Asset Allocation

Highlights A lot has changed in a week and a half, … : The FOMC meeting that we thought would mark the end of global market-moving news until September turned out to be a prelude for the real fireworks. … as U.S.-China trade tensions escalated, … : The imposition of tariffs on the only remaining subset of Chinese imports that had escaped duties so far inspired China to let the yuan fall below a key technical level. … and other countries braced for the fallout: China’s devaluation opened up a new front in the conflict, turning a bilateral tariff spat into a threat to other countries’ well-being and competitiveness. Asia-Pacific central banks swiftly followed with larger-than-expected rate cuts. Below-benchmark-duration positioning is no longer appropriate in the near term, and we recommend moving to benchmark duration: Interest rates will be hard-pressed to rise with global central banks squarely in easing mode. Although we still believe that inflation and the fed funds rate will surprise to the upside, it’s going to take a while. Feature Dear Client, There will be no U.S. Investment Strategy next week as we take our final summer break. U.S. Investment Strategy will return on Monday, August 26th. Best regards, Doug Peta So much for the idea that the July 30-31 FOMC meeting would be the last market-moving event before Labor Day. By lunchtime on August 1st, the S&P 500 was back to its July 30th close above 3,010; the 10-year Treasury yield had settled around 1.96%, ten basis points (“bps”) lower than its pre-meeting level; and gold had fallen by ten bucks, to $1,420, as markets digested the news that the Fed was less concerned about the economy than they were. Then the trade war reared its ugly head in the form of new tariffs on Chinese imports to the U.S., and the S&P slid to 2,822, the 10-year Treasury yield tumbled to 1.59%, and gold surged to $1,510. The new round would ensnare the subset of goods that had previously been spared from import duties, and Beijing promised to retaliate. It’s hard for rates to rise when every central bank has an easing bias as it nervously eyes the U.S.-China tilt.   Chart 1Beijing Plays The Currency Card The retaliation arrived Sunday night in the U.S., when Chinese officials allowed the renminbi to trade above 7 to the dollar for the first time since 2008 (Chart 1). The move provoked a global equity selloff, and the S&P 500 lost 3% in its worst session of the year. With the currency floodgates opened, the trade war morphed from a bilateral tariff spat into a global battle for competitiveness, and central banks in India, Thailand and New Zealand responded with larger-than-expected rate cuts. India is a comparatively closed economy battling a domestic downturn, but it is clear that countries with any reliance on exports are loath to be saddled with a strong currency that will hamstring their global competitiveness. It turns out that the Fed isn’t the only central bank that sees the appeal of taking out some insurance. That is an unfriendly backdrop for below-benchmark-duration positioning, and we are joining our fixed-income colleagues in raising our duration recommendation from underweight to neutral over the tactical timeframe (0-3 months). While we still believe that the fed funds rate and long yields will surprise to the upside, they cannot do so while bond investors are adamant that the Fed is going to have to adopt an easing bias over the near term. Our rates checklist, discussed in the rest of this report, supports the decision. The shift in the rates backdrop undermines our newly established agency mortgage REIT recommendation, and we are watching it closely. The Rates Checklist: The Fed Table 1Rates View Checklist Turning to our rates view checklist (Table 1), the first item is derived from our U.S. Bond Strategy service’s golden rule of bond investing.1 The golden rule asks one simple question to anchor views on Treasuries: Over the next 12 months, will the Fed move the fed funds rate by more or less than the bond market is currently discounting? Since 1990, when the Fed has surprised dovishly (the fed funds rate has turned out to be lower than the money market implied twelve months earlier), Treasuries have almost always generated positive excess returns over cash. Periods of negative excess returns have occurred nearly exclusively when the Fed has delivered a hawkish surprise. We still think inflation will become a problem, but it certainly isn’t one yet. Since we rolled out the checklist last year, we have consistently expected a hawkish surprise. Though we continue to believe that an extended cycle of rate cuts is not in the cards, markets disagree, and we concede that the Fed now has a near-term easing bias, despite Chair Powell’s demurrals at the post-meeting press conference. We are leaving the box unchecked because we believe that nearly four more 25-bps cuts over the next twelve months, equating to a target fed funds rate of 1.25-1.50% (Chart 2), are unlikely. The spread between our expectations and the market’s expectations is still wide enough to merit a below-benchmark-duration view over the next twelve months, even if benchmark duration makes more sense for the rest of the year. Chart 2Four More Rate Cuts Are A Stretch The yield curve’s inversion has become more pronounced in the wake of the re-escalation of the trade war (Chart 3), and we duly check the second box. As a reminder, we track the 3-month/10-year segment of the yield curve to define inversion because it is less susceptible to estimate error, and has been a timelier indicator of recessions, than the more frequently cited 2-year/10-year segment. We have argued before that the unprecedentedly large negative 10-year term premium makes the curve more prone to invert and makes it a less sensitive economic barometer, but part of the rationale of creating a checklist is to limit one’s discretion in interpreting events. Chart 3More Rate Cuts, Please The Rates Checklist: Inflation Inflation has gone AWOL around the globe. Although the U.S. no longer faces the negative output gaps that remain in other major economies, its main measures of consumer prices (Chart 4) do nothing to counteract the widespread view that the Fed has a free pass to devote its energies to shoring up growth. Inflation break-evens were making progress toward the 2.3-2.5% range consistent with the Fed’s 2% inflation target when we launched the checklist last year, but the plunge in oil prices stopped them in their tracks (Chart 5). Rather than encouraging the Fed to hike, soft inflation expectations helped drive the Fed’s dovish pivot. Chart 4Realized Inflation Is Below Target, ... Chart 5... And So Are Inflation Expectations Our view that the seeds of inflation pressures have been sown has not changed. After slowing on a real final domestic demand basis in the first quarter from the one-two punch of the government shutdown and the fourth quarter’s sharp tightening of financial conditions, the U.S. economy has resumed operating above capacity. Though we check the “sluggish-inflation” boxes, and acknowledge that inflation is not going to inspire a more restrictive turn in Fed policy any time soon, we do think it will become an issue down the road. The Rates Checklist: The Labor Market The labor market remains robust. The headline unemployment rate remains at a level last seen in 1969, and is well below the CBO’s estimate of NAIRU. NAIRU is the minimum structural unemployment rate, and wage gains quicken when the unemployment rate falls below it (Chart 6). The broader definition of unemployment, encompassing discouraged workers and involuntary part-time workers, fell to its lowest level since 2000 in July (Chart 7), and the job openings and job quits rates (Chart 8) indicate that demand for workers remains high. Chart 6Wage Gains Will Accelerate, ... Chart 7... As Slack Has Been Absorbed, ... Chart 8... And Demand Is Robust   3.2% year-over-year growth in average hourly earnings may not be thrilling, but wages do remain in an uptrend. The laws of supply and demand (Chart 9), and the Fed’s best efforts, suggest that the uptrend will continue. We do not check any of the labor market boxes, and expect that we will not over the rest of the year. The Rates Checklist: Instability At Home And Abroad Chart 10No Overheating Yet There continue to be no signs of cyclical overheating in the U.S. economy, as the most cyclical segments of the economy are nowhere near the red end of the tachometer (Chart 10). Financial imbalances have moved to the back burner, but they are part of the Fed’s post-crisis mandate, and we are leaving the imbalances box unticked to reflect that the “low spreads and loosening credit terms” Governor Brainard decried last September2 may stay the Fed from embarking on a full-on easing cycle. We are checking the international duress box, at least for the time being, given the potential for a self-reinforcing rate-cutting cycle that could hold down the entire term structure of rates around the world. Bottom Line: The inverted yield curve, a lack of consumer price inflation, and the cloud cast by the trade war all suggest that bond markets will require some convincing before they allow rates to rise much higher. We conclude that a neutral duration stance is appropriate in the near term. Keeping Score We have been staunch supporters of below-benchmark duration positioning since the end of last July,3 given that we thought the 10-year Treasury yield was too low relative to our assessment of the strength of the U.S. economy and the potential for inflation to begin to rise. It appears that our stronger-than-consensus economic view was correct, but we were myopic in failing to grasp how punk growth in the rest of the world would keep long-maturity Treasury yields from making a sustained move higher. We were way early on inflation’s ETA, and slow to grasp how sensitive the Fed would be to faltering global growth and escalating trade tensions in its absence. In short, both our model of the Fed’s reaction function and the inputs to our model turned out to be faulty. The duration call stings, but our asset allocation recommendations have worked out. The fix we are making is to wait until inflation is a clear and present danger before assuming that the Fed will respond to it. Although we got the duration call wrong, investment-grade and high-yield corporate bonds have outperformed Treasuries in the aggregate since we upgraded them to overweight versus Treasuries at the end of January (Chart 11). BCA as a house niftily sidestepped the fourth-quarter selloff in equities by downgrading them to equal weight, and raising cash to overweight, late last June. We upgraded equities to overweight versus cash and fixed income in our first publication of the year, and the S&P 500 has handily outperformed Treasuries since that date, despite the nasty selloff following the July FOMC meeting and the new round of tariffs (Chart 12). Chart 11Spread Product Has Modestly Outperformed Treasuries, ... Chart 12... But Equities Have Crushed Them Agency Mortgage REIT Implications We recommended agency mortgage REITs a day before the FOMC meeting, suggesting that investors allocate capital away from equities and high yield as a way to reduce equity beta and boost portfolio income away from the herd chasing lower and lower high-yield bond yields. Through Thursday’s close, the Bloomberg Mortgage REIT Index has gained about 35 bps on a total return basis, while the Barclays High Yield Index is off 70 bps and the S&P 500 is down 2.7%. Unfortunately, the agency mREITs we sought out for their yield curve exposure have lagged badly as the yield curve has relentlessly flattened. For now, only the one agency mREIT with a dedicated adjustable-rate mortgage portfolio faces immediate earnings pressure. The rest are subject to refinancing volumes, which are likely to be higher than we expected when we projected that the 10-year Treasury yield wouldn’t fall much below 2%. The specter of increased prepayments makes the agency mREITs a less attractive investment than we thought they would be two weeks ago. On the other hand, their exclusively domestic exposure, and low credit risk, increases their value as a haven from global turmoil. Net-net, we are sticking with them, though they are now on a far shorter leash than they were when we made the recommendation. We will not stick with a position to save face, or to avoid looking irresolute. Flexibility and a willingness to admit mistakes are essential characteristics of successful investors. When the facts change, we change our mind, without the faintest hint of embarrassment. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the July 24, 2018 U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” available at usbs.bcaresearch.com. 2 Brainard, Lael (2018). “What Do We Mean by Neutral And What Role Does It Play in Monetary Policy,” speech delivered at the Detroit Economic Club, Detroit, Mich., September 12, 2018. 3 Please see the July 30, 2018 U.S. Investment Strategy Weekly Report, “The Rates Outlook,” available at usis.bcaresearch.com.

