Elections

Special Report

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given my many concerns about the outlook. Our portfolio has done well in the past year thanks to the surge in bond prices and the outperformance of defensive equities. However, I am deeply troubled by the amount of monetary stimulus required to support risk assets, and by how expensive bonds and equities are. Moreover, the global economy remains engulfed in deflationary risks, and policymakers are running out of ammunition. As always, there is much to talk about. Ms. X: Let me add that I am also pleased to once again be here to discuss the major risks and opportunities in the global marketplace. A year ago, I held a more positive market view than my father. Directly after our meeting, the deep market correction gave me second thoughts, but ultimately, the rebound in stock prices vindicated my view. Clearly, your assertion that markets would be turbulent proved correct. Since I joined the family firm in early 2017, I have been pushing my father to keep a higher equity exposure than he was normally comfortable with. We agreed to still favor stocks last year, albeit, with a bias toward defensive sectors, and this strategy paid off. But after the past year’s powerful rally in both bonds and stocks, we are again left wondering how to position our portfolio. Ultimately, I do not believe a recession is imminent. Yes, stocks are expensive, but bonds are even more so. Since I expect economic growth to pick up, I am inclined to tilt the portfolio further into equities and move away from our preference for defensive sectors. As usual, I am very interested to hear your views. BCA: Our core theme for 2019 was that we would face classic late-cycle turbulence. Despite this volatility, a run-up in asset prices was likely. Soon after we met, the stock market plunged, hitting a low on December 26, 2018. We anticipated the Federal Reserve to be much more hawkish than what actually transpired. Wage growth and even core inflation have remained firm in the US, but the weakness in global inflation expectations drove central banks’ reaction functions more powerfully than we anticipated. Moreover, the rapid escalation of the Sino-US trade war added a layer of uncertainty that exacerbated the economic slowdown that had started in mid-2018, forcing global central banks to ease policy as an indemnity against recession. Looking ahead, central bankers are highly unlikely to tighten monetary policy as long as inflation expectations remain below their normal range consistent with a 2% inflation target. We agree that the odds of a US recession in the coming year are still low because financial conditions are set to remain accommodative, Chinese authorities are setting policy to shore up growth, and a trade truce is likely. Global economic activity will rebound in early 2020. Instead, the most probable timeframe for a broad based recession is late 2021/early 2022. As a result, we remain positive on risk assets, especially foreign stocks. We are also underweighting bonds as they offer extremely poor absolute and relative value. Mr. X: I can see we will have a lively discussion because I do not share your or my daughter’s optimism. My list of concerns is long, I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: This exercise is always interesting and often humbling, too. A year ago, our key conclusions were that: Tensions between policy and markets would be an ongoing theme in 2019. With the US unemployment rate at a 48-year low, it would take a significant slowdown for the Fed to stop hiking rates. Ultimately, the Fed would deliver more hikes in 2019 than discounted in the markets. This would push up the dollar and keep the upward trend in Treasury yields intact. The dollar would peak in mid-2019. China would also become more aggressive in stimulating its economy, which would boost global growth. However, until both of these things happened, emerging markets would remain under pressure. We favored developed market equities over their EM peers. We also preferred defensive equity sectors such as healthcare and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the US would outperform Europe and Japan over the next few quarters, especially in dollar terms. Stabilization in global growth would ignite a blow off rally in global equities. If the Fed was raising rates in response to falling unemployment, it would be unlikely to derail the stock market. However, once supply-side constraints began to bite fully in early 2020 and inflation began to rise well above the Fed’s target of 2%, stocks would begin to buckle. This would mean that a window would exist in 2019 for stocks to outperform bonds. We would maintain a benchmark allocation to stocks, but increase exposure if global bourses were to fall significantly from then (late 2018) current levels without a corresponding deterioration in the economic outlook. Corporate credit would underperform stocks as government bond yields rise. A major increase in credit spreads was unlikely as long as the economy remained in expansion mode, but spreads could still widen modestly. US shale companies had been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices would be unlikely to rise much from current levels over the long term. However, we expected production cuts in Saudi Arabia would push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio was likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. As already noted, our forecast for more Fed rate hikes was wrong. This meant that we were offside in our duration call. Ultimately, 10-year Treasuries have generated returns of 10.8% so far this year, and German bunds and Japanese government bonds returns of 5.8% and 1.0% in EUR and JPY terms, or 2.5% and 2.0% in USD terms, respectively (Table 1). Nonetheless, our expectation of a run-up in risk asset prices was spot on. Equities outperformed bonds, with global stocks climbing 22.2% in USD terms. We missed the initial outperformance of corporate bonds relative to Treasuries, as investment grade credit rose by 13.9%. However, our bond team took a more constructive stance on corporates as the year progressed. Table 1Market Performance Chart 12019 Was A Good Year For Stocks In terms of regional allocation recommendations, we were correct to overweight US equities which beat non-US stocks by 13.4%, partly thanks to the dollar’s appreciation. We were also right to underweight EM equities, with Asia and Latin America generating dollar returns of only 12.6% and 6.9%. Overall, it was a good year for financial markets (Chart 1). Our growth forecasts were mixed. We predicted global growth would slow in the first half of 2019 but improve thereafter. Instead, the slowdown extended and intensified into the second half of the year as the Sino-US trade war escalated more than expected, and Chinese policymakers were more reluctant to reflate than anticipated. The IMF also revised down its growth forecasts. In the October 2019 World Economic Outlook report, growth in advanced economies for the year was cut to 1.7% from 2.1% compared to 2018 forecasts, led by a downward revision to 1.5% from 2% in Europe (Table 2). They also pared down 2019 EM growth estimates to 3.9% from 4.7%. Consequently, inflation was softer than originally predicted. These trends in economic activity meant that our dollar call was partially right. The currency did not peak in the middle of the year as we foresaw, but has been flat since the spring and today trades where it was in April. Meanwhile, the weaker-than-expected growth put our oil call offside, with Brent averaging $62/bbl this year, not $82/bbl. Table 2IMF Economic Forecasts The Cycle’s End Game Mr. X: You mentioned that you remain positive on risk assets and stocks for 2020. You will not