) global CBs start cutting interest rates and in some cases doubling down on negative interest rates currency wars are overheating Nevertheless, what has changed is the price, and we deem that global gold miners that have gone parabolic are in desperate need of a breather. The top panel of Chart 16 shows that gold stocks have rallied 58% since the May 5, 2019 Trump tweet. This outsized four-month relative return is remarkable and likely almost fully reflects a very dovish Fed and melting real U.S. Treasury yields (TIPS yield shown inverted, bottom panel, Chart 15). A much needed pause for breath is required before the next leg of the relative rally resumes, and we opt to move to the sidelines. Chart 15Positive Backdrop… Chart 16…But Reflected In Prices Moreover, on the eve of the ECB’s September meeting, were President Mario Draghi to re-commence QE in the form of sovereign and corporate bond purchases as markets participants expect, counterintuitively a selloff in the bond markets would confirm that QE and its signaling is working (bottom panel, Chart 16). Ergo, this would likely exert upward pressure on global interest rates including the U.S., especially given the one-sided positioning in the respective global risk free assets. The implication is that the shiny metal and global gold miners would suffer a setback as real yields would rise further. As a reminder, gold bullion yields nothing and gold mining equities next to nothing, thus when competing safe haven assets at the margin start yielding higher, investors flee gold and gold miners and flock to risk free assets. Sentiment toward gold and global gold miners is stretched. Gold ETF holdings are at multi-year highs (second panel, Chart 17) and gold net speculative positions are at a level that has marked previous reversals. In addition, bullish consensus on gold is near 72%, a percentage last reached in 2012 (third & bottom panels, Chart 17). Similarly, relative share price momentum is also warning that global gold mining equities are currently extended (bottom panel, Chart 18). Chart 17Extreme… Chart 18…Sentiment Finally, while the bond market’s view of 100bps in Fed cuts in the next 12 months should have undermined the trade-weighted U.S. dollar, it has actually defied gravity and slingshot to fresh cycle highs. This is a net negative both for gold and gold mining equities as the underlying commodity is priced in U.S. dollars and enjoys an inverse correlation with the greenback. The implication is that the multi-decade inverse correlation will hold and will likely pull down gold and gold mining equities at least in the short-run (U.S. dollar shown inverted, Chart 19). In sum, the exponential rise in global gold miners is in need of a breather. Sentiment is stretched, the restating of global QE will likely reverse or at least halt the drubbing in global yields and the U.S. dollar inverse correlation should reassert itself and weigh on relative share prices Chart 19Gold Miners/Dollar Correlation Re-establishment Risk Bottom Line: Downgrade the global gold mining index to neutral, but stay tuned.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com Footnotes 1      Please see U.S. Equity Strategy Weekly Report, “Capex Blues” dated September 3, 2019, available at uses.bcaresearch.com 2      Please see The Bank Credit Analyst Special Report, “Big Trouble In Greater China” dated August 29 , 2019, available at bca.bcaresearch.com Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives   (downgrade alert) Favor value over growth Favor large over small caps

Highlights The fundamental backdrop continues to be mixed, but last week’s key data releases were encouraging on balance: While the U.S. manufacturing ISM survey entered contraction territory, and European manufacturing PMIs remained moribund, the services surveys were quite strong, and services contribute much more to developed economies’ total output. The U.S. economy should be able to grow at trend for the next six to twelve months: Consumption is underpinned by a robust labor market, federal government spending will not flag ahead of the 2020 elections, and state and local revenues are well supported. Investment is unlikely to sabotage the other two pillars of the U.S. economy. The view that inflation is deader than New York Mayor de Blasio’s presidential ambitions is widespread and entrenched: Participating on a panel at an inflation-themed conference last week, we were struck by the conviction that inflation is going nowhere over the next few years. The risk-reward of taking the other side of that debate may be quite attractive. Feature Another week, another mixed set of data releases. Last Tuesday, the bears’ most cherished fantasies seemed to be within reach as the ISM Manufacturing Index slid below the boom-bust line in a print that fell well short of consensus expectations. The S&P 500, which had probed around August’s 2,945 resistance level in the final pre-Labor Day session, quickly shed more than a percentage point in response. The U.S. data confirmed the message from the previous day’s European manufacturing PMIs: global manufacturing remains in a deep funk, and a turnaround is not yet at hand. It’s hard to get a recession without tight monetary policy, and it’s hard to get a bear market without a recession, ... Wednesday’s European services PMI releases gave the bulls a lift. Though manufacturing activity truly stinks (Chart 1), it shows no signs of contaminating the services sector, which is still expanding at a solid clip (Chart 2). The U.S. ISM Non-Manufacturing Index surged in August, beating consensus expectations by the same two-point margin by which manufacturing fell short. U.S. equities were already trading higher on the back of an imminent resumption of U.S.