Just as it appeared the slowdown in global industrial activity had run its course, commodity markets face another test of demand resiliency brought on by exogenous political shocks (Chart Of The Week). As luck would have it, these shocks – arriving in the form of an unexpected escalation of Sino-U.S. trade tensions – came on the heels of reports of further weakness in global manufacturing activity, a less-dovish-than-expected Fed, and a breach of the 7.0 level of the RMB/USD cross. The fallout – a global risk-off event – raises the spectre of a deeper trade war damaging EM GDP growth, which would weaken commodity demand. We continue to expect global fiscal and monetary stimulus to revive commodity demand, albeit further out the curve – i.e., later this year, as opposed to earlier in 2H19. Given the trade-war escalation, we are recommending a tactical long position in spot silver to hedge portfolio risk. The metal has been tracking gold’s ups and downs post-GFC – more so than industrial demand for silver – indicating it may have some catching up to do. This will make us strategically long gold, and tactically long silver at tonight’s close. Chart Of The WeekRenewed Trade Tensions Threaten Industrial Commodities' Recovery   Highlights Energy: Overweight. U.S. President Trump informed Congress earlier this week he was imposing a total economic embargo on Venezuela, which freezes assets of the Maduro government and all business dealings with its representatives except for humanitarian aid. Venezuela’s oil production averaged ~ 750k b/d in 2Q19, and was supported by the assistance of Russian technicians, U.S.-based Chevron Corp., and four service companies that were granted 90-day waivers by the U.S. to continue to do business in the country.1 Our long Sept19 Brent vs. short Sept20 Brent position expired with a gain of 101.7%. We remain long 4Q19 Brent vs. short 4Q20 Brent. Base Metals: Neutral. Industrial metals, iron ore and steel came under renewed selling pressure this week, in the wake of heightened trade tensions between the U.S. and China. Precious Metals: Neutral. Safe-haven demand rallied gold 3% over the week ended Tuesday, following the escalation in Sino-U.S. trade tensions. We continue to favor gold as a strategic portfolio hedge, particularly if central banks are compelled to accelerate monetary accommodation as global trade tensions rise, and are adding a tactical long silver position to our recommendations. Ags/Softs: Underweight. China’s Commerce Ministry reported U.S. ag products no longer are being purchased by Chinese companies earlier this week.2 U.S. President Trump’s decision to impose tariffs on Chinese imports to the U.S. were occasioned by his claim China was not living up to an agreement to increase agricultural purchases. This broke the truce in the Sino-U.S. trade war that accompanied the resumption in negotiations last month. Feature A recovery in industrial-commodity demand – particularly for oil and base metals – could be stretched out longer than we expected just a week ago. It’s still too early to tell whether the escalation in Sino-U.S. trade tensions will throw a spanner into the revival of commodity demand we’ve been expecting, but it does give us pause. Prior to the political shocks and other disappointments hitting markets this past week, our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. EM GDP growth drives commodity demand growth globally, which is why it is so important in our analysis. Our Chart of the Week illustrates this point, showing three relationships we've developed that allow us to track the evolution of EM GDP growth in something close to real time: BCA’s Global Industrial Activity (GIA) index, which is highly sensitive to economic activity in EM generally and China in particular;3  BCA’s Global Commodity Factor (GCF), which condenses the information contained in 28 commodity price series to a common factor using principal components analysis; and BCA’s EM Import Volume model, which generates an expectation of EM import volumes using mainly FX values for countries highly exposed to global trade. To be precise, we find the output of these three models shown in the Chart of the Week and EM GDP growth are deeply entwined.4 As can be seen in the chart, these models appeared to have bottomed and were preparing to hook up. This is supported by current global activity indicators (CAIs), particularly for China and EM, which still is showing positive y/y growth, even if its rate is slowing. (Chart 2), and the recent upturn in EM Financial Conditions we track here at BCA Research (Chart 3).  Chart 2Global CAIs Support EM Growth Expectation Chart 3EM Financial Conditions Move To Easier Setting However, the escalation of Sino-U.S. trade tensions, coming off a somewhat disappointing Fed rate cut of 25bps and weak manufacturing data, was enough to erase 6% and 3% from the GSCI and Bloomberg commodity indices over the week ended Tuesday (Chart 4), and to lift volatility in industrial commodities’ prices sharply (Chart 5).5    Chart 4Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Chart 5Crude Oil, Copper Vol Jump On Policy Shock   A Fraught Situation The Sino-U.S. trade standoff is fraught with risk for both sides. A full-blown trade war could devolve into domestic recessions (there is a non-trivial risk to the global economy, as well). In addition, a kinetic military confrontation between China and its allies and the U.S. and its allies cannot be ruled out, as tensions rise. The case for resolving the trade dispute is strong. Our colleague Peter Berezin notes that while an escalation in the Sino-U.S. trade war “would tip the scales towards recession, the risk of such an outcome remains low.”6 An all-out trade war could push the U.S. economy into a recession next year, just as President Trump faced re-election, which strongly suggests a goodwill gesture or two from the U.S. – e.g., the Commerce Department renewing the licenses allowing U.S. firms to deal with Huawei – could go a long way to getting trade talks back on track.  Our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. That said, we cannot gainsay the conclusions of our colleague Matt Gertken, who runs our Geopolitical Strategy: “The U.S.-China trade negotiations are falling apart at the moment. … (B)ut with the latest round of tariffs we think it is more likely that we will get a major escalation of strategic tensions and even saber-rattling,” as U.S. and Chinese positions harden, particularly around North Korea, Hong Kong and Taiwan.7 Clearly, the outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated. Moving To A Safe Haven: Silver While we continue to expect global fiscal and monetary stimulus will revive commodity demand, the shocks and disappointments visited upon markets could incline firms, households and investors globally to scale back on risky investments and purchases until the dust settles.8  Over the near term – i.e., 3 months or so – seeking refuge in a safe haven is sensible. In particular, we believe silver offers near-term cover, and expect it will continue to follow the evolution of gold prices.9  We expect central banks generally – the Fed in particular – will err on the side of maintaining monetary accommodation while uncertainty over trade and global growth prospects remains elevated. Fed Chairman Jay Powell's description of the central bank's July rate cut of 25 bps as a mid-cycle adjustment – and not the beginning of a lengthy cutting cycle – was perceived as a hawkish surprise, but markets appear to be pricing in additional cuts this year, which will support precious metals until further guidance from the Fed arrives. An escalation of the trade war likely would increase the probability the Fed cuts rates further at its next meeting, which would push down recession fears. The outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated.   On the supply side, silver typically is mined as a secondary metal, and usually is found with gold, copper and lead deposits, according to the Silver Institute.10 On the demand side, investment and electronics account for much of the usage. Prior to the Global Financial Crisis (GFC), silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization, which led to higher consumption. This resulted in a large supply-deficit in most industrial commodities, including silver (Chart 6). Following the GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. (Chart 7).11  Chart 6Silver Is Less Industrial, More Precious Now Chart 7Post-GFC, Silver and Gold Are More Closely Aligned We expect this to continue, given our view central banks are likely to either increase or accelerate monetary accommodation to offset Sino-U.S. trade tensions, should they worsen. The U.S. dollar outlook remains important for precious metals. The dollar is a counter-cyclical currency. Thus, the escalation in trade tensions risks delaying the rebound we expect in emerging markets. This could support the USD for longer than we expected. Bottom Line: We expect commodity demand to revive on the back of global fiscal and monetary stimulus. However, exogenous political shocks along the way toward that revival likely will force households, firms and investors to re-think spending and investment decisions. This could potentially lead to reduced aggregate demand, in the event uncertainty around manufacturing, which still accounts for significant employment and output in EM economies, and global trade becomes too high. Until this is sorted, taking refuge in a safe haven is prudent. To hedge against this, we are recommending spot silver as a tactical portfolio hedge. We already are long gold as a strategic portfolio hedge, and this position is up 20% this year.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   1      Please see U.S. sanctions waiver for Chevron signals Venezuela solution near: opposition ambassador, published by S&P Global Platts July 30, 2019. 2      Please see U.S. farmers suffer 'body blow' as China slams door on farm purchases published by reuters.com August 5, 2019. 3      Please see Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals, published by BCA Research’s Commodity & Energy Strategy May 9, 2019, for a discussion of the GIA index. The index is a weighted average of selected trade, currency, manufacturing PMIs, and Chinese industrial sector variables. The article is available at ces.bcaresearch.com. 4      This is to say there is strong two-way Granger causality between EM GDP and the output of the models shown above in the Chart of the Week. Knowing the output of one of the models allows one to forecast EM GDP growth, and vice versa. We will be doing further research into using these models to estimate the change in EM GDP at a higher frequency than the stand-alone EM GDP data are reported – e.g., the World Bank’s most recent actual EM GDP data in constant 2010 USD is reported up to 1Q18, while the models shown in the chart can be updated daily (GCF and the EM Import Volume models); and monthly, as the components of the GIA index become available. 5      For a discussion of global fixed-income markets’ response to the escalation of the Sino-U.S. trade war and the outlook for more aggressive monetary policy accommodation globally, please see Trade War Worries: Once More, With Feeling, published by BCA Research’s Global Fixed Income Strategy August 6, 2019. It is available at gfis.bcaresearch.com. 6      Please see A One-Two Punch, published by BCA Research’s Global Investment Strategy August 2, 2019. It is available at gis.bcaresearch.com. 7      Please see Tariffs ... And The Last Prime Minister Of The United Kingdom?, published by BCA Research’s Geopolitical Strategy, August 2, 2019. It is available at gps.bcaresearch.com.  Almost on cue, China warned the U.S. it would view its deployment of intermediate-range missiles in Asia following Russia’s revival of its intermediate-range missile development as “offensive in nature.” Please see China warns US against deploying missiles on its ‘doorstep’, published by the Financial Times August 6, 2019.  8      Our global macro expectation can be found in Oil Markets Await Lift From Global Stimulus, published by BCA Research’s Commodity & Energy Strategy August 1, 2019. It is available at ces.bcaresearch.com. 9      Please see "The Gold Trifecta," published June 27, 2019, by BCA Research's Commodity & Energy Strategy, for our most recent analysis of the gold market and of our long-held bullish gold view. It is available at ces.bcaresearch.com. 10     The Institute’s supply-demand annual supply-demand balances showed a 29.2mm-ounce deficit in 2018. 11     When we model silver returns as a function of gold and base metals’ returns, silver’s elasticity to gold prices more than doubles – from 0.68 over the 1999 - 2010 period, to 1.67 post-GFC (2010 to now). The elasticity to changes in base-metals prices was roughly cut in half over this period, to 0.28 post-GFC.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Dear Client, In case you missed it in real time, please listen to a replay of this quarter’s webcast ‘The Investment World in 5 Charts and 18 Minutes’ available at eis.bcaresearch.com. Also please note that we will be taking a summer break, so our next report will come out on August 22. Dhaval Joshi Highlights The aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from a down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector and regional losers and winners. Economically-sensitive ‘value’ sectors will be the losers, specifically Industrials and Semiconductors. Defensive ‘growth’ sectors will be the relative winners, specifically Healthcare. Continue to overweight European equities versus Chinese equities. Feature Chart of the WeekThe Global Bond Yield Is Within A Whisker Of An All-Time Low This week the global long bond yield came within a whisker of the all-time low reached after the shock vote for Brexit in June 2016 (Chart of the Week). By definition, this means that the aggregate bond market has gone nowhere for several years. Since the autumn of 2017, the aggregate equity market has also gone nowhere, with no rally or sell-off lasting more than three months (Chart I-2).1 Chart I-2Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months The correct strategy then has been to sell the equity market’s three month rallies and buy the three month sell-offs. In June we predicted that equities would end the year at broadly the same level as then, but that they would experience a dip of at least 4-5 percent along the way. We are now experiencing the dip. The correct strategy has been to sell the three month rallies and buy the three month sell-offs. But isn’t the global bond yield approaching an all-time low a good thing for the economy and equity market? The answer is yes, and no. Yes, the ultra-low level of yields is a boon for the valuation of risk-assets. However, when it comes to credit-sourced economic growth, what matters is not the level of the bond yield, nor its direction, so much as its rate of change.      