be surprised that I am extremely skeptical of this view. The Fed could only raise rates to 2.5% before all hell broke loose, and it has now cut them back to 1.75%. The European Central Bank has lowered its deposit rate to -0.5% and is resuming its asset purchase program, while the Bank of Japan is clearly out of ammunition. Yet global growth remains weak. Despite this lack of economic traction, US stocks are at a record high and are unequivocally expensive. This situation seems untenable. If global growth weakens further, there is little more policymakers can do. I think the risk of a recession is a lot more elevated than you believe, especially as we cannot count on a lasting trade détente. Meanwhile, the US presidential election makes me uncomfortable, and I cannot see how business leaders will want to deploy capital to expand capacity given the risk that the regulatory and tax environment could become hostile to the corporate sector. If I’m wrong about growth – and I hope I am – then inflationary pressures will build and central banks will have to tighten policy suddenly. As bond yields rise, stocks will be sold and yet bonds will not offer any protection since they yield so little. Also, I have not even talked about negative interest rates. $12.1 trillion of debt yields less than zero percent. This is obviously preventing creative destruction from purging the system of rot. It is also promoting capital misallocation and undue risk-taking by financial institutions who cannot meet fiduciary liabilities. Ms. X: Based on this tirade, you can easily imagine what life at the office has been like in recent months. I do share some of my father’s concerns. Negative rates cannot be a good thing, especially from a long-term perspective. If growth weakens further, I’m also concerned that central banks have few options left. However, I do not see these risks as imminent. There are nascent signs that the global economy will stabilize soon; both President Trump and President Xi have strong incentives to reach a trade truce; and central banks are nowhere near removing the proverbial punch bowl. While US stocks are expensive, other risk assets offer value if global growth rebounds. The wall of worry is high, but stocks can and will climb that wall. BCA: Your debate is similar to our own internal discussions. It is undeniable that the investing landscape looks shaky at the moment, especially with the S&P 500 currently trading at 18-times forward earnings. However, the situation you are describing is a direct consequence of one BCA’s long running macro themes: The end of the debt supercycle. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular. The private debt load in advanced economies has declined by 20% of GDP since 2009 (Chart 2A). Despite the burgeoning US federal government deficit, public debt accumulation has not been strong enough to cause total debt loads to increase. Instead, aggregate indebtedness has been stuck slightly above 260% of GDP for the past 10 years. Depressed, and in some cases, negative interest rates reflect weak demand for credit. Chart 2AThe Debt Supercycle Is Dead In DM... Chart 2B...But Not In EM   The end of the debt supercycle has both a negative and positive impact. Without increasing leverage, domestic demand cannot grow faster than trend GDP. Thus, it takes much more time for inflationary pressures to build. Concurrently, in the absence of inflationary pressure, more time passes before monetary policy reaches a restrictive level causing recession. The upshot is that the business cycle can last much longer. Moreover, a world less geared to credit accumulation reduces the fragility of the financial system, at the margin. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular (Chart 2B), where the demand for credit is still very sensitive to changes in monetary settings. EM countries are the major source of volatility in the global business cycle. Chinese policymakers’ management of the tradeoff between growth and leverage will determine whether the global economy can avoid deflation. If they decide to tackle debt excesses head on, EM credit growth will contract and EM final demand will suffer. In this scenario, negative rates will persist in low-growth advanced economies, and the Fed will be incapable of raising rates because global deflationary forces will be too strong. Chart 3The World Is In The Midst Of A Deflationary Episode The second half of 2018 and the whole of 2019 gave us a taste of these forces. When China tightened credit conditions, the EM economies slowed first. Trade and manufacturing hubs like Europe, Australia and Japan quickly followed. A deflationary wave spread around the world, as evidenced by a drop in global producer prices (Chart 3). The US is a comparatively closed economy, but it could not avoid this gravitational pull. The ISM manufacturing survey ultimately started to contract in August 2018, converging to weakness in the rest of the world. The trade war’s hit to business confidence added insult to the injury of an already weak economic environment. Looking ahead, our optimism reflects an expectation that Chinese policymakers will adopt a more pro-growth policy stance because they too are spooked by the downtrend in their economy. While the Politburo Standing Committee has not abandoned its structural reform agenda, it realizes that aggressive deleveraging is dangerous. The Chinese economy is growing at its weakest pace in nearly 30 years and deflation is once again taking hold. In response to date, policymakers have lowered China’s reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased the issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. EM economies will respond to these stimulative measures. The Chinese credit and fiscal impulse has stabilized (Chart 4). Meanwhile, the Fed has pushed the real fed funds rate 74.4 basis points below the Holston-Laubach-Williams estimate of the neutral rate, and coordinated global policy easing points to a rebound in the global manufacturing sector (Chart 4, bottom panel). Moreover, the global inventory purge that magnified the industrial sector’s pain is getting exhausted and the auto sector is looking up. Finally, we agree with Ms. X that both President Trump and President Xi have their own incentives to deescalate trade policy uncertainty. We are entering the end game of this business cycle and bull market. Global borrowing rates will rise, but only to a limited extent. Rightly or wrongly, major central banks are terrified by the prospect of the Japanification of their economies. Practically speaking, this means that they want inflation expectations to move back up to normal levels (Chart 5). However, after undershooting their 2% targets for 11 years, achieving this objective will require central banks to let realized inflation overshoot these targets first. Thus, central banks are unlikely to tighten policy until late next year at the earliest, which will limit how far yields can climb in 2020. Chart 4…But Do Not Bet Against Reflation Chart 5Depressed Inflation Expectations   Equities and other risk assets should perform well if global growth re-accelerates but interest rates don’t rise much at first. Some benefit of this fertile backdrop is already priced in, but many pockets of value levered to stronger global growth still exist. We are entering the end game of this already long business cycle. While the general environment favors remaining invested in risk assets in 2020, this is likely the last window of opportunity to do so. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will ultimately be forced to lift rates much more aggressively. China will continue to resist excessive leverage. Neither the business cycle nor the equity bull market will withstand these final assaults. Mr. X: Your benign outlook reminds me of when we met in December 2007. Do you remember? You told me that the housing slowdown and the credit market seizure were large risks, but central banks would put a floor under global growth. How did that turn out? I agree that in advanced economies, overall debt loads have been stable. But this belies major disparities. For example, US corporate debt has never represented a larger share of GDP than it does today. This must be a major vulnerability. While household balance sheets look healthy, I do not think consumption will save the day if companies are cutting capex and employment while they clean up their balance sheets. Countries like Canada and Australia are drowning in private sector debt. How can you ignore these vulnerabilities? BCA: A comparison with 2008 actually reveals why advanced economies, particularly the US, are not the powder keg that they once were. US corporate debt is elevated when compared to GDP, but profits also represent a much larger share of GDP than they did 10 or 20 years ago, and interest rates are close to historic lows. As a result, interest coverage ratios are still adequate (Chart 6). In 2007, household debt loads were large, but interest payments also accounted for 18.1% of disposable income, the highest proportion since 1972. Additionally, US firms’ debt-to-asset ratio is in line with the post-1970 average of 22.1%. Finally, US businesses have not used rising leverage to fund capital spending, as demonstrated by the elevated age of the capital stock. Thus, the US corporate sector continues to generate positive net savings. Ahead of recessions, US businesses typically generate negative net savings. The composition of the creditors is another important difference. In 2007, an extremely large share of the spurious borrowings resided on banks’ balance sheets. Moreover, the banking system was woefully undercapitalized with a leverage ratio of 17x. Weak banks had to absorb 2.2 trillion of losses after 2008. Consequently, the money creation mechanism broke down, and money multipliers collapsed (Chart 7). Today, US banks boast relatively stronger balance sheets, and they are still judicious about extending credit despite being less exposed to the corporate sector than they were to the mortgage market in 2008. Instead, most corporate debt is held by less levered entities such as ETFs, pension plans, and insurance companies. The leveraged losses that proved so debilitating in 2008 are less likely to be a source of systemic risk in this cycle. Chart 6US Businesses Can Still Service Their Debt Chart 72008 Heralded A Destruction Of Money   Countries like Australia and Canada have much more worrisome private sector debt dynamics, as their servicing costs are elevated (Chart 8). However, these economies are unlikely to collapse when global rates are low, as long as the global economy can avoid a recession, which would reduce export revenue in these trade-sensitive countries. You expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. The bottom line is that both the US corporate sector and at-risk countries like Canada should avoid a day of reckoning until interest rates rise meaningfully. As we have already mentioned, central banks are very clear that they will allow inflation to overshoot before tightening policy anew. We monitor US inflation breakeven rates to gauge the likely timing of that outcome. At 1.6%, they remain well below the 2.3% to 2.5% range, which is historically consistent with central banks durably achieving their inflation target (Chart 9). Until inflation expectations are re-anchored back up in that range, we will not worry about an imminent tightening in monetary conditions. Chart 8Canada And Australia Are Close To Their Debt Walls Chart 9The Fed Is In No Rush To Tighten   Chart 10Inflation Is A Lagging Indicator It is true that inflationary pressures are building in the US. Historical evidence points to a kink in the Phillips curve, the link between wage growth and the unemployment rate. Since the labor market is tight, we are already seeing average hourly earnings growth accelerate. Moreover, the output gap is mostly closed. However, keep in mind that inflation is also a lagging economic indicator (Chart 10). Consequently, the recent global economic slowdown is likely to keep US inflation at bay for most of 2020. The sharp fall in US capacity utilization along with the decline in imported goods and core producer price inflation corroborate this picture. Mr. X: So you believe that as long as rates stay low, the day of reckoning will be delayed. But ultimately, that it is unavoidable. BCA: Correct. No matter what, we are entering the end game of this already long business cycle. The current period of easy policy will allow cyclical spending to rise as a share of output, and debt to build up again over the coming 18 months. Because slack is clearly limited, this latest wave of policy easing will generate inflationary pressures. Ultimately, the Fed will be forced to play catch up and tighten more aggressively than expected in 2021. Paradoxically, the longer the onset of recession is delayed, the deeper it is likely to be… Mr. X: Because imbalances and vulnerabilities will only grow larger! BCA: Absolutely! Mr. X: That is something we can agree on. Ms. X: The way you complete one another’s sentences is a testament to how many years you have been talking to each other. For me, the most concerning issue is political risk. While I am more positive on the outlook for trade policy than my father, I do worry about the impact of US election risk on capital spending. Chart 11If The 2012 Election Is Any Guide, Trump Can Still Win A Second Term BCA: On the trade war, we would like to address your father’s concerns. All politicians, even unconventional ones like President Trump, seek re-election. Yet, President Trump’s overall approval rating is low (Chart 11). If the election were held today, his odds of winning would be minimal. However, US presidential elections do ultimately favor the incumbent. If the re-election of President Obama in 2012 is any guide, President Trump has enough time to boost his approval rating over the coming 12 months to secure a second term through the Electoral College. In order to achieve this outcome, he must reverse the large slowdown in wage growth currently plaguing the swing states he won by only a small margin in 2016 (Chart 12). Workers in states like Michigan, Pennsylvania and Wisconsin are suffering disproportionately from the uncertainty created by the trade tensions. President Trump will have to pause the tariffs – and even cut tariff rates – to support the economy and reassure voters. Chart 12Trump's Fear Is Coming True China is willing to accept a trade truce. The Chinese economy is weak and producer prices are once again deflating. President Xi doesn’t want to preside over another massive surge in leverage or a 1930’s Irving Fisher-style deflationary spiral. Reviving private sector investment sentiment via a reduction in trade policy uncertainty would help stabilize spending and avoid a disorderly economic slump. Moreover, President Xi may not trust the current White House, but the prospect of a Democratic administration that will be tough on both environmental standards and human rights would offer little solace. This brings us to the US election. The recent Bank of America Merrill Lynch positioning survey shows that the investment community shares your concerns. This risk is hard to quantify. The Democratic nomination is wide open. Former Vice President Joe Biden leads the opinion polls, and is a known quantity. Meanwhile, the rising progressive wing of the party, embodied in Senator Elizabeth Warren, is hostile to business and likely to cause concerns in boardrooms across the US, especially