-China negotiations when the series was released Thursday morning, and the combination helped the S&P 500 decisively break through the level that had held it in check for a month (Chart 3). Chart 1Global Manufacturing ##br##Is Ailing ... Chart 2... But The Service Sector Is Expected To Expand Chart 3Breakout Taking a step back from the consistently mixed data, recessions don’t occur when monetary conditions are easy. Equity bear markets rarely occur outside of recessions, so our default position is to remain at least equal weight equities in a balanced portfolio. We estimate that the equilibrium fed funds rate is somewhere in the neighborhood of 3 to 3.25%, so the monetary backdrop remains comfortably accommodative with fed funds at 2.25% and seemingly heading to 2% or lower in the coming months. Our estimate of equilibrium is no more than an estimate, however, so we are reprising our analysis of where consumption, investment and government spending are headed over the next six to twelve months. We remain constructive on the basis of that analysis. The GDP Equation GDP is the sum of consumption, investment, government spending and net exports. Rendered as an equation, GDP = C + I + G + (X-M). Net exports are not terribly meaningful for the comparatively closed U.S. economy, and we take a small fixed trade deficit as a given, so we reduce the equation to GDP = C + I + G. Ex-trade, consumption accounts for two-thirds of output, and fixed investment and government spending for one-sixth each. At four times each of the other components’ weight, consumption is the dominant driver of U.S. activity. Investment is considerably more variable, however, making it more likely to wipe out trend growth from the other drivers (Chart 4). As we showed the first time we performed the (C+I+G) analysis, investment would only have to fall to 0.83 standard deviations below its long-run mean to zero out 2% growth in consumption and government spending.1 Chart 4Investment Is The Wild Card In a normal distribution, events 0.83 or more standard deviations below the mean are expected to occur randomly about 20% of the time. It would take a -1.31-sigma consumption event (probability ≈ 10%) to zero out 2% growth in the rest of the economy. An expansion-killing decline in government spending would be a -1.86-sigma event (probability ≈ 3%). Investment is most likely to be the swing factor tilting the economy in the direction of a recession. Consumption Both retail sales and personal consumption expenditures have accelerated since early April (Chart 5). A robust labor market should continue to support consumption spending, as our payroll model projects a pickup in hiring (Chart 6, top panel), thanks to more ambitious NFIB hiring plans (Chart 6, second panel) and falling initial unemployment claims (Chart 6, bottom panel). Job openings are at their highest level in the 19-year history of the series, indicating that demand for new employees is high, and an elevated quits rate indicates that employers are paying up to poach workers from each other to satisfy that demand. We reiterate that more Americans will be working at the end of 2019 than at the end of 2018, and that all of them will be getting paid more, on average. A robust labor market will give household incomes a boost, and solid balance sheets will give them leave to spend it. Households don’t have to spend income gains, however. If they choose instead to save them, or divert them to paying down debt, consumption won’t get much of a near-term boost. The state of household balance sheets is also a driver of consumption’s direction, and they’ve improved at the margin since our last review. The savings rate moved sharply higher in the interim (Chart 7, top panel) and household debt as a share of GDP ticked lower (Chart 7, second panel), while the burden of servicing existing debt remains light (Chart 7, bottom panel). Chart 5Consumption Is Healthy Chart 6Hiring Is Poised To ##br##Tick Higher, ... Chart 7... And Households Are In A Position To Spend Bottom Line: Consumption remains well supported and will likely continue to be over a six- to twelve-month horizon. Investment Despite hopes that the reduction in corporate income tax rates and immediate expensing of qualified investments would promote capital expenditures, growth in nonresidential fixed investment has been uninspiring. Looking ahead, surveys of corporate investment intentions are decent coincident indicators of capex, and their monthly releases provide some leading insights into quarterly GDP investment. Capital spending plans in the NFIB small business survey have bounced since early April (Chart 8, top panel), but capex plans in the regional Fed surveys have weakened (Chart 8, bottom panel). Although both surveys have turned down, they remain at fairly elevated levels, suggesting that an investment plunge capable of negating trend growth in consumption and government spending is unlikely. Chart 8Neither Here Nor There Residential investment is less than a quarter of nonresidential investment and therefore typically only has a marginal impact on investment. It remains in a slump, with momentum in starts