If Bond Yields Decline At A Reduced Pace, Growth Slows Many people struggle to understand this subtle and counterintuitive point. If the bond yield declines, but at a reduced pace, it can slow credit-sourced growth. To understand why, imagine that in a certain period, a -0.5 percent decline in the bond yield added €50 billion to credit creation. This would constitute additional economic demand. If, in the following period, a further -0.5 percent yield decline added another €50 billion of credit-sourced demand, it would constitute the same amount of additional demand – which is to say, the same growth – as in the first period. By comparison, a -0.25 percent yield decline which added €25 billion to demand would result in the growth rate halving. The subtle and counterintuitive point is that the bond yield has continued to decline, yet it has caused credit-sourced growth to slow! Chart I-3In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago This counterintuitive dynamic has unfolded in the global economy this year. Although bond yields have been heading lower, the peak rate of decline – notably in China – happened six months ago. Meaning that credit-sourced growth has almost certainly slowed (Chart I-3). Amplifying this down-oscillation in growth, geopolitical storm clouds are now regathering over the global economy. In the early part of this year, trade tensions and currency wars between the major economic blocs seemed to dissipate, the Middle East was quiet, and the Brexit deadline was postponed. But the lull was temporary. The geopolitical headwinds to growth are now strengthening with a vengeance. That’s the bad news.  Equity Valuations Are Hyper-Sensitive To Low Bond Yields Now the good news. While the level of bond yields does not drive economic growth, it does drive the valuations of equities and other risk-assets. Moreover, it does so in a powerful non-linear way. Below a threshold level, ultra-low bond yields can give the valuation of equities an exponential boost. Geopolitical storm clouds are now regathering over the global economy. We refer readers to our other reports for the details, but in a nutshell at ultra-low bond yields the risk of owning bonds converges to the risk of owning equities. The upshot of this risk convergence is that investors price equities to deliver the same feeble nominal return as bonds, meaning that the valuation of equities soars (Chart I-4).2 Chart I-4The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 Theoretically and empirically, this threshold level of the bond yield is in the region of 2 percent. And the bond yield that matters is the global long bond yield, defined as the simple average of the 10-year yields of the U.S., the euro area, and China. To simplify matters, we can proxy the 10-year yield of the aggregate euro area with the 10-year yield of France. So calculate the simple average of the 10-year yields of the U.S., France, and China. A value rising towards 2.5 percent equates to danger for equity valuations. A value falling below 2.0 percent equates to an underpinning for equity valuations. Today, the value stands near 1.5 percent creating a good support for equity and risk-asset valuations. The upshot is that the aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from the down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector losers and winners. Essentially, economically-sensitive ‘value’ sectors will be the losers while defensive ‘growth’ sectors will be the relative winners. Put simply, the sector trends present during the last up-oscillation in global growth are likely to unwind if they have not already done so. In which case, the sectors most likely to suffer underperformance are:   Industrials and Semiconductors (Chart I-5). Chart I-5Industrials Outperformed Strongly... But Are Now Underperforming And the sector most likely to see (continued) outperformance is: Healthcare. There will also be regional losers and winners. This is because regional equity market relative performance just follows from sector relative performance combined with each region’s sector ‘fingerprint’. Bear in mind that a fingerprint can be defined not just by overweight sectors but also by underweight sectors, such as the Shanghai Composite’s negligible weighting in Healthcare, making the Chinese index ultra-cyclical. Continue to overweight European equities versus Chinese equities (Chart I-6).  Chart I-6Overweight Europe Versus China Market Dislocations And Recessions: Cause And Effect As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major dislocation in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months. There have been three such episodes in the twenty-first century.3 Yet our market based definition of a major dislocation also perfectly captures the three last times that the European economy went into recession or near-recession. Does this mean that the recessions caused the financial market dislocations? No. Quite the reverse. The twenty-first century’s recessions have all resulted from financial market dislocations. The twenty-first century’s recessions have all resulted from the financial market dislocations that followed market distortion or mispricing: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-7); the mispricing of U.S. mortgages and credit in 2007 (Chart I-8); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-9). Therefore, the major dislocations in the financial markets have always preceded the recessions and near-recessions, sometimes by several quarters, even when both are measured in real time. Chart I-7The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... Chart I-8...The Mispricing Of U.S.##br## Mortgages And Credit In##br## 2007/2008...   Chart I-9...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 Today, the consensus overwhelmingly believes that a recession will cause the next major dislocation in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Hence, a major dislocation in the financial markets – should one occur – will cause the next recession. And not the other way round! Fractal Trading System* The nickel price has surged on continued fears over Indonesian exports bans. But from a technical perspective the recent surge is excessive and susceptible to a reversal on any easing of the fears. Accordingly, this week’s trade is short nickel versus copper, setting a profit target of 10 percent with a symmetrical stop-loss. In other trades, short ASX200 versus FTSE100 hit its 2 percent stop-loss, but short MSCI All-Country World has moved well into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10Short Nickel, Long Copper The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 We define the global long bond yield as the simple average of the 10-year yields in the U.S., euro area, and China. And to make things simple, France provides a good proxy for the euro area long bond yield. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com. 3 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. Fractal Trading System 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 Chart 1Keep Tracking The CRB / Gold Ratio The Fed cut rates by 25 basis points last week, a move that Chairman Powell described as an “insurance” cut meant to counter the risks from trade tensions and global growth weakness. Powell also described the move as a “mid-cycle adjustment to policy” and not “the beginning of a lengthy cutting cycle”. We agree with the Fed’s “mid-cycle” view of the U.S. economy and think an extended cutting cycle is unwarranted, but the market clearly disagrees. Long-end yields fell on Powell’s remarks and fell further as U.S. / China trade tensions re-escalated during the past few days. The 2015/16 period continues to be a good roadmap for the current environment, and we expect the next big move in Treasury yields will be higher. The timing of that move, however, is highly uncertain. Our political strategists expect an increase in saber-rattling between the U.S. and China in the coming months, and bond yields will not rise until either trade tensions ease and/or the global growth data recover. We recommend a tactical neutral allocation to portfolio duration, but expect to switch back to below-benchmark when those conditions are met. The CRB / Gold ratio will continue to be a good guide for the 10-year yield (Chart 1). Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds outperformed the duration-equivalent Treasury index by 63 basis points in July, bringing year-to-date excess returns up to +432 bps. Corporate spreads widened somewhat following Jerome Powell’s perceived hawkishness at last week’s FOMC meeting, but that spread widening will prove fleeting. The Fed remains committed to keeping monetary policy accommodative and that means doing everything it can to prevent a significant tightening of financial conditions.1 The soaring price of gold is the strongest indicator of the Fed’s dovishness, and it is also a buy signal for corporate credit (Chart 2). In terms of valuation, Baa-rated securities offer the most value in investment grade corporate bond space. Baa spreads remain 7 bps above our cyclical target.2 Conversely, Aa and A-rated spreads are 3 bps and 4 bps below target, respectively (panel 4). Aaa spreads are 16 bps below target (not shown). The Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed that commercial & industrial (C&I) lending standards eased for the second consecutive quarter. C&I loan demand continued to contract, but less aggressively than its recent pace (bottom panel). Easing lending standards usually coincide with spread tightening, and vice-versa.  High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield outperformed the duration-equivalent Treasury index by 66 basis points in July, bringing year-to-date excess returns up to +673 bps. The average index option-adjusted spread tightened 6 bps in July, then widened 26 bps in the first two days of August. At 397 bps, it is currently well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 71 bps above our target (Chart 3), B-rated spreads are 142 bps above our target (panel 3) and Caa-rated spreads are 298 bps above our target (not shown).3 Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 2.9% over the next 12 months, not far from our own projection.4 This would translate into 238 bps of excess spread in the High-Yield index, after adjusting for default losses (panel 4). This is comfortably above zero, and only just below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +32 bps. The conventional 30-year zero-volatility spread tightened 10 bps on the month, consisting of a 9 bps tightening in the option-adjusted spread (OAS) and a 1 bp decline in the compensation for prepayment risk (option cost). Falling mortgage rates hurt MBS in the first half of this year, as lower rates led to an increase in refi activity that drove MBS spreads wider (Chart 4). In fact, the conventional 30-year index OAS moved all the way back to its pre-crisis mean, before tightening last month (panel 3). However, as we noted in a recent report, the nominal 30-year MBS spread remains very tight, at close to one standard deviation below its historical mean.5 The mixed valuation picture means we are not yet inclined to augment MBS exposure, especially given the recent downleg in Treasury yields that could spur another small jump in refis. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation.   Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index outperformed the duration-equivalent Treasury index by 30 basis points in July, bringing year-to-date excess returns up to +164 bps. Sovereign debt outperformed duration-equivalent Treasuries by 68 bps on the month, bringing year-to-date excess returns up to +490 bps. Local Authorities outperformed the Treasury benchmark by 31 bps, bringing year-to-date excess returns up to +244 bps. Meanwhile, Foreign Agencies outperformed by 49 bps, bringing year-to-date excess returns up to +153 bps. Domestic Agencies outperformed by 6 bps in July, bringing year-to-date excess returns up to +31 bps. Supranationals outperformed by 7 bps on the month, bringing year-to-date excess returns up to +36 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). While this remains an attractive option from a valuation perspective, the President’s on again/off again tariff threats make it a risky near-term proposition. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds outperformed the duration-equivalent Treasury index by 102 basis points in July, bringing year-to-date excess returns up to +58 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury yield ratio fell 8% in July, and currently sits at 78% (Chart 6). The ratio is more than one standard deviation below its post-crisis mean, and even below the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We noted the strong outperformance of municipal bonds in our report two weeks ago, and recommended cutting exposure from overweight to neutral, based on how expensive the bonds have become.6 In that report we noted that Aaa-rated Municipal / Treasury yield ratios for 2-year, 5-year and 10-year maturities were all more than one standard deviation below average pre-crisis levels. Only 20-year and 30-year Aaa-rated municipal bonds continue to look cheap, and we recommend that investors focus muni exposure on that segment of the market. Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our shift to a more cautious stance is driven purely by valuation, and not any immediate concern for municipal bond credit quality. Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bear-flattened in July, before undergoing a roughly parallel shift down of about 30 bps in the first two days of August, following the FOMC meeting and news about the escalation of the U.S./China trade war. As we go to press, the 2/10 Treasury slope stands at 16 bps, 9 bps flatter than at the end of June. The 5/30 slope is currently 76 bps, exactly equal to its end-of-June level. Our 12-month Fed Funds Discounter is currently -78 bps (Chart 7). This means that the market is priced for roughly three more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of the uncertainty surrounding the timing of the next move higher in yields, three rate cuts on a 12-month horizon still seems excessive given the underlying strength of the U.S. economy. For this reason we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts spread over the next four FOMC meetings. A short position continues to make sense. On the yield curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS outperformed the duration-equivalent nominal Treasury index by 43 basis points in July, bringing year-to-date excess returns up to +71 bps. The 10-year TIPS breakeven inflation rate rose 8 bps in July to reach 1.77%, before falling back to 1.67% in the first few days of August (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate followed a similar path and currently sits at 1.88%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.7 In the long-run, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors will also need to see evidence that realized inflation can be sustained near 2%. On that note, the core PCE deflator grew at an annualized rate of 2.48% during the past three months. However, the 12-month rate of change remains at 1.5%. The 12-month trimmed mean PCE inflation rate is currently running at 2%, exactly equal to the Fed’s target. In a recent report we noted that 12-month core PCE inflation has a track record of converging toward the trimmed mean.8 We see continued upside in core inflation over the remainder of the year, and therefore recommend an overweight allocation to TIPS versus nominal Treasuries.