in the tech, energy, financial services and healthcare sectors. This could dampen animal spirits. Biden’s and Warren’s odds of beating President Trump are overstated by current polls, especially if the President softens his stance on trade to allow for a growth pick-up. Moreover, to be competitive nationally, Senator Warren will have to abandon some of her more progressive plans and pivot toward the center. The recent upbeat equity market performance of sectors like managed healthcare suggests that markets are discounting this shift. Thus, we doubt the election is currently really weighing on business intentions. The recent pick up in capital spending intentions in various Fed Manufacturing surveys fades this risk. Chart 13A Structural Tailwind Has Vanished What is clear though is that if the economy were to weaken further, Senator Warren’s chances would improve and CEOs would genuinely begin to worry about re-regulation, potentially unleashing a vicious cycle. Thus, the end game is an unstable equilibrium. On a structural basis, whether one looks at the rise of populism or the geopolitical rivalry between China and the US, trade tensions will remain a pesky feature of the global economy. In effect, the trade truce will not be a permanent deal. The global economy has therefore lost the tailwind of deepening global integration achieved through trade (Chart 13). This will limit global potential GDP growth. Ms. X: Thank you. I think the time is right to explore your economic outlook in more detail. The Economic Outlook Chart 14China: Modest Reflation Is Underway Mr. X: From your arguments, it seems that the outlook for China and Emerging Markets is critical, so let’s start there. My impression is that President Xi is not abandoning his structural reform agenda. Avoiding the middle-income trap will require decreasing China’s dependence on credit as a growth driver. Can economic activity really stabilize under those circumstances? BCA: You are correct: Senior Chinese administrators are reluctant to allow another major phase of debt accumulation to take hold. However, as we already highlighted, policymakers are taking steps to end the most severe economic slowdown since the first half of the 1990s. China is currently implementing a middling stimulus program. The positive impact of the lower bank reserve requirement ratio, the tax cuts and increased public infrastructure spending is being mitigated by strong regulatory constraints on the shadow banking system and small financial institutions, by efforts to limit real estate speculation, and by the cash crunch facing real estate developers. These crosscurrents make it unlikely that the credit impulse will rise as sharply as it did following the reflationary campaigns of 2009, 2012 or 2016. Nonetheless, the Chinese economy is indeed exhibiting some mildly positive signals. Our monetary indicator and state-owned enterprise capital spending point to a rebound in overall Chinese economic activity (Chart 14). Moreover, household spending is trying to bottom. If China stabilizes, then the EM slowdown will end soon. Without a deepening drag from the Chinese economy, EM countries should be able to take advantage of the easing in global financial and liquidity conditions. But the end of the Chinese drag on EM growth does not mean a massive tailwind will be forthcoming. Additionally, deflationary forces remain stronger in the emerging world than in the US. As a result, EM real rates will remain stubbornly above the level that real economic activity warrants, posing a headwind for capital and durable goods spending. Generally speaking, EM and China are moving from a headwind for the world to a mild tailwind. Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone. Ms. X: I’m somewhat more positive than you on global growth next year. The policy easing around the world looks very promising for economic activity. How do you factor the impact of improving global liquidity conditions into your outlook for 2020? BCA: It is undeniable that global liquidity conditions have eased massively. As we already highlighted, the majority of global central banks cutting rates is a very positive dynamic for global growth. Trends in measures of liquidity ratify this message. Foreign exchange reserves are again growing and our BCA US Financial Liquidity index has rallied sharply over the past 12 months. Historically, this indicator forecasts the trend in the BCA Global Leading Economic Indicator, commodity prices and EM export prices by 18 months (Chart 15). Moreover, money aggregates are growing faster than credit across the major advanced economies. Such developments typically foretell an acceleration in global economic activity (Chart 16). Chart 15Liquidity Dynamics: Fueling A Global Growth Recovery Chart 16Rising Money Supply Is A Good Thing   The duration of the current slowdown also warrants optimism. We have often highlighted that since the early 1990s, the global manufacturing sector evolves over 36-month symmetric cycles (Chart 17). The current soft patch has lasted more than 18 months. In the context of easing liquidity and depleted inventories, pent-up demand can easily translate into actual spending. The recent surge in the new orders-to-inventories ratio confirms that global manufacturing activity should soon pick up (Chart 18). The auto sector’s weakness, which was exacerbated by previous inventory buildups, changing emission standards, and rising borrowing costs, is also ebbing. Chart 17The Mid-Cycle Slowdown Is Long In The Tooth Chart 18The New Order-To-Inventory Ratio Points To A Global Rebound     Various growth indicators are sniffing out this positive inflection point. The recent trough in the global ZEW survey is revealing (Chart 19). It materialized quickly after Sino-US trade tensions began to ease. Enough positive global economic momentum exists such that a minor decline in policy uncertainty could unleash a large improvement in growth expectations. The rebound in Taiwanese equities and European luxury stocks confirms that the global economy should soon bottom. There are two things we cannot emphasis enough. First, this is the end game of the business cycle, after which a recession will ensue. Second, investors should not expect the kind of strong synchronized growth rebound witnessed in 2017. Without a Chinese and EM boom, a crucial source of demand will be wanting. Mr. X: What about US growth? The yield curve inverted this summer and deteriorating consumer and business confidence raised the specter of an imminent recession. Moreover, the fiscal stimulus that helped the economy in the first half of 2019 is now over. In fact, with a $1 trillion federal deficit despite an unemployment rate of only 3.6%, we have run out of fiscal room to support activity if and when a recession materializes. BCA: The recent yield curve inversion most likely overstated the risk of an economic contraction. First, in the mid-1990s, if the term premium had been as low as it is today, the curve would have also inverted without any recession materializing from 1995 to 2000. Second, this summer, the curve inverted up to the 5-year tenor and steepened for longer maturities. Prior to recessions, the curve inverts across all maturities. Recessions are not born out of thin air. They are caused by imbalances and tight monetary policy. The large debt buildup and other investment imbalances that have preceded prior US recessions are not yet apparent. Prior to the 1991, 2001 and 2008 recessions, the private sector debt load had increased by 20.6%, 14.6% and 25.6% of GDP in the previous five years, not the current 1.4% run rate. The Fed’s policy is now clearly accommodative. Not only is the real fed funds rate 74.4 basis points below the Fed’s favored estimate of the neutral rate of