and permits sputtering (Chart 9, top panel); existing home sales running in place (Chart 9, middle panel); and inventories of homes for sale up since April, albeit still at low levels relative to history (Chart 9, bottom panel). Despite a sharp decline in mortgage rates since the end of last year, housing activity has failed to revive. Conversations with various market participants lead us to believe that zoning restrictions, sparse quantities of affordable land, difficulty in assembling construction crews, and a general idling of smaller developers in the wake of the crisis have all contributed to insufficient supplies of the entry-level and first-move-up homes for which there is ample demand. Chart 9Housing Is Weaker Than It Should Be, But It Doesn't Mean The Economy Is In Trouble Bottom Line: Neither nonresidential nor residential investment appears vulnerable enough to spark a decline in investment that could cause the economy to stall out. Government Spending All systems are go from a fiscal perspective. The federal spending taps will surely be open in a hotly contested presidential election year. State income and sales tax revenues have improved since our last review in April (Chart 10, top two panels), and should be well supported by a strong labor market. Solid home price appreciation will nudge the appraisals underpinning property taxes higher (Chart 10, third panel), supporting municipal tax receipts. Government spending will continue to hold up its end. Chart 10State And Local Revenues Will Hold Up Is Inflation Dead? Chart 11Another Upleg Is Coming We participated in a panel discussion last week at an inflation-linked products conference. The panel included Fed researchers and a veteran inflation-products trader turned investment manager. After a wide-ranging discussion that touched on U.S. economic prospects, the message from the yield curve, the impact of trade tensions and the continuing relevance of the Phillips Curve, each panelist was asked if inflation has already peaked for the cycle. The response was a resounding unanimous yes until we got our turn. The other panelists were not laypeople, traders, bottom-up analysts, or anyone else with only a passing interest in macroeconomics. They were experts, and we were struck by the conviction with which they dismissed the possibility that inflation could yet break out in the current cycle. Judging by the shrinking scale of the annual conference (this year’s edition was half the size of the previous two years’), the idea that inflation is dead for the foreseeable future has found a wide following. We do not think that inflation, and bond yields, will go anywhere in the immediate future, but it is far from assured that they will remain moribund for the rest of the expansion (Chart 11). Taking the other side looks attractive to us, given the preponderance of inflation-is-dead opinions. It is not terribly surprising that wide output gaps opened following an especially job-destructive downturn. With economic capacity considerably ahead of aggregate demand across the major economies, inflation had little chance of taking hold at an economy-wide level. The picture is changing, however, with the IMF estimating that the U.S. output gap closed in 2017 and in the advanced economies as a whole sometime last year (Chart 12). Goods inflation is primarily a global phenomenon, and with the IMF estimating that output gaps persist in Australia, Canada, Japan and the U.K., international slack can still mitigate domestic price pressures, though new tariff barriers would bind inflation more closely to domestic conditions. Services inflation, which is much more domestically driven, could begin to perk up now that unemployment is below NAIRU in the Eurozone as well as the U.S. (Chart 13). Finally, while central banks are hardly omnipotent, Milton Friedman’s always-and-everywhere admonition leaves little doubt that the monetary authorities can boost inflation expectations if they really want to. Chart 12Demand Has Caught Up To Capacity Chart 13Mind The Gap Investment Implications The investing backdrop is hardly ideal. Spreads are tight, stocks aren’t cheap, the two largest standalone economies are trying to inflect pain on each other, the U.K. can’t agree on how to get divorced from the EU, and the fate of the longest U.S. expansion on record is in doubt. The risks are well known, however, and save-haven assets have gotten pretty crowded. While the danger that shaky confidence could become self-fulfilling is real, our base case is that the expansion will trundle along, allowing stocks to rise as the worst-case scenarios fail to come to pass. It is at least possible that rumors of inflation’s demise have been greatly exaggerated. We continue to recommend that investors remain at least equal weight equities in balanced portfolios and at least equal weight spread product within bond allocations. We enthusiastically endorse our bond colleagues’ overweight TIPS recommendation. When nearly everyone agrees that a particular outcome cannot happen, it is often worth carving out some space in a portfolio in the event it actually does.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Please see Table 1 of the April 8, 2019 U.S. Investment Strategy Weekly Report, “If We Were Wrong,” available at usis.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 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  

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