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 8 basis points in July, bringing year-to-date excess returns up to +59 bps. The index option-adjusted spread for Aaa-rated ABS tightened 3 bps on the month. It currently sits at 31 bps, well below the pre-crisis mean of 64 bps (Chart 9). In addition to poor valuation, the sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate going forward (panel 3). Meanwhile, the Fed’s Senior Loan Officer Survey for Q2, released yesterday, showed a continued tightening in lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). On the bright side, stronger demand for both credit cards and auto loans was reported for the first time since the fourth quarter of 2016. All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS.       Non-Agency CMBS: Neutral     Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities outperformed the duration-equivalent Treasury index by 42 basis points in July, bringing year-to-date excess returns up to +234 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS tightened 6 bps on the month. It currently sits at 64 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate looks somewhat unfavorable, with lenders tightening standards (panel 4) amidst falling demand (bottom panel). However, on a positive note, commercial real estate prices recently accelerated and are now much more consistent with current CMBS spreads (panel 3). Despite the mixed fundamental picture, CMBS still offer excellent compensation compared to other similarly-rated fixed income sectors.9 Agency CMBS: Overweight   Agency CMBS outperformed the duration-equivalent Treasury index by 26 bps in July, bringing year-to-date excess returns up to +119 bps. The index option-adjusted spread tightened 3 bps on the month and currently sits at 47 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. An overweight allocation to this defensive sector remains appropriate. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 78 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of August 2, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of August 2, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +55 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 55 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “The Fed’s Got Your Back”, dated June 25, 2019, available at usbs.bcaresearch.com 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Special Report, “Assessing Corporate Default Risk”, dated March 19, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “The Long Awkward Middle Phase”, dated July 2, 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 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 8 Please see U.S. Bond Strategy Weekly Report, “Hedge Near-Term Credit Exposure”, dated May 28, 2019, available at usbs.bcaresearch.com 9 Please see U.S. Bond Strategy Weekly Report, “The Search For Aaa Spread”, dated March 12, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Feature The global manufacturing cycle looks dire at the moment. Around the world, manufacturing PMIs have fallen, profit growth has slowed, and capex has been reined back (Chart 1). This is clearly a risky moment for the economic expansion (and the equity bull market) which began in 2009. We hear that many clients are having vigorous debates on their investment committees about what to do – and indeed, at BCA, the views of our strategists are unusually divided.1 Recommendations Chart 1Heading Downhill Fast       Global Asset Allocation veers towards the optimistic camp. In brief, we expect the services and consumer sectors of major economies to remain robust, and that manufacturing will bottom out in the coming months, partly as a result of easier financial conditions, including the dovish turn by central banks and monetary stimulus in China. But we recognize the risks currently and have constructed our portfolio accordingly. We remain overweight equities versus bonds, but leaven that with an overweight on the most defensive equity market, the U.S. The global economy is a wonderful self-organizing system. The disparity between manufacturing and services is stark everywhere. Both the soft data, such as PMIs (Chart 2), and hard data, such as industrial production and retail sales (Chart 3), show that manufacturing almost everywhere is in recession (the U.S. is not yet, but is perhaps headed that way), but that services growth remains robust. Services have been held up by decent wage growth (even in the manufacturing-heavy eurozone) and generally easier fiscal policy (in the eurozone and China, in particular), which have allowed consumers to continue spending. (In the U.S., the risk of tighter fiscal policy next year has been alleviated by last month’s budget agreement which will produce a small positive fiscal thrust in 2020 – see Chart 4.) Chart 2Service Sector Surveys Look Healthier... Chart 3...Supported By The Hard Data   Chart 5China Is The Root Cause   The manufacturing recession was clearly triggered by China – it is notable, for instance, that large exporting countries have seen no slowdown in sales to the U.S. but a big drop in those to China (Chart 5). In 2017-18, China slowed as a result of its tighter monetary policy and clamp-down on shadow banking. The countries that have been most affected by the slowdown over the past 18 months are, unsurprisingly then, those which have the largest manufacturing sectors, notably Korea, Germany and Japan (Chart 6). But the global economy is a wonderful self-organizing system. Historically, intra-expansion industrial cycles have typically lasted around 18 months from peak to trough, and 18 months from trough to peak (Chart 7). Lower commodity prices, easier financial conditions, and pent-up demand mean that, after a period of slowdown, demand and risk appetite build up. This self-equilibrating cycle breaks only if there is a major structural imbalance, usually excess debt or rising inflation. As we have argued previously, we do not see clear signs currently that either of these usual structural triggers of recession is present (Chart 8). Chart 7Close To The End Of The Down Wave? Chart 8No Structural Triggers For Recession   Chart 9Financial Conditions Have Eased The Fed cut rates on July 31 as a risk management measure, “a mid-cycle adjustment to policy,” as Chair Powell put it in his post-FOMC press conference. With the stock market close to a record high and unemployment at a 50-year low, there is no obvious need for the Fed to implement a full-out easing campaign. But with inflation well below its 2% target, and a risk that the manufacturing slowdown could spill over into consumption (perhaps if companies start to lay off workers – something there is little sign of yet), an “insurance” cut seemed prudent. Financial conditions have eased significantly in the U.S. this year, and somewhat in Europe (Chart 9), and this should soon start to positively affect growth. China’s stimulus remains key. So far it has been half-hearted (Chart 10). This is because Chinese growth has to a degree stabilized, trade negotiations with the U.S. continue, and because the authorities have not abandoned their wish to delever the economy – it is notable that shadow-bank credit creation has not rebounded (Chart 11). Both fiscal and monetary stimulus will need to be ramped up in the second half if we are to see a repeat of 2016’s China-driven risk rally. Investors should see this as a put option – if Chinese growth slows again, and the trade talks break down (both of which are likely), the authorities will roll out a stimulus on the scale of their previous efforts. Chart 10China's Stimulus Is Only Half-Hearted Chart 11Still Clamping Down On Shadow Banks Chart 12Have Stocks Already Discounted A Rebound? What is the biggest risk to our sanguine view? With global stocks up 16% and U.S. stocks 20% year-to-date, the bottoming-out of the manufacturing cycle and greater monetary easing may already be priced in. Chart 12 shows that year-on-year stock market moves typically follow the manufacturing PMIs closely. Even if stock prices remain only at their current level to year-end, they are already discounting a sharp bounce in the PMIs. Fixed Income: If we are right about the macro environment, U.S. Treasury bond yields should rise from their current 2%. Yields usually move in line with consensus GDP forecasts (Chart 13). Economists have cut their 2020 forecast to only 1.8% (from 2.5% for this year). If the 2020 number is revised up, as we expect, Treasury yields have some room to move back up. Moreover, the Fed is unlikely to cut rates twice more by year-end as the futures market implies. Therefore, we stay underweight duration. We have a neutral stance on credit, but this asset class should produce reasonable excess returns over coming quarters given current spreads (Chart 14). U.S. high yield (especially B and below) and eurozone investment grade bonds (which the ECB may start buying again) look attractive. Chart 13Yields Will Rise With GDP Forecasts Chart 14Some Credit Spreads Look Attractive Equities: Given the uncertainties over the timing and strength of Chinese stimulus, we remain cautious on Emerging Markets and euro area stocks, the most obvious beneficiaries of this. Both regions have structural headwinds (excess foreign-currency debt in the case of EM, the fragile banking system and flattening yield curve for Europe) which mean that, even when Chinese stimulus comes, their outperformance may prove short-lived. For now, we prefer U.S. equities, although we recognize that upside for this year is limited. The key will be whether earnings can surprise analysts’ (over cautious) forecast of only 3% EPS growth in 2019. This seems likely since the Q2 earnings season, with almost half of companies having reported, is coming in at close to 80% beats on the bottom line. To hedge against the upside risk of Chinese stimulus, we continue to recommend building a position in Australian equities and in the Industrials sector. China’s stimulus remains key, but so far it has been half-hearted. Currencies: The U.S. dollar is a counter-cyclical currency and should start to depreciate once signs of a manufacturing recovery become apparent. Moreover, the Fed’s dovish move – and the fact that it has significantly more room to ease than other large DM central banks – should also prove to be dollar bearish eventually (Chart 15). One key cross to watch for signs that the global cycle is bottoming is AUD/JPY, since the Australian dollar is a very cyclical, and the Japanese yen a very defensive, currency (Chart 16). Chart 15Dovish Fed Is Dollar Bearish Chart 16Watch AUD/JPY For Signs Of A Bottom   Chart 17Oil Has Further To Rise Commodities: We continue to have a bullish outlook for oil. Although developed-world demand growth has slowed slightly this year, OPEC supply constraints mean that inventories should draw down further (Chart 17). We expect Brent crude to average $74 a barrel in 2H2019 (from $65 today). Gold has performed well this year, up 11%. Our colleagues in BCA’s Foreign Exchange Strategy and Commodity & Energy Strategy services conclude that this has largely been because of monetary and financial factors, mostly lower real rates (Chart 18).2 In the coming months, while rates may rise, gold should be helped by a weaker USD. We are neutral on the metal and see it more as an insurance asset. Our FX and Commodity strategists concur with GAA’s long-standing view that gold is a useful portfolio diversification tool to protect against financial, geopolitical, and inflation risks. Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see BCA’s Special Report, “What Goes On Between Those Walls? BCA’s Diverging Views In The Open,” dated 19 July 2019, available at www.bcaresearch.com. 2      Please see Commodity & Energy Strategy Special Report, “All That Glitters…And Then Some,” dated 25 July 2019, available at ces.bcaresearch.com.   GAA Asset Allocation  

Feature GAA DM Equity Country Allocation Model Update Chart 1GAA DM Model Vs. MSCI World The GAA DM Equity Country Allocation model is updated as of July 31, 2019.  The quant model reversed its abnormal upgrade of Sweden in the previous model update. In hindsight, the model’s behavior when a bond yield moves close to zero needs to be watched closely. Currently, the model still favors Spain, Italy, Germany, Netherland and Australia at the expenses of U.S., Japan, U.K., France and Canada, as shown in Table 1.  As shown in Table 2 and Charts 1, 2 and 3, the overall model underperformed the MSCI World benchmark by 94 bps in July, largely driven by 146 bps of underperformance from the Level 2 model, and 26 bps of underperformance from the Level 1. Directionally, 7 out of the 12 choices generated positive alpha. However, the overweight in Sweden and Spain generated outsized underperformance. Since going live, the overall model has outperformed by 94 bps, with 297 bps of outperformance by the Level 2 model, offset by 42 bps of underperformance from the Level 1. Table 1Model Allocation Vs. Benchmark Weights Table 2Performance (Total Returns In USD %) Chart 2GAA U.S. Vs. Non U.S. Model (Level 1) Chart 3GAA Non U.S. Model (Level 2)   Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model The GAA Equity Sector Model (Chart 4) is updated as of July 31, 2019. Chart 4Overall Model Performance The model’s tilts between cyclicals and defensives have changed compared to last month. Following the Fed’s decision to cut interest rates yesterday, the liquidity component shifted its inputs to phase 4 – a period in which the central bank is cutting rates, while simulative monetary conditions persist. Although this should favor most cyclical sectors, the lack of evidence of global growth bottoming is tilting the model to favor a mixed bag of sectors. The valuation component continues to remain muted across all sectors. The model is now overweight 4 sectors in total, 2 cyclical and 2 defensive sectors. These are Consumer Discretionary, Information Technology, Consumer Staples, and Healthcare. Table 3Model’s Performance (March 1, 2019 - Current) Table 4Current Model Allocations   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. Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes

Highlights Portfolio Strategy Despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. Recent Changes There are no changes to the portfolio this week. Table 1 Feature Equities hit all-time highs last week, eagerly anticipating this Wednesday’s Fed decision to commence an easing interest rate cycle and save the day. The looming global liquidity injection is the sole reason that stocks are holding near their all-time highs. While markets are treating the Fed as a deity, empirical evidence suggests that risks are actually lurking beneath the surface. Over the past two decades the correlation between stocks and the fed funds rate has been tight and positive. Given the bond market’s view of four fed cuts in the coming year, equity gains are likely running on fumes (Chart 1). Chart 1Mind The Positive Correlation As we highlighted recently, we remain perplexed that stocks are diverging from earnings.1 Anticipating a flush global liquidity backdrop (i.e. global central banks increasing their reflationary efforts) likely explains this dynamic as the former should ultimately rekindle economic growth, which in turn should boost profit growth. However, the disinflationary fallout from the ongoing manufacturing recession and the petering out in the global credit impulse signal that the liquidity pipes remain clogged. We recently read and re-read the Bank For International Settlements (BIS) Hyun Song Shin’s “What is behind the recent slowdown” speech where he eloquently argues that the global trade deceleration predates last spring’s U.S./China trade dispute.2 Shin has a compelling argument blaming the growth deceleration on the drop in manufactured goods global value chains (GVC) and he depicts this as global trade trailing global GDP (top panel, Chart 2). Interestingly, despite the V-shaped recovery following the Great Recession, global trade never really regained its footing, failing to surpass the 2007 peak. Shin then links this slowdown in global supply chains to financial conditions and the role that banking plays in global trade financing. The middle panel of Chart 2 shows that the GVC move with the ebbs and flows of global banks. In other words, healthy banks tend to boost global trade and vice versa. Finally, given that most trade financing is conducted in U.S. dollars, the greenback’s recent appreciation also explains trade blues. Simply put, decreased availability of U.S. dollar denominated bank credit as a result of a rising greenback is another culprit (U.S. dollar shown inverted, bottom panel, Chart 2). Ergo, there is no miracle cure for the sputtering world economy, especially given the recent re-escalation in global trade tensions and the stubbornly high U.S. dollar, and the gap between buoyant share prices and poor profit performance is likely to narrow via a fall in the former. Two weeks ago we highlighted that foreign sourced profits for U.S. multinationals are under attack as BCA’s global ex-U.S. ZEW survey ticked down anew (top panel, Chart 3). Tack on the global race to ZIRP (and in some cases further into NIRP) and it is crystal clear that the profit recession has yet to run its course. Chart 2Grim Trade Backdrop... Chart 3...Will Continue To Weigh On Foreign Sourced Profits   Meanwhile, China is likely exporting its deflation to the rest of the world and until its business sector regains pricing power, U.S. profits will continue to suffer (bottom panel, Chart 3). Turning over to U.S. shores and domestic corporate pricing power, the news is equally grim. Our pricing power proxy is outright contracting and warns that revenue growth is also under duress for U.S. corporates. Similarly, the ISM manufacturing prices paid subcomponent fell below the 50 boom/bust line and steeply contracting raw industrials commodities are signaling that 6%/annum top line growth for the SPX is unsustainable (Chart 4). On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. Chart 4Sales Pressures... Chart 5...Are Building Rapidly Melting inflation expectations and the NY Fed’s softening Underlying Inflation Gauge (UIG) best encapsulate this softening revenue backdrop and warn that any further letdown in inflation risks sinking S&P 500 sales growth below the zero line (Chart 5).   Netting it all out, despite the Fed’s supra natural powers, the deep rooted global growth slowdown will likely win the tug of war versus flush liquidity, especially if the trade war spat stays unresolved and the U.S. dollar remains well bid, both of which undermine U.S. corporate sector profitability. On a cyclical 3-12 month time horizon we remain cautious on the broad equity market. This is U.S. Equity Strategy’s view, which stands in contrast to the more sanguine equity BCA House View. What follows is a recap of recent (mostly) defensive moves in the health care, consumer staples, materials, tech, consumer discretionary and communication services sectors.   Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com   S&P Health Care (Overweight) Upgraded from Neutral S&P Health Care Equipment (Overweight) Upgraded from Neutral Fear-based sell-off created a buying opportunity in the U.S. health care equipment index as fundamentals remain upbeat. Rising U.S. medical equipment exports are a tailwind for this health care subgroup as 60% of its revenues are generated outside the United States (second panel). The EM demographic shift (not shown) represents yet another boost to the sector as U.S. companies are the technology leaders and often the only source for equipping hospitals/clinics around the globe. Our move to upgrade the S&P health care equipment index also pushed the entire health care sector from neutral to overweight (bottom panel). S&P Health Care S&P Managed Health Care (Overweight) Upgraded from Neutral The Bernie Sanders “Medicare For All” bill reintroduction created a buying opportunity in the S&P managed health care index and we were swift to act on it in mid-April. Contained industry cost factors including wages staying at the 2% mark help preserve industry margins (bottom panel). Melting medical cost inflation signals that HMO profit margins will likely expand (third panel). Overall healthy labor market conditions with unemployment insurance claims probing 60-year lows should underpin managed health care enrollment (top & second panels). S&P Managed Health Care   S&P Hypermarkets (Overweight) Upgraded from Neutral S&P Soft Drinks (Neutral) Upgraded from Underweight A deteriorating macro landscape reflected in the steep fall in U.S. economic data surprises, the drubbing of the 10-year U.S. Treasury yield and melting inflation make a compelling case for an overweight stance in the S&P Hypermarkets index (top & second panels). Similarly, safe haven soft drinks stocks shine when economic conditions are deteriorating (third panel). This defensive pure-play consumer goods sub-sector is also enjoying a rebound in operating metrics, and thus it no longer pays to stay bearish. We lifted exposure to neutral last week, locking in gains of 5.5% since inception. S&P Hypermarkets   S&P Materials (Neutral) Downgraded from Overweight S&P Chemicals (Underweight) Downgraded from Neutral Global macro headwinds continue to weigh on this deep cyclical sub-index as the risks of a full-blown trade war will likely take a bite out of final demand (third panel). Chemical producers garner 60% of their revenues from abroad and falling U.S. chemical exports are troublesome for this index (top & second panels). Given that chemicals have a 74% market cap weight in the S&P materials index, our move to underweight on the sub-index level also pushed the entire S&P materials index to neutral from overweight. S&P Materials   S&P Technology (Neutral) Downgrade Alert S&P Software (Overweight) Lifted trailing stops As a part of our portfolio de-risking measures, we put a 27% profit-taking stop loss on our overweight S&P software index call on June 10. Once triggered, a downgrade to neutral in the S&P software index would also push our S&P tech sector weight to a below benchmark allocation. Meanwhile, our EPS model for the overall tech sector is on the verge of contraction on the back of sinking capex and a firming U.S. dollar (middle panel). The San Francisco Fed’s Tech Pulse Index is also closing in on the expansion/contraction line warning that tech stocks are in for a rough ride (bottom panel). S&P Technology   S&P Technology Hardware, Storage & Peripherals (Neutral) Downgraded from Overweight As nearly 60% of the revenues for the S&P technology hardware, storage & peripherals (THS&P) index are sourced from abroad, deflating EM currencies sap foreign consumer purchasing power and weigh on the industry’s exports (third panel). Global export volumes have sunk into contractionary territory, to a level last seen during the Great Recession (not shown) and underscore that industry exports will remain under pressure. The IFO World Economic Survey confirms this challenging export backdrop as it is still pointing toward sustained global export ails (second panel). As a result, all of this has shaken our confidence in an overweight stance in the S&P THS&P and we were compelled to move to the sidelines in early June for a modest relative loss since inception. S&P Technology Hardware, Storage & Peripherals S&P Consumer Discretionary (Underweight) Upgrade Alert S&P Home Improvement Retail (Neutral) Upgraded from underweight In the July 8 Weekly Report, we put the S&P consumer discretionary sector on an upgrade alert as this early-cyclical sector benefits the most from lower interest rates (bottom panel). The way we will execute this upgrade will be by triggering the upgrade alert on the S&P internet retail index. Melting interest rates and rebounding lumber prices are a boon for home improvement retailers (HIR, second & third panels). Tack on profit-augmenting industry productivity gains and it no longer pays to be bearish HIR. S&P Consumer Discretionary S&P Homebuilders (Neutral) Downgraded from overweight Long S&P Homebuilders / Short S&P Home Improvement Retail Booked Profits Lumber represents an input cost to homebuilders (we booked profits of 10% in our overweight recommendation on May 22 and downgraded to neutral) whereas it is an important selling item in Big Box building & supply retailers that make a set margin on it (third panel). On June 18, as part of our de-risking strategy, we locked in 10% gains in the long S&P homebuilders/short S&P home improvement retail trade that hit our stop loss and we moved to the sidelines. S&P Homebuilders S&P Telecommunication Services (Neutral) Upgraded from Underweight The recent escalation of the trade spat has pushed July’s Markit’s flash U.S. manufacturing PMI reading to 50 - the lowest level since the history of the data. Historically, relative S&P telecom services share price momentum has moved inversely with the manufacturing PMI and the current message is to expect a sustained rebound in the former (bottom panel). Rock bottom profit expectations and firming industry operating metrics signal that most of the grim news is priced in bombed out telecom services valuations (middle panel), and it no longer pays to be underweight. In late-May, we lifted exposure to neutral for 6% relative gains since inception. S&P Telecommunication Services S&P Movies & Entertainment (Overweight) Upgraded from Neutral Structural shifts in the streaming services industry marked a start of a pricing war with incumbents and new entrants fighting for market share, as evidenced by DIS’s pricing of their upcoming Disney+ service. Consumer confidence remains glued to multi-decade highs and there are high odds that the big gulf that has opened up between confidence and relative S&P movies & entertainment share prices will narrow via a rise in the latter (top panel). Moreover, more dollars spent on recreation is synonymous with a margin expansion in the S&P movies & entertainment index (bottom panel). This consumer spending backdrop is also conducive to a rise in relative profitability, the opposite of what the sell-side currently expects. S&P Movies & Entertainment   Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Beware Profit Recession” dated July 8, 2019, available at uses.bcaresearch.com. 2      https://www.bis.org/speeches/sp190514.pdf   Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon.  Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S.   A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin.  The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply.   Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner   A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle.   Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14).  Chart 14Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17).     Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves     As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1    The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Special Report

Highlights From time immemorial, gold has been a medium of exchange, a store of value, and a safe haven to hedge portfolios. In modern times, the market in which it trades has evolved into an important filter of information and expectations re monetary policy, inflation expectations, and geopolitical risk. At any moment in time, one or all of these factors can drive gold prices. At present, we believe the precious metal is pricing to all three of them. However, as we show below, one group of factors – monetary and financial aggregates – holds sway over the evolution of gold prices at present (Chart of the Week). Feature We view gold primarily as a financial asset – almost a currency, but not quite, since it has non-monetary value as well as being a medium of exchange (e.g., in electronics applications). We separate the factors to which gold prices are responsive into three groups of fundamentals: Demand for inflation hedges; Monetary and financial aggregates; and, Demand for portfolio-diversification assets, including safe-haven demand. In modeling gold prices, we also pay attention to a group of tactical indicators that complements our fundamental analysis using sentiment, positioning and technical indicators (Table 1).1 Table 1Fundamental And Technical Gold-Price Drivers As important as real rates are to the evolution of gold prices, technical factors – chiefly sentiment and positioning – also played a large role in gold’s recent breakout (Chart 2). Our tactical composite indicator moved from oversold to overbought territory. Sentiment often is a thin reed on which to place too much conviction, and, over the near term, this could weigh on prices, as market participants try to anticipate when sentiment will change.2 Tracking these variables allows us to generate a “fair value” for gold, which represents the equilibrium at which all of these diverse forces meet (Chart 3). Chart 2Technical Indicators Play A Role In Price Formation Chart 3Gold Fair Value Model Captures Upward Trajectory For Gold Below, we discuss each group of fundamentals driving gold prices, using this analysis to draw investment conclusions. Inflation Hedging Demand Hedging against inflation historically has been one of the key drivers of gold demand. For most of the 21st century, inflationary pressures in the U.S. have remained subdued (Chart 4). For the most part, the recent fall in realized inflation is due to transitory factors like the sharp decline in financial-services costs inflation following last December’s market sell-off (Chart 5). However, it also reflects a larger-than-expected slowdown in the U.S. and global economy, as well as falling inflation expectations (Chart 6). Low realized and expected inflation will, we believe, make it easier for the Fed to cut rates at its upcoming end-July meeting.   Chart 4Inflation Pressures Remain Subdued Our research shows inflation-hedging demand for gold only supports the metal’s price in periods of “high” inflation – i.e., realized and expected inflation rates running above 4.5% p.a. Chart 5Transitory Factors Push Realized Inflation Lower Chart 6Inflation Expectations Also Are Subdued Over the short term – i.e., the next 3 months or so – this means demand for an inflation hedge will not be the primary driver of gold prices. All the same, markets might be getting out ahead of themselves on this score: The Fed’s recent dovish turn signals inflation could surprise to the upside, and likely will move above target next year. As our U.S. Bond strategists note, the Fed’s new battleground is between inflation expectations and financial conditions.3 Indeed, the upcoming “insurance cut” from the Fed at its end-July meeting largely reflects the Fed’s goal of reviving inflation expectations.4 Our research shows inflation-hedging demand for gold only supports the metal’s price in periods of “high” inflation – i.e., realized and expected inflation rates running above 4.5% p.a. We expect inflation to trend higher later in 2020.5 Ordinarily, during inflationary periods, store-of-value assets like gold are bid up as demand exceeds relatively inelastic supply.6 Bottom Line: For now, even though realized and expected inflation remains subdued, it can exceed the Fed’s and other systematically important central banks’ policy rates. This produces low inflation-adjusted interest rates – real rates, in the vernacular – which are bullish for gold prices. We explore this further below. Monetary And Financial Aggregates In the current low-interest-rate environment, inflation rates do not have to rise far above central-bank targets to trigger a flight to gold. Indeed, real rates can quickly turn negative as inflation rises, which diminishes the real return of holding bonds. Since 2014, gold’s price has correlated well with negative yields in global debt markets (Chart 7). The recent dovish turn by systematically important central banks will reinforce this tendency. At present, the monetary and financial aggregates we follow are the most important determinants of gold prices. From an explanatory perspective – vis-à-vis modeling gold prices – these are the most robust group of variables in our analytical framework, as shown in the price decomposition in Chart 1. These variables are important because they focus on the opportunity cost of holding gold, which, in and of itself, generates no yield, and the impact of the U.S. dollar on gold demand, via its price and wealth effects on consumers ex U.S. Chart 7Gold Correlations Rise With Negative-Yielding Debt Chart 8Gold Correlations Also Higher Versus Real Rates U.S. real rates: As a non-yielding asset, gold’s opportunity cost increases with real interest rates. This makes investment demand for gold negatively correlated with real rates (Chart 8). As mentioned previously, the recent dovish turn by major central banks – notably the Fed – supported gold’s 10.8% return YTD, and will continue to do so as we approach the July FOMC meeting. Nonetheless, the positive effect of monetary easing could diminish going into 2H19. Our U.S. Bond strategists’ recent research shows yields rise, on average, following a mid-cycle “insurance rate” cut (Chart 9).7 A second “insurance cut” in 2H19 would delay a rise in yields further into 2H19 or 2020. Because of this, markets will be focused on the Fed’s forward guidance, following it FOMC’s end-July meeting. U.S. Dollar: One of the most stable and powerful relationships with gold prices is its inverse correlation to the U.S. dollar (USD). Chart 10 illustrates this relationship, which has held since the 1990s and before, and has been even more profound than that of oil and copper with the greenback. For one, gold, like oil and copper, is quoted in U.S. dollars, so a drop in the greenback is manifested through higher gold prices because of the numeraire effect. But the powerful relationship between the dollar and gold is at the heart of the function of gold as a medium of exchange, from time immemorial. Chart 10Gold's Relationship With USD Is Long-Standing Gold continues to outperform Treasurys today, which has historically been an ominous sign for the U.S. dollar. Ever since the end of the Bretton Woods agreement broke the gold/dollar link in the early ‘70s, bullion has stood as a viable barometer of dollar liabilities, capturing the ebbs and flows of investor confidence in the greenback tick for tick. With the Federal Reserve’s dovish shift, we may just have triggered one of the necessary catalysts for a selloff in the U.S. dollar. A pick-up in global and Chinese growth amidst ample liquidity conditions will be supportive of gold. The rationale is pretty simple. Investors who are worried about U.S. twin deficits – fiscal and trade – and the crowded trade of being long Treasurys will shift into gold, since pretty much every other major bond market (Germany, Switzerland, Japan) has negative yields. That favors gold at the expense of the dollar. The reverse is true if investors consider Treasurys more of a safe haven. The bond-to-gold ratio and dollar tend to move tick for tick, so a breakout in one can be a signal for what will happen to the other (Chart 11). Given interest rates, portfolio flows, balance-of-payments dynamics and growth differentials are moving against the U.S. dollar, a breakdown will be a powerful catalyst for higher gold prices. Meanwhile, a fall in the dollar improves the purchasing power of many emerging-market countries as their currencies appreciate. These countries, especially China, Russia and India tend to be the marginal buyers of gold. Chart 12 shows that there is a pretty strong and consistent relationship between the performance of EM relative to DM equities and the gold price. The important takeaway is that the rise in the gold price has not yet been supported by the normal wealth-effect channels from emerging markets, suggesting we are just in the early stages of the rally. Chart 11As Is The USD's Relationship With The Bond/Gold Ratio Chart 12Gold's Second Leg Up Likely Comes From EM Demand Gold tends to be a “Giffen Good,” meaning physical demand increases as prices rise. Ever since the gold bubble burst in 2011, both financial and jewelry demand have evaporated. The reality is that both China and India went on a buying binge of coins and jewelry during gold’s last bull market, and there is no reason to expect this time to be different, if, as we expect, incomes continue to rise in these markets (Chart 13). This is especially important since less than 28% of gold demand is investment related, with the balance being consumer and industrial. Ergo, a pick-up in global and Chinese growth amidst ample liquidity conditions will be supportive of gold. Consumer and industrial demand for gold is vividly captured in our GIA index (Chart 14). As a weighted average of select country trade data, currencies, industrial production and a few Chinese manufacturing sector variables, it captures the ebb and flow of the global production cycle. More important for the gold price is the trend in this index rather that the amplitude. The upturn remains tentative, but will be another catalyst that cements the gold bull market. Bottom Line: Given interest rates, portfolio flows, balance-of-payment dynamics and growth differentials are moving against the U.S. dollar, a breakdown will be a powerful catalyst for higher gold prices. Higher EM income growth will also be supportive. Chart 14Rebound in EM Industrial Activity Will Boost EM Wealth, Gold Demand Gold As A Portfolio-Diversification Asset Safe-haven assets provide an essential source of returns for investors in times of crisis. Gold remains one of the best safe-haven assets to protect portfolios against drawdowns arising from financial, geopolitical and political crises. Our analysis shows gold performs better than most alternative safe-haven assets – i.e. U.S., Japanese and Swiss bonds and currencies (Chart 15, Top Panel). Importantly, gold is unique because of the non-linearity in its hedging ability: In times of crisis, gold beats most other safe-havens, while also being the top performer among the group in periods of economic and equity market expansion (Chart 16).8 This makes gold a less risky safe-haven asset to own defensively in late cycles. Critically, gold’s performance during periods of heightened geopolitical risk is formidable. Not to put too fine a point on it, but we believe geopolitical risks will remain elevated in 2H19. Three ongoing developments remain important to monitor: Iran-U.S. conflict and the heightened probability of an oil shock. We believe markets are underestimating the likelihood of a military conflict between Iran and the U.S. in the Persian Gulf. While both sides to this standoff in the Gulf have professed their desire to avoid war, the real risk is an inadvertent escalation in hostilities arising from routine operations, as has happened in the past. An escalation of hostilities in the Gulf almost surely would rally oil and gold prices, as Chart 15, Middle Panel – Performance During Geopolitical Crises – shows.9 EM central banks’ de-dollarization. Data from the International Monetary Fund (IMF) shows that the global allocation of foreign exchange reserves towards the U.S. dollar peaked at about 72% in the early 2000s and has been in a downtrend since. At the same time, foreign central banks have been amassing gold reserves, notably Russia and China, almost to the tune of the total annual output of the yellow metal (Chart 17, Bottom Panel). The U.S. dollar remains the reserve currency of the world today, but that exorbitant privilege is fading. Escalating Sino-U.S. trade tensions. The effects on gold prices from an escalation in Sino-U.S. trade tensions are difficult to model. On the one hand, such an escalation would positively impact gold prices, because it increases the probability of more rate cuts from central banks – including the Fed and PBOC – and likely would lead to an increase in equity volatility. It also could impact gold prices negatively, because it likely would diminish EM GDP growth more than U.S. growth, which, over the short-to-medium term, would be negative for gold and commodities generally. This likely also would rally the dollar, which is negative for gold, and commodities generally. About the only thing we can venture at this point is such an escalation would increase the safe-haven demand for gold, as investors rush for cover. Chart 17Central Banks Are Absorbing Most Gold Production Chart 18Gold Becomes More Appealing As Recession Fears Grow Each factor influencing gold is time-varying. The safe-haven component of gold’s price is a modest driver of its price in ordinary times. However, as an economic expansion reaches its limit, gold benefits from mounting recession fears, as these worries usually are exacerbated by the Fed‘s tightening cycles (Chart 18). In these periods, gold’s correlation with real rates diminishes and the inflation and recession/equity-correction risks dominate. This contributed to gold’s outperformance since 4Q18. We continue to recommend gold as a portfolio hedge, given its performance during periods of financial, monetary and geopolitical stress. For the present, however, the dovish turn by systematically important central banks – combined with fiscal stimulus earlier this year, and monetary stimulus later this year in China – implies the expansion will last longer than previously expected, pushing portfolio-diversification demand lower in the ranking of gold’s drivers until the hiking cycle restarts some time in the future.10 Bottom Line: We continue to recommend gold as a portfolio hedge, given its performance during periods of financial, monetary and geopolitical stress, as shown above. Risks remain elevated in all of these dimensions, which will keep gold well supported over the short and medium terms.     Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com   Footnotes 1      The supply of gold is relatively fixed over the short and long term – every ounce of gold ever produced still is in circulation in one form or another (e.g., as jewelry or as an electronic component).Please see the World Gold Council’s Supply and Demand Statistics, which show these data to 1Q19. 2      Please see The Gold Trifecta published June 27, 2019, by BCA Research’s Commodity & Energy Strategy. It is available at ces.bcaresearch.com. 3      Please see The New Battleground For Monetary Policy, published by BCA Research’s U.S. Bond Strategy March 26, 2019.It is available at usbs.bcaresearch.com. 4      This expression was used by Fed Chair Jay Powell in his March congressional testimony: “In our thinking, inflation expectations are now the most important driver of actual inflation.”Please see Fed Puts Inflation Expectations at Heart of Major Policy Review, published by Bloomberg.com March 15, 2019. 5      For more details on gold – and other assets – performance during different inflation regimes, please see BCA Research’s Global Asset Allocation’s Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises, published May 22, 2019.It is available at gaa.bcaresearch.com. 6      Gold’s inelastic supply is important. Gold is regularly treated as a currency; however, it lacks a central bank that can increase its supply via turning up the printing press. This makes the precious metal a so-called "hard currency," and endows it with the ability to maintain its purchasing power during periods of inflation. In addition, it is an asset that is accepted as collateral to support bank lending and margining by the Bank for International Settlements (BIS), and numerous commercial and private banks. 7      Please see The Long Awkward Middle Phase published by BCA Research’s U.S. Bond Strategy July 2, 2019.It is available at usbs.bcaresearch.com. 8      Gold’s performance across the spectrum of bear-to-bull equity markets shows it is, in some respects, similar to a long option position with puts protecting the downside and calls protecting the upside. Its value increases as equities and other asset classes are falling, and it also appreciates as these other assets are rising, albeit not as much at times. 9      Please see Supply – Demand Balances Consistent With Higher Oil Prices, published by BCA Research’s Commodity & Energy Strategy June 20, 2019, for further discussion.See also The Emerging Crisis in the Persian Gulf by Richard Nephew, published by Columbia University's Center on Global Energy Policy July 19, 2019. 10     Please see “Third Quarter 2019 Strategy Outlook: The Long Hurrah” published by BCA Research’s Global Investment Strategy June 28, 2019, for a discussion of U.S. and Chinese stimulus.It is available at gis.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2   Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Special Report

BCA takes pride in its independence. Strategists publish what they really believe, informed by their framework and analysis. Occasionally, this independence results in strongly diverging views and we currently are in one of those times. Within BCA, two views on the cyclical (six to 12-months) outlook for assets have emerged. One camp expects global growth to rebound in the second half of the year. Along with accelerating growth, they anticipate stock prices and risk assets to remain firm, cyclical equities to outperform defensive ones, safe-haven yields to move up, and the dollar to weaken. Meanwhile, another group foresees a further deterioration in activity or a delayed recovery, additional downside in stocks and risk assets, outperformance of defensives relative to cyclicals, low safe-haven yields, and a generally stronger dollar. For the sake of transparency, we have asked representatives of each camp to make their case in a round-table discussion, allowing our clients to decide for themselves which view is more appealing to them. Global Investment Strategy’s Peter Berezin, U.S. Investment Strategy’s Doug Peta, and Global Fixed Income Strategy’s Rob Robis take the mantle for the bullish camp. U.S. Equity Strategy’s Anastasios Avgeriou, Emerging Market Strategy’s Arthur Budaghyan, and European Investment Strategy’s Dhaval Joshi represent the bearish group.1   The round-table discussion below focuses on the cyclical outlook. For longer investment horizons, most strategists agree that a recession is highly likely by 2022. Moreover, on a long-term basis, valuations in both risk assets and safe-haven bonds are very demanding. In this context, a significant back up in yields could hammer risk assets. The BCA Round Table Mathieu Savary: Yield curve inversions have often been harbingers of recessions. Anastasios, you are amongst those investors troubled by this inversion. Do you not worry that this episode might prove similar to 1998, when the curve only inverted temporarily and did not foreshadow a recession? Moreover, how do you account for the highly variable time lags between the inversion of the yield curve and the occurrence of a recession? Chart II-1 (ANASTASIOS)The 1998 Episode Revisited Anastasios Avgeriou: The yield curve inverts at or near the peak of the business cycle and it eventually forewarns of upcoming recessions. This past December, parts of the yield curve inverted and now, BCA’s U.S. Equity Strategy service is heeding the signal from this simple indicator, especially given that the SPX has subsequently made all-time highs as our research predicted.2 The yield curve inversion forecasts a Fed rate cut, and it has never been wrong on that front. It served well investors that heeded the message in June of 1998 as the market soon thereafter fell 20% in a heartbeat. If investors got out at the 1998 peak near 1200 and forwent about 350 points of gains until the March 2000 SPX cycle peak, they still benefited if they held tight as the market ultimately troughed near 777 in October 2002 (Chart II-1). With regard to timing the previous seven recessions using the yield curve, if we accept that mid-1998 is the starting point of the inversion, it took 33 months before the recession commenced. Last cycle, the recession began 24 months after the inversion. Consequently, December 2020 is the earliest possible onset of recession and September 2021, the latest. Our forecast calls for SPX EPS to fall 20% in 2021 to $140 with the multiple dropping between 13.5x and 16.5x for an SPX end-2020 target range of 1,890-2,310.3 In other words we are not willing to play a 100-200 point advance for a potential 1,000 point drawdown. The risk/reward tradeoff is to the downside, and we choose to sit this one out. Mathieu: Rob, you take a much more sanguine view of the current curve inversion. Why? Rob Robis: While the four most dangerous words in investing are “this time is different,” this time really does appear to be different. Never before have negative term premia on longer-term Treasury yields and a curve inversion coexisted (Chart II-2). Longer-term Treasury yields have therefore been pushed down to extremely low levels by factors beyond just expectations of a lower fed funds rate. The negative Treasury term premium is distorting the economic message of the U.S. yield curve inversion. Chart II-2 (ROB)Negative Term Premium Distorting The Economic Message Of An Inverted Yield Curve Term premia are depressed everywhere, as seen in German, Japanese and other yields, reflecting the intense demand for safe assets like government bonds during a period of heightened uncertainty. Global bond markets may also be discounting a higher probability of the ECB restarting its Asset Purchase Program, as term premia typically fall sharply when central banks embark on quantitative easing. This has global spillovers. Prior to previous recessions, U.S. Treasury curve inversions occurred when the Fed was running an unequivocally tight monetary policy. That is not the case today. The real fed funds rate still is not above the Fed’s estimate of the neutral real rate, a.k.a. “r-star,” which was the necessary ingredient for all previous Treasury curve inversions since 1960 (Chart II-3). Chart II-3 (ROB)Fed Policy Is Not Tight Enough For Sustained Curve Inversion Mathieu: The level of policy accommodation will most likely determine whether Anastasios or Rob is proven right. Peter, you have been steadfastly arguing that policy, in the U.S. at least, remains easy. Can you elaborate why? Peter Berezin: Remember that the neutral rate of interest is the rate that equalizes the level of aggregate demand with the economy’s supply-side potential. Loose fiscal policy and fading deleveraging headwinds are boosting demand in the United States. So is rising wage growth, especially at the bottom of the income distribution. Given that the U.S. does not currently suffer from any major imbalances, I believe that the economy can tolerate higher rates without significant ill-effects. In other words, monetary policy is currently quite easy. Of course, we cannot observe the neutral rate directly. Like a black hole, one can only detect it based on the effect that it has on its surroundings. Housing is by far the most interest rate-sensitive sector of the economy. If history is any guide, the recent decline in mortgage rates will boost housing activity in the remainder of the year (Chart II-4). If that relationship breaks down, as it did during the Great Recession, it would suggest that the neutral rate is quite low. Chart II-4 (PETER)Declining Mortgage Rates Bode Well For Housing Given that mortgage underwriting standards have been quite strong and the homeowner vacancy is presently very low, our guess is that housing will hold up well. We should know better in the next few months. Mathieu: Dhaval, you do not agree. Why do you think global rates are not accommodative? Dhaval Joshi: Actually, I think that global rates are accommodative, but that the global bond yield can rise by just 70 bps before conditions become perilously un-accommodative. Here’s where I disagree with Peter: for me, the danger doesn’t come from economics, it comes from the mathematics of ultra-low bond yields. The unprecedented and experimental panacea of our era has been ‘universal QE’ – which has led to ultra-low bond yields everywhere. But what is not understood is that when bond yields reach and remain close to their lower bound, weird things happen to the financial markets. I refer you to other reports for the details, but in a nutshell, the proximity of the lower bound to yields increases the risk of owning supposedly ‘safe’ bonds to the risk of owning so-called ‘risk-assets’. The result is that the valuation of risk-assets rises exponentially (Chart II-5). Because when the riskiness of the asset-classes converges, investors price risk-assets to deliver the same ultra-low nominal return as bonds.4   Comparisons with previous economic cycles miss the current danger. The post-2000 policy easing distorted the global economy by engineering a credit boom – so the subsequent danger emanated from the most credit-sensitive sectors in the economy such as mortgage lending. In contrast, the post-2008 ‘universal QE’ has severely distorted the valuation relationship between bonds and global risk-assets – so this is where the current danger lies. Higher bond yields can suddenly undermine the valuation support of global risk-assets whose $400 trillion worth dwarfs the global economy by five to one. Where is this tipping point? It is when the global 10-year yield – defined as the average of the U.S., euro area,5 and China – approaches 2.5%. Through the past five years, the inability of this yield to remain above 2.5% confirms the hyper-sensitivity of financial conditions to this tipping point (Chart II-6). Right now, I agree that bond yields are accommodative. But the scope for yields to move higher is quite limited. Chart II-6 (DHAVAL)Since 2015, the Global Long Bond Yield Has Struggled To Surpass 2.5 Percent Mathieu: Monetary policy is important to the outlook, but so is the global manufacturing cycle. The global growth slowdown has been concentrated in the manufacturing sector, tradeable goods in particular. Across advanced economies, the service and consumer sectors have been surprisingly resilient, but this will not last if the industrial sector decelerates further. Arthur, you still do not anticipate any major improvement in global trade and industrial production. Can you elaborate why? Chart II-7 (ARTHUR)Global Trade Is Down Due To China Not U.S. Arthur Budaghyan: To properly assess the economic outlook, one needs to understand what has caused the ongoing global trade/manufacturing downturn. One thing we know for certain: It originated in China, not the U.S.  Chart II-7 illustrates that Korean, Japanese, Taiwanese and Singaporean exports to China have been shrinking at an annual rate of 10%, while their shipments to the U.S. have been growing. China’s aggregate imports have also been contracting. This entails that from the perspective of the rest of the world, China has been and remains in recession. Chart II-8 (ARTHUR)Stimulus Versus Marginal Propensity To Spend U.S. manufacturing is the least exposed to China, which is the main reason why it has been the last shoe to drop. Hence, the U.S. has lagged in this downturn, and one should not be looking to the U.S. for clues about a potential global recovery. We need to gauge what will turn Chinese demand around. In this regard, the rising credit and fiscal spending impulse is positive, but it has so far failed to kick start a recovery (Chart II-8). The key reason has been a declining marginal propensity to spend among households and companies. Notably, the marginal propensity to spend of mainland companies leads industrial metals prices by a few months, and it currently continues to point south (Chart II-8, bottom panel).   The lack of willingness among Chinese consumers and enterprises to spend is due to several factors: (1) the U.S.-China confrontation; (2) high levels of indebtedness among both enterprises and households (Chart II-9); (3) ongoing regulatory scrutiny over banks and shadow banking as well as local government debt; and (4) a lack of outright government subsidies for purchases of autos and housing. Chart II-9 (ARTHUR)Chinese Households Are Leveraged Than U.S. Ones On the whole, the falling marginal propensity to spend will all but ensure that any recovery in mainland household and corporate spending is delayed. Mathieu: Meanwhile, Peter, you have a much more optimistic stance. Why do you differ so profoundly with Arthur’s view? Peter: China’s deleveraging campaign began more than a year before global manufacturing peaked. I have no doubt that slower Chinese credit growth weighed on global capex, but we should not lose sight of the fact there are natural ebbs and flows at work. Most manufactured goods retain some value for a while after they are purchased. If spending on, say, consumer durable goods or business equipment rises to a high level for an extended period, a glut will form, requiring a period of lower production.  These demand cycles typically last about three years; roughly 18 months on the way up, 18 months on the way down (Chart II-10). The last downleg in the global manufacturing cycle began in early 2018, so if history is any guide, we are nearing a trough. The fact that U.S. manufacturing output rose in both May and June, followed by this week’s sharp rebound in the July Philly Fed Manufacturing survey, supports this view. Chart II-10 (PETER)The Global Manufacturing Cycle Has Likely Reached A Bottom Of course, extraneous forces could complicate matters. If trade tensions ratchet higher, this would weaken my bullish thesis. Nevertheless, with China stimulating its economy again, it would probably take a severe trade war to push the global economy into recession. Mathieu: Dhaval, you are not as negative as Arthur, but nonetheless expect a slowdown in the second half of the year. What is your rationale? Dhaval: To be clear, I am not forecasting a recession or major downturn – unless, as per my previous answer, the global 10-year bond yield approaches 2.5% and triggers a severe dislocation in global risk-assets. In fact, many people get the relationship between recession and financial market dislocation back-to-front: they think that the recession causes the financial market dislocation when, in most cases, the financial market dislocation causes the recession! Nevertheless, I do believe that European and global growth is entering a regular down-oscillation based on the following compelling evidence: 1. From a low last summer, quarter-on-quarter GDP growth rates in the developed economies have already rebounded to the upper end of multi-year ranges. 2. Short-term credit impulses in Europe, the U.S., and China are entering down-oscillations (Chart II-11). Chart II-11 (DHAVAL)Short-Term Impulses Rebounded... But Are Now Rolling Over 3. The best current activity indicators, specifically the ZEW economic sentiment indicators, have rolled over. 4. The outperformance of industrials – the equity sector most exposed to global growth – has also rolled over. Why expect a down-oscillation? Because it is the rate of decline in the bond yield that drove the rebound in growth after its low last summer. Furthermore, it is impossible for the rate of decline in the bond yield to keep increasing, or even stay where it is. Counterintuitively, if bond yields decline, but at a reduced pace, the effect is to slow economic growth.  Mathieu: A positive and a negative view of the world logically result in bifurcated outlooks for interest rates and the dollar. Rob, how do you see U.S., German, and Japanese yields evolving over the coming 12 months? Rob: If global growth rebounds, U.S. Treasury yields will have far more upside than Bund or JGB yields. Inflation expectations should recover faster in the U.S., with the Fed taking inflationary risks by cutting rates with a 3.7% unemployment rate and core CPI inflation at 2.1%. The Fed is also likely to disappoint by delivering fewer rate cuts than are currently discounted by markets (90bps over the next 12 months). Treasury yields can therefore increase more than German and Japanese yields, with the ECB and BoJ more likely to deliver the modest rate cuts currently discounted in their yield curves (Chart II-12). Chart II-12 (ROB)U.S. Treasuries Will Underperform Bunds & JGBs Japanese yields will remain mired at or below zero over the next 6-12 months, as wage growth and core inflation remain too anemic for the BoJ to alter its 0% target on 10-year JGB yields. German yields have a bit more potential to rise if European growth begins to recover, but will lag any move higher in Treasury yields. That means that the Treasury-Bund and Treasury-JGB spreads will move higher over the next year. Negative German and Japanese yields may look completely unappetizing compared to +2% U.S. Treasury yields, but this handicap vanishes when all three yields are expressed in U.S. dollar terms. Hedging a 10-year German Bund or JGB into higher-yielding U.S. dollars creates yields that are 50-60bps higher than a 10-year U.S. Treasury. It is abundantly clear that German and Japanese bonds will outperform Treasuries over the next year if global growth recovers. Mathieu: Peter, your positive view on global growth means that the Fed will cut rates less than what is currently priced into the OIS curve. So why do you expect the dollar to weaken in the second half of 2019? Peter: What the Fed does affects interest rate differentials, but just as important is what other central banks do. The ECB is not going to raise rates over the next 12 months. However, if euro area growth surprises on the upside later this year, investors will begin to question the need for the ECB to keep policy rates in negative territory until mid-2024. The market’s expectation of where policy rates will be five years out tends to correlate well with today’s exchange rate. By that measure, there is scope for interest rate differentials to narrow against the U.S. dollar (Chart II-13). Chart II-13A (PETER)Interest Rate Expectations Against The U.S. Should Narrow (II) Chart II-13B (PETER)Interest Rate Expectations Against The U.S. Should Narrow (I)   Chart II-14 (PETER)The Dollar Is A Countercyclical Currency Keep in mind that the U.S. dollar is a countercyclical currency, meaning that it moves in the opposite direction of global growth (Chart II-14). This countercyclicality stems from the fact that the U.S. economy is more geared towards services than manufacturing compared with the rest of the world. As such, when global growth accelerates, capital tends to flow from the U.S. to the rest of the world, translating into more demand for foreign currency and less demand for dollars. If global growth picks up in the remainder of the year, as I expect, the dollar will weaken. Mathieu: Arthur, as you are significantly more negative on growth than either Rob or Peter, how do you see the dollar and global yields evolving over the coming six to 12 months? Arthur: I am positive on the trade-weighted U.S. dollar for the following reasons: The U.S. dollar is a countercyclical currency – it exhibits a negative correlation with the global business cycle. Persistent weakness in the global economy emanating from China/EM is positive for the dollar because the U.S. economy is the major economic block least exposed to a China/EM slowdown. Meanwhile, the greenback is only loosely correlated with U.S. interest rates. Thereby, the argument that lower U.S. rates will drive the value of the U.S. currency much lower is overemphasized. The Federal Reserve will cut rates by more than what is currently priced into the market only in a scenario of a complete collapse in global growth. Yet this scenario would be dollar bullish. In this case, the dollar’s strong inverse relationship with global growth will outweigh its weak positive relationship with interest rates. Contrary to consensus views, the U.S. dollar is not very expensive. According to unit labor costs based on the real effective exchange rate – the best currency valuation measure – the greenback is only one standard deviation above its fair value. Often, financial markets tend to overshoot to 1.5 or 2 standard deviations below or above their historical mean before reversing their trend. One of the oft-cited headwinds facing the dollar is positioning, yet there is a major discrepancy between positioning in DM and EM currencies versus the U.S. dollar. In aggregate, investors – asset managers and leveraged funds – have neutral exposure to DM currencies, but they are very long liquid EM exchange rates such as the BRL, MXN, ZAR and RUB versus the greenback. The dollar strength will occur mostly versus EM and commodities currencies. In other words, the euro, other European currencies and the yen will outperform EM exchange rates. I have less conviction on global bond yields. While global growth will disappoint, yields have already fallen a lot and the U.S. economy is currently not weak enough to justify around 90 basis points of rate cuts over the next 12 months. Mathieu: Before we move on to investment recommendations, Anastasios, you have done a lot of interesting work on the outlook for U.S. profits. What is the message of your analysis? Chart II-15 (ANASTASIOS)Gravitational Pull Anastasios: While markets cheered the trade truce following the recent G-20 meeting, no tariff rollback was agreed. Since the tariff rate on $200bn of Chinese imports went up from 10% to 25% on May 10, odds are high that manufacturing will remain in the doldrums. This will likely continue to weigh on profits for the remainder of the year. Profit growth should weaken further in the coming six months. Periods of falling manufacturing PMIs result in larger negative earnings growth surprises as market forecasters rarely anticipate the full breadth and depth of slowdowns. Absent profit growth, equity markets lack the necessary ‘oxygen’ for a durable high-quality rally. Until global growth momentum turns, investors should fade rallies. Our four-factor SPX EPS growth model is flirting with the contraction zone. In addition, our corporate pricing power proxy and Goldman Sachs’ Current Activity Indicator both send a distress signal for SPX profits (Chart II-15). Already, more than half of the S&P 500 GICS1 sectors’ profits are estimated to have contracted in Q2, and three sectors could see declining revenues on a year-over-year basis, according to I/B/E/S data. Q3 depicts an equally grim profit picture that will also spill over to Q4. Adding it all up, profits will underwhelm into year-end. Mathieu: Doug, you do not share Anastasios’s anxiety. What offsets do you foresee? Moreover, you are not concerned by the U.S. corporate balance sheets. Can you share why? Doug Peta: As it relates to earnings, we foresee offsets from a revival in the rest of the world. Increasingly accommodative global monetary policy and reviving Chinese growth will give global ex-U.S. economies a boost. That inflection may go largely unnoticed in U.S. GDP, but it will help the S&P 500, as U.S.-based multinationals’ earnings benefit from increased overseas demand and a weaker dollar. When it comes to corporate balance sheets, shifting some of the funding burden to debt from equity when interest rates are at generational lows is a no-brainer. Even so, non-financial corporates have not added all that much leverage (Chart II-16). Low interest rates, wide profit margins and conservative capex have left them with ample free cash flow to service their obligations (Chart II-17). Chart II-16 (DOUG)Corporations Have Not Added Much Leverage ... Chart II-17 (DOUG)...Though They Have Ample Cash Flow To Service It Every single viable corporate entity with an effective federal tax rate above 21% became a better credit when the top marginal rate was cut from 35% to 21%. Every such corporation now has more net income with which to service debt, and will have that income unless the tax code is revised. You can’t see it in EBITDA multiples, but it will show up in reduced defaults. Mathieu: The last, and most important question. What are each of your main investment recommendations to capitalize on the economic trends you anticipate over the coming 6-12 months? Let’s start with the pessimists: Arthur: First, the rally in global cyclicals and China plays since December has been premature and is at risk of unwinding as global growth and cyclical profits disappoint. Historical evidence suggests that global share prices have not led but have actually been coincident with the global manufacturing PMI (Chart II-18). The recent divergence is unprecedented. Chart II-18 (ARTHUR)Global Stocks Historically Did Not Lead PMIs Chart II-19 (ARTHUR)China And EM Profits Are Contracting Second, EM risk assets and currencies remain vulnerable. EM and Chinese earnings per share are shrinking. The leading indicators signal that the rate of contraction will deepen, at least the end of this year (Chart II-19). Asset allocators should continue underweighting EM versus DM equities. Finally, my strongest-conviction, market-neutral trade is to short EM or Chinese banks and go long U.S. banks. The latter are much healthier than EM/Chinese ones, as we discussed in our recent report.6  Anastasios: The U.S. Equity Strategy team is shifting away from a cyclical and toward a more defensive portfolio bent. Our highest conviction view is to overweight mega caps versus small caps. Small caps are saddled with debt and are suffering a margin squeeze. Moreover, approximately 600 constituents of the Russell 2000 have no forward profits. Only one S&P 500 company has negative forward EPS. Given that both the S&P and the Russell omit these figures from the forward P/E calculation, this is masking the small cap expensiveness. When adjusted for this discrepancy, small caps are trading at a hefty premium versus large caps (Chart II-20). We have also upgraded the S&P managed health care and the S&P hypermarkets groups. If the economic slowdown persists into early 2020, both of these defensive subgroups will fare well. In mid-April, we lifted the S&P managed health care group to an above benchmark allocation and posited that the selloff in this group was overdone as the odds of “Medicare For All” becoming law were slim. Moreover, a tight labor market along with melting medical cost inflation would boost the industry’s margins and profits (Chart II-21). Chart II-20 (ANASTASIOS)Continue To Avoid Small Caps Chart II-21 (ANASTASIOS)Buy Hypermarkets   Chart II-22 (ANASTASIOS)Stick With Managed Health Care This week, we upgraded the defensive S&P hypermarkets index to overweight arguing that the souring macro landscape coupled with a firming industry demand outlook will support relative share prices (Chart II-22). Dhaval: To be fair, I am not a pessimist. Provided the global bond yield stays well below 2.5 percent, the support to risk-asset valuations will prevent a major dislocation. But in a growth down-oscillation, the big game in town will be sector rotation into pro-defensive investment plays, especially into those defensives that have underperformed (Chart II-23). On this basis: Overweight Healthcare versus Industrials. Overweight the Eurostoxx 50 versus the Shanghai Composite and the Nikkei 225. Overweight U.S. T-bonds versus German bunds. Overweight the JPY in a portfolio of G10 currencies. Chart II-23 (DHAVAL)Switch Out Of Growth-Sensitives Into Healthcare Mathieu: And now, the optimists: Doug: So What? is the overriding question that guides all of BCA’s research: What is the practical investment application of this macro observation? But Why Now? is a critical corollary for anyone allocating investment capital: Why is the imbalance you’ve observed about to become a problem? As Herbert Stein said, “If something cannot go on forever, it will stop.” Imbalances matter, but Dornbusch’s Law counsels patience in repositioning portfolios on their account: “Crises take longer to arrive than you can possibly imagine, but when they do come, they happen faster than you can possibly imagine.” Look at Chart II-24, which shows a vast white sky (bull markets) with intermittent clusters of gray (recessions) and light red (bear markets) clouds. Market inflections are severe, but uncommon. When the default condition of an economy is to grow, and equity prices to rise, it is not enough for an investor to identify an imbalance, s/he also has to identify why it’s on the cusp of reversing. Right now, as it relates to the U.S., there aren’t meaningful imbalances in either markets or the real economy. Chart II-24 (DOUG)Recessions And Bear Markets Travel Together Even if we had perfect knowledge that a recession would arrive in 18 months, now would be way too early to sell. The S&P 500 has historically peaked an average of six months before the onset of a recession, and it has delivered juicy returns in the year preceding that peak (Table II-1). Bull markets tend to sprint to the finish line (Chart II-25). If this one is like its predecessors, an investor risks significant relative underperformance if s/he fails to participate in its go-go latter stages. We are bullish on the outlook for the next six to twelve months, and recommend overweighting equities and spread product in balanced U.S. portfolios while significantly underweighting Treasuries. Peter: I agree with Doug. Equity bear markets seldom occur outside of recessions and recessions rarely occur when monetary policy is accommodative. Policy is currently easy, and will get even more stimulative if the Fed and several other central banks cut rates. Global equities are not super cheap, but they are not particularly expensive either. They currently trade at about 15-times forward earnings. Given the ultra-low level of global bond yields, this generates an equity risk premium (ERP) that is well above its historical average (Chart II-26). One should favor stocks over bonds when the ERP is high. Chart II-26A (PETER)Equity Risk Premia Remain Elevated (I) Chart II-26B (PETER)Equity Risk Premia Remain Elevated (II)   The ERP is especially elevated outside the United States. This is partly because non-U.S. stocks trade at a meager 13-times forward earnings, but it also reflects the fact that bond yields are lower overseas. As global growth accelerates, the dollar will weaken. Equity sectors and regions with a more cyclical bent will benefit (Chart II-27). We expect to upgrade EM and European stocks later this summer. A softer dollar will also benefit gold. Bullion will get a further boost early next decade when inflation begins to accelerate. We went long gold on April 17, 2019 and continue to believe in this trade.  Rob: For fixed income investors, the most obvious way to play a combination of monetary easing and recovering global growth is to overweight corporate debt versus government bonds (Chart II-28). Chart II-27 (PETER)EM And Euro Area Equities Outperform When Global Growth Improves Chart II-28 (ROB)Best Bond Bets: Overweight Global Corporates & Inflation-Linked Bonds   Within the U.S., corporate bond valuations look more attractive in high-yield over investment grade. Assuming a benign outlook for default risk in a reaccelerating U.S. economy, with the Fed easing, going for the carry in high-yield looks interesting. Emerging market credit should also do well if we see a bit of U.S. dollar weakness and additional stimulus measures in China. European corporates, however, may end up being the big winner if the ECB chooses to restart its Asset Purchase Program and ramps up its buying of European company debt. There are fewer restrictions for the ECB to buy corporates compared to the self-imposed limits on government bond purchases. The ECB would be entering a political minefield if it chose to buy more Italian debt and less German debt, but nobody would mind if the ECB helped finance European companies by buying their bonds. If one expects reflation to be successful, a below-benchmark stance on portfolio duration also makes sense given the current depressed level of government bond yields worldwide. Yields are more likely to grind upward than spike higher, and will be led first by increasing inflation expectations. Inflation-linked bonds should feature prominently in fixed income portfolios, especially in the U.S. where TIPS will outperform nominal yielding Treasuries. Mathieu: Thank you very much to all of you. Below is a comparative summary of the main arguments and investment recommendations of each camp. Anastasios Avgeriou U.S. Equity Strategist Peter Berezin Chief Global Strategist Arthur Budaghyan Chief Emerging Markets Strategist Dhaval Joshi Chief European Investment Strategist Doug Peta Chief U.S. Investment Strategist Robert Robis Chief Fixed Income Strategist Mathieu Savary The Bank Credit Analyst   Summary Of Views And Recommendations The Bulls… …And The Bears Footnotes 1       To be fair to each individual involved, this is simplifying their views. Even within each camp, the negativity or positivity ranges on a spectrum, as you will be able to tell from the debate itself. 2       Please see BCA U.S. Equity Strategy Weekly Report, “Signal Vs. Noise,” dated December 17, 2018, available at uses.bcaresearch.com. 3       Please see BCA U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment,” dated June 10, 2019, available at uses.bcaresearch.com. 4       Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance,” October 25, 2018 available at eis.bcaresearch.com. 5     France is a good proxy for the euro area. 6     Please see Emerging Markets Strategy Weekly Report, “On Chinese Banks And Brazil,” available at ems.bcaresearch.com.