interest, but also real estate, the most interest-rate sensitive economic sector, is rebounding. In 2018, real estate activity collapsed in response to mortgage rates rising to 4.9%. Today, the NAHB Homebuilding index has retraced 79% of its losses; mortgage demand has improved; and housing starts and building permits have recovered (Chart 20). When policy is tight, real estate activity never recovers this quickly, even as yields fall. Chart 19Positive Signals For Global Growth Chart 20The Housing Market Signals That Policy Is Accommodative   Chart 21Robust Household Financial Health A counterargument is that real estate price appreciation is weak. However, tight monetary policy is not the cause. Two forces are dampening house prices. First, the Jobs and Tax Act of 2017 lowered allowable mortgage interest and state and local tax deductions. High-end properties in high-tax states such as California, New York and Massachusetts have suffered from this adjustment. Second, the US housing market has an overhang of large, pricey homes relative to strong demand for smaller, starter homes. Median home prices outpacing average ones show this divergence. We also to need to gauge if consumer spending is likely to follow the manufacturing sector lower. If it does, a recession will be unavoidable. On this front, we are hopeful because: The outlook for household income is positive. As you noted, the unemployment rate is still extraordinarily low, and more Americans will be working by the end of 2020 than today. Additionally, the rising employment-to-population ratio for prime-age workers is tightly linked to stronger wages (Chart 21). Also, the recent pick up in productivity growth points to higher real wage growth. The household savings rate is elevated and has limited upside. Households already have a large cushion insulating them from unforeseen shocks. At 8.1% of disposable income, the savings rate is in the 65th percentile of its post-1980 distribution. It is especially lofty if we take into account robust American households’ net worth (Chart 21, bottom panel). Consumer credit demand is rising, according to the Fed’s Senior Loan officer survey. Since household liquid assets are quickly expanding and the household formation rate is robust, consumption of durable goods should pick up, especially in light of the large decrease in borrowing costs. This is particularly true since the household debt-to-assets ratio is at its lowest level since 1985 and debt-servicing costs only represent 9.7% of disposable income, the lowest share for nearly 40 years. The corporate sector outlook should brighten soon. The modest rise in productivity protects margins from higher wages, an effect that will linger given that capacity expansion is consistent with further productivity gains (Chart 22). Crucially, the combined fiscal and monetary easing in China should bolster capital-spending intentions around the world, including the US (Chart 23). Rising productivity will only consolidate these trends. Chart 22Capacity Growth Provides Some Support For Productivity Chart 23Chinese Reflation Will Revive US Capital Spending   The most positive development for the US corporate sector is our outlook for non-US growth. If the global manufacturing sector mends itself, so will the US. Ample liquidity is a positive for the world economy, as well as for US manufacturing conditions (Chart 24). On the fiscal front, we appreciate your worries, but they are not a story for 2020. The US fiscal thrust will not be as positive as it was in 2018 or 2019, but it is set to remain a small tailwind, not a drag. Furthermore, given that 2020 is an election year it is unlikely that politicians will tighten purse strings over the coming 12 months. Fiscal risks are undoubtedly greater in the long run. However, a sudden fiscal consolidation is a remote probability because fiscal austerity has gone out of style. Instead, the federal debt burden will be a major source of long-term inflation because there is no other easy way to address this gigantic pile of liabilities. The path of least resistance will be more spending and financial repression. In other words, real rates will stay too low and excess government spending will push prices higher, conveniently eroding the real value of that high federal debt burden. This was a big story in the 20th century and it will remain so in the 21st (Chart 25), especially since an aging population and the peak in globalization will weigh on global savings. Chart 24The US Manufacturing Slowdown Has Run Its Course Chart 25Inflation Is About Political Decisions   Ms. X: Your point about demographics makes me think of Europe and Japan. Brexit has not been resolved; populism remains a concern in Italy; and the European banking system is still fragile. Japan suffers from an even worse demographic profile and the recent VAT increase was ill-timed, economically. Given these headwinds, can these regions participate in the global recovery you foresee? BCA: The short answer is yes, albeit to varying degrees. The outlook for Europe is more promising than Japan. A No-Deal Brexit is now a very low probability event, even after next month’s UK election. The conservatives’ support for Prime Minister Johnson’s Brexit plan will ensure as much. A large source of uncertainty is being lifted, which will allow European businesses to resume investment planning. The situation in the European periphery is also improving. Non-performing loans in Spain and Italy are falling (Chart 26), which is allowing for a normalization of credit origination. The narrowing Italian and peripheral spreads to German bunds will be helped by easing financial conditions in the European economies that need it most. Higher Italian bond prices improve banks’ solvency and cut borrowing costs for the private sector. Finally, populism is alive and well in Europe, rejecting fiscal austerity, but not embracing euro-skepticism. More generous fiscal spending would be a positive for Europe. European liquidity conditions are also generous. Deposit growth has strengthened and financial conditions have benefited from lower German yields and a cheap euro, which trades 15% below fair-value estimates. Our model for European banks’ return on tangible equity is rising, which is a clear indication that easy financial and liquidity conditions should deliver stronger incremental economic activity (Chart 27). Chart 26Declining Non-Performing Loans Are A Positive For The European Periphery Chart 27European Banks' Return On Equity Will Improve In 2020   The fiscal outlook is murkier. European fiscal thrust was a positive 0.4% of GDP in 2019, but it will decline to 0.1% in 2020. However, fiscal policy affects economic activity with a lag. The impact of this year’s easing has yet to be fully felt. Since European rates are so low and the economy is not operating at full capacity, the fiscal multiplier is greater than one. Therefore, Europe can still reap a substantial fiscal dividend next year. Finally, Europe remains a very pro-cyclical economy. A large share of euro area GDP is connected to manufacturing and exports. As a result, Europe will be one of the prime beneficiaries of a pickup in global growth. Already, the sharp rebound in the German and euro area ZEW survey expectation components point to a brighter outlook for the region. Japan is also a very pro-cyclical economy, which will reap a dividend from a bottom in global manufacturing activity. However, the Land of the Rising Sun is still subject to idiosyncratic constraints. Japanese financial conditions have not improved as much as those in Europe. The yen has appreciated 2.6% in trade-weighted terms this year, while Japanese yields have not melted as much as European ones (because Italian and peripheral yields fell so much in 2019). Japan will also have to reckon with the impact of the October VAT increase. Ahead of the tax hike, retail sales spiked by 9.1% on a year-on-year basis, or 7.1% compared to the previous month, a script similar to 2014. 2015 was a payback year where consumption was depressed. This scenario will play out again, even if the Abe government has implemented some fiscal offsets. Ultimately, the Japanese economy will lag Europe’s in the first half of the year but should catch up in the second half. The impact of the tax hike will dissipate. Most importantly, rebounding global growth will hurt the yen, at least on a trade-weighted basis, providing a lift to export prospects and easing Japanese financial conditions relative to the rest of the world, which will produce a growth dividend later in 2020. Ms. X: To summarize, you expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. EM activity will also pick up but will not generate fireworks. The US will be okay but Europe will probably deliver the largest positive growth surprise as external and domestic conditions align positively. Japan will also stabilize on the back of stronger global growth, but domestic headwinds mean that a true reacceleration won’t happen until the latter part of the year. This recovery constitutes the business cycle’s end game as inflation will become a concern in 2021, forcing the Fed to tighten then. BCA: Yes, this is correct. Ms. X: Thank you! Bond Market Prospects Chart 28Global Bonds Are Extremely Overvalued Ms. X: I do not like US Treasuries at current yields. They do not protect me against an inflation surprise and will do nothing for me in an economic recovery. However, my bearishness is tempered by the large stock of bonds with negative yields in Europe and Japan. As long as this strange situation persists, I doubt US yields will experience much upside. US paper is too attractive to foreign asset managers right now. BCA: We share your view and are recommending an underweight to global government bonds. Global yields offer little value and are vulnerable to a rebound in economic activity or a trade détente. Our Global Bond Valuation index is flashing a clear sell signal (Chart 28). As yields rise, global yield curves are bound to steepen. We also agree that the upside for Treasury yields is limited, but we disagree with the limiting factor. Foreign investors are not the major buyers of Treasuries. Indeed, the data shows that European and Japanese investors have not been aggressive purchasers of US government securities. The US yield curve is flat and US short rates tower above European and Japanese ones, hedging currency exposure when buying Treasuries is expensive. In euro or yen terms, a hedged Treasury yields -67 basis points and -60 basis points, less than 10-year bunds or JGBs, respectively. Meanwhile, EM central banks are diversifying their FX reserves away from the US dollar into gold. Instead, our view is governed by the concept we dub the “Golden Rule of Treasury Investing.” According to this principle, the outperformance of Treasuries relative to cash is a direct function of the Fed’s ability to surprise the market. If the Fed cuts rates more than the OIS curve anticipated 12 months prior, Treasuries outperform. The opposite happens if the Fed delivers a hawkish surprise (Chart 29). Chart 29The Golden Rule Of Treasury Investing Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone, because the OIS curve is now only pricing in 28 basis points of rate cuts over the next year. It is not just the US OIS curve that has priced out a large amount of rate cuts; this phenomenon has materialized around the world over the past five weeks. Chart 30The Term Premium Is Too Low Any upside risk to that 2.25% to 2.5% forecast for 2020 will come from the inflation expectations and term premium components of yields. Central banks, including the Fed, have telegraphed an intention to allow inflation expectations to rise, initially, in response to stronger global growth. Moreover, declining risk aversion should also allow the exceptionally depressed term premium to normalize (Chart 30). Only in late 2020 or early 2021 will Treasury yields durably move above this 2.25-2.5% zone. Punching above these levels will require core PCE inflation to have been above target long enough to re-anchor inflation expectations back up to their 2.3% to 2.5% target zone. Only then will the Fed give the all-clear signal to the bond market to lift yields higher. Mr. X: You still have not directly addressed the question of negative yields in Europe and Japan. This story will not end well. Do you worry about these bond markets over the next year? BCA: Our answer is an emphatic yes. But we assume you will not let us leave it at that. Mr. X: You know me too well. BCA: Over the course of the past 50 years, we have learned a thing or two about you. In all seriousness, let’s start with our simple but effective valuation ranking. It compares the current level of real yields for each country to their historical averages and standard deviations. You can see that the most unattractive bond markets right now are all in Europe (Chart 31). Chart 31European Bonds Are Too Dear Chart 32Swiss Bonds Are A Lose-Lose Proposition The lower bound of interest rates is another reason to avoid these markets. This floor seems to lie around -1% in nominal terms. Because of these constraints, in recent months, Swiss, Swedish, Dutch and German 10-year bonds have failed to rally as much as their higher-yielding US, Canadian or Australian counterparts when global yields are declining. However, they also underperform when yields are rising (Chart 32). They have become a lose-lose proposition. The only pockets of value left in DM bond markets are Greece, Portugal or Italy. Despite their apparent risks, we still like them. Support for the euro in Greece and Italy is 70% and 65%, respectively. Even populist governments in these nations are reluctant to attack euro membership anymore. Moreover, the ECB remains committed to the survival of the euro area in its current form. Christine Lagarde will not change that. For 2020 or 2021, the risk of euro breakup is practically zero. The same may not be true on a 5- to 10-year investment horizon, but for the coming year, these bonds offer an attractive risk-adjusted carry. Ms. X: Unsurprisingly, my father does not like corporate bonds because of highly levered corporate balance sheets. I think this is a long-term problem, but not a risk for 2020, so I’m looking to stay overweight spread product relative to Treasuries. Where do you stand on this market? BCA: On this issue, we sit somewhere between you both. Our Corporate Health Monitor continues to deteriorate (Chart 33). The high debt load of the US business sector coupled with the decline of the return on capital worries us. Furthermore, the covenant-lite trend in recent issuance suggests that corporate borrowers, not lenders, are getting the good deals. Essentially, too much cash is still chasing too little available yield pick-up. In this environment, capital is sure to be misallocated, and money ultimately lost. We find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. On a short-term basis, the spreads will not widen much. An easy Fed, recovering global growth, and the gigantic pile of negative-yielding bonds around the world will make sure of that. We advocate a neutral stance on investment grade corporates because IG bonds have high modified duration such that breakeven spread compensation versus Treasuries is near the bottom of its historical distribution across the IG credit spectrum (Chart 34). This means that credit will generate poor returns if government bond yields rise. Chart 33Dangerous Long-Term Picture For US Corporates Chart 34No Value Left In IG   Chart 35EMs Still Experiencing Deflation Thankfully, they are ways around this problem: emphasizing exposure to high-yield (HY) bonds and agency mortgage-backed securities (MBS) instead. HY breakeven spreads remain much more attractive than in the IG space, and option-adjusted spreads will benefit if our growth and inflation forecasts materialize. Investors reluctant to commit capital to these products should look into high quality agency MBS. After the recent wave of mortgage refinancing, these securities’ duration has collapsed to 3.0 compared to 7.9 for IG corporates. These securities therefore offer much better protection in a rising-yield environment. Ms. X: Before we move on to equities, where do you stand on EM bonds? BCA: We need to differentiate between EM local-currency bonds and EM USD-denominated bonds. We do like some EM local currency bonds. Inflation in EM countries is low and dropping. Money and credit growth is slowing, which implies that the disinflationary trend will remain in place through 2020 (Chart 35). Weaker nominal growth means that central banks in EM will continue to cut rates, providing a nice tailwind for local-currency bond prices. This comes with a caveat. Lower policy rates will boost bond prices but hurt EM currencies, especially because most EM currencies are not cheap and are already over-owned. Next year, it will be preferable to garner exposure to those countries interest rate moves via the swap market rather than the cash bond market. Chart 36The Mexican Peso Is Cheap There are some exceptions, like Mexico. The MXN is already very cheap because of fears surrounding the economic policies of President Andres Manual Lopez Obrador (AMLO) (Chart 36). However, we doubt he will turn out to be as dangerous as feared. Hence, MXN Mexican bonds are attractive to foreign investors in unhedged terms. We are currently avoiding EM USD-denominated debt, corporate and sovereign. Since emerging markets sport $5.1 trillion of dollar-denominated debt, falling EM exchange rates will increase the cost of servicing this debt, which makes it riskier. Mr. X: I think we will continue to underweight corporate and EM bonds in our fixed income portfolio. Spread levels still make no sense in terms of providing compensation for credit risk. I must admit that I find your recommendation to overweight MBS intriguing. We will need to ponder this idea further. Ms. X: And please wish me luck trying to convince my father to buy some high-yield bonds. Equity Market Outlook Mr. X: US stocks are too expensive for my taste, with the S&P 500 trading at a forward P/E ratio of 18. I’m well aware of the argument that equities may be expensive but that they are actually cheap compared to bonds, which implies that I should favor stocks over bonds. However, you know that I emphasize capital preservation. With stocks this rich already, equities offer no margin of safety. If I own stocks, I am therefore exposed to any unexpected shocks. Because I do not share your optimism on the economy, I am more worried about downside risk. Moreover, even if the economy performs better than I fear, I suspect stocks will respond poorly to higher yields. Chart 37The S&P Is Very Expensive Ms. X: I agree with my father that stocks are expensive. Nonetheless, as Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” In today’s context, to me this means that stocks can ignore their overvaluation so long as liquidity is plentiful, rates are low, and a recession is avoided. BCA: On this question, we agree with Ms. X. We all agree that US equities are expensive. As you mentioned, their price-to-earnings ratio is 18. Only at the apex of the tech bubble and in early 2018 was the S&P 500 more expensive. Worryingly, the price-to-sales ratio is at 2.3, an even larger historical outlier than the P/E (Chart 37). Chart 38Low Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Ms. X is correct that we cannot look at stock valuations in isolation. Investing is about opportunity cost and the macroeconomic context. On this front, even US equities have their merit. Despite the S&P 500’s expensive multiples, our Composite Valuation Indicator is no more elevated than it was in 2013. Meanwhile, our Monetary Indicator has rarely been as supportive of stock prices as it is today, and our Speculation Indicator is in line with its January 2016 reading (Chart 38). Moreover, BCA’s Composite Sentiment indicator is still below its long-term historical average and margin debt has declined by $47.5 billion to the lowest share of US market capitalization since June 2005. These are hardly signs of irrational exuberance. Ultimately, bear markets and recessions travel together. A durable 20% drop in stock prices requires a significant and long-lasting decline in earnings. These developments happen during recessions (Chart 39). Our call is for a recession in the next 24 months or so. We must also remember that while equities perform poorly six months ahead of a recession, the end of a bull market, its last 12 to 18 months, tend to be very rewarding (Table 3). We are within this window. Chart 39Bear Markets And Recessions Travel Together Table 3The End Game Can Be Rewarding Based on our forecast for interest rates, we do not share the concerns that rising bond yields will topple stocks right away. Stock prices are an inverse function of risk-free rates, but a positive function of growth expectations. Higher yields will initially reflect stronger growth, not restrict it. But remember: the upside for yields is limited because central banks do not want to choke off the recovery. They will maintain accommodative policy. In other words, we expect real rates to lag behind growth expectations. Because long-term growth expectations, whether from sell-side analysts or extracted out of market prices using the Gordon Growth Model, are low, we are willing to make this bet (Chart 40). Equities will suffer if the global bond yield rises above 2.5%. This is more a story for 2021, and not our central scenario for 2020. It is nonetheless a reminder that we are entering the end game of the business cycle, so we are also entering the end-game of the bull market. Mr. X: I think you are playing with fire. Stocks are so expensive that if you are wrong on either the growth call or the yield call, they will suffer. I would rather miss the last melt-up in stocks than unnecessarily expose my portfolio to a meltdown. Additionally, you have not addressed the fact that S&P 500 margins have begun to soften but are still extremely elevated. Shouldn’t this dampen your optimism? BCA: Aggregate S&P 500 margins have some downside. Our Composite Margin Proxy, Operating Margins Diffusion index and Corporate Pricing Power indicator all remain weak (Chart 41). The deceleration in the crude PPI excluding food and energy and the past strength in the dollar confirm this insight, especially as the corporate wage bill climbs in a tight labor market. The biggest mitigating factor is that productivity is also on the mend, which curbs the negative impact of higher worker pay. Chart 40Growth Expectations Are Muted Chart 41US Margins Under Pressure   This danger must be put into perspective though. Margin expansion has been dominated by the tech sector (Chart 42). Excluding this industry, S&P 500 margins are roughly in line with their previous peak, and are not declining. The aggregate softness in margins is a reflection of the sharper decline in tech margins. Declining margins do not spell the imminent end of the bull market either. Table 4 shows that on average, the S&P 500 rises by 9.5% following the peak in margins. Equities can rise after margins crest because this is often an environment where wages are climbing, which boosts consumption. Consequently, top-line growth can accelerate and earnings can rise even if they represent a lower proportion of sales. This is the environment we foresee over 2020. Chart 42Tech Margins Have Likely Peaked Table 4Margin Peaks Do Not Spell S&P Doom   Chart 43Taiwanese Stocks Are Sniffing Out Better Global Growth Ms. X: You have talked about the tech sector being a drag on overall margins. How would you position a US stock portfolio? BCA: First, around the world, we prefer cyclical sectors to defensive ones. Cyclical stocks are depressed relative to defensive firms’ shares. Rebounding global growth and rising bond yields will favor cyclical sectors. Globally, the performance of cyclical equities relative to defensive ones correlates with Taiwanese equities, which are currently rallying smartly (Chart 43). This suggests that at the margin, the most cyclical asset markets are beginning to express optimism about global growth. Within the S&P 500, our favorite pair trade to express this bias is to overweight energy stocks at the expense of utilities. Utilities are bond proxies which will substantially underperform energy stocks when the rate of change of Treasury yields moves up (Chart 44). Moreover, based on our valuation indicators, energy stocks have never traded at such a deep discount to utilities, nor have they ever been as oversold. Chart 44Favor Energy Over Utilities Second, we are currently neutral on tech stocks but have put them on a downgrade alert. Tech equities are expensive, trading at a forward P/E ratio 21% above the other cyclicals. Moreover, since software spending has remained surprisingly resilient despite the global economic slowdown, it will likely lag investment in machinery and structures when industrial demand rebounds. Consequently, tech earnings will lag other traditional cyclical sectors. Tech multiples will also suffer when bond yields rise. As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to changes in the discount rate We implement this view by way of an underweight in tech and an overweight to industrials. Industrials have suffered disproportionately from the trade war. Any near term truce is unlikely to contain a grand bargain on intellectual property rights transfer that galvanizes tech exports, but it will remove some of the uncertainty weighing on industrials. Moreover, industrials are a much cheaper play on a global growth rebound. The global manufacturing slowdown has caused industrial equities to trade at their greatest discount to the tech sector since the financial crisis. Finally, the wage bill for the industrial sector is melting relative to tech, and our margin proxy is surging (Chart 45). This has created a very positive backdrop for this pair trade. We also like financials. They will be a key beneficiary of rising yields and a steepening yield curve. Additionally, household credit demand has picked up and overall credit growth should accelerate as central banks will maintain very accommodative monetary conditions. The yield impulse already points toward higher bank credit growth and companies are issuing an increasingly large stock of bonds (Chart 46). Chart 45Operating Metrics Will Boost Industrials Versus Tech Equities Chart 46Easing Financial Conditions Will Support Credit Creation   Ms. X: When combining valuation analysis with your fundamental sectoral slant, I am guessing that you must favor European, Japanese and EM stocks over the S&P 500? BCA: We do favor European and Japanese equities. Based on valuation alone, all the regions you mentioned offer higher expected long-term real rates of return than the US (Chart 47). Moreover, the dollar is expensive relative to advanced economies’ currencies. Hence, these markets are cheaper vehicles than the S&P 500 to bet on a global economic recovery. But valuation alone is not enough. US stocks are trading at unprecedented levels relative to global equities because of the FAANG craze (Chart 48). Looking at sector representation, our positive view on non-tech cyclicals also flatters exposure to Europe and Japan (Table 5). Chart 47Non US Equities Offer Better Value Chart 48FAANG-Driven US Outperformance   Table 5Equity Market Sector Composition Chart 49European Banks Are Cheap Europe is particularly attractive because of its large skew towards industrials and financials, which represent 32.3% of the market versus 22.3% in the US. Moreover, European financials are also a tantalizing bet because they trade at a 50% discount to US financials, according to their price-to-book ratio. Additionally, their return on tangible equity will benefit from higher German yields, easing financial conditions, declining non-performing loans in the periphery and rebounding global growth. Our RoE model for European banks already points to a resurgence in their stock prices (Chart 49). Of the major markets we track, Japan offers the highest prospective long-term real returns. Its strong cyclical slant and low share of tech stocks means it is another market investors should overweight to bet on a global recovery. The biggest problem for Japanese equities is the yen. When global yields climb higher, a weak JPY will clip some of the Nikkei’s gains for foreign investors. Finally, we are reluctant to overweight EM stocks just yet. In this space, median P/E ratios are much higher than on a market capitalization-weighted basis (Chart 50). State-owned companies explain this bifurcation, Chinese banks in particular. Since we expect Chinese banks to remain a conduit for policy, credit origination may flatter economic growth more than shareholders’ interests. Moreover, we have a negative outlook on EM currencies, and hedging this exposure is expensive. Finally, if China’s economic activity improves only modestly in 2020, the 2012 experience suggests that EM stocks can still underperform the global equity universe as global growth improves and yields rise (Chart 51). In other words, we find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. Chart 50EM Stocks Are No Bargain Yet Chart 51EM Stocks Can Underperform When Global Growth Improves     Mr. X: Thank you. I am still not sure what share of our portfolio will be dedicated to stocks. However, I think that whatever this proportion will be, buying global equities makes more sense than US ones. Your valuation argument alone is swaying me, considering my more conservative instincts. Ms. X: I’m glad we will not have to argue on this point, but I know we will nonetheless battle on the stock/bond/gold split. Should we move on to your currency and commodity forecasts? BCA: It would be our pleasure. Currencies And Commodities Mr. X: You have often argued that the dollar is a countercyclical currency. Based on our discussion so far, you must expect the dollar to decline until we get closer to the next recession. I am not fully convinced. Specifically, I remember that in the back half of 2016 global growth was rebounding, but the dollar soared. Therefore, the growth/dollar relationship can be more complex than you argue. Meanwhile, with negative interest rates in Europe, Japan and Switzerland, why would I even consider divesting out of my positive yielding dollar assets? Chart 52The Dollar Is A Counter Cyclical Currency BCA: You raise interesting questions, and you are correct that we expect the dollar to depreciate if our constructive view on global growth pans out for 2020. The inverse relationship between global industrial production (excluding the US) and the trade-weighted dollar is unambiguous (Chart 52). As you also mentioned, the reality is a little bit more nuanced. To understand why, it is important to remember how currencies function. We can think of an exchange rate as an adjustment mechanism that solves for the gap in growth between any two countries. This is at the root of the dollar’s counter-cyclicality. When global growth is picking up, returns tend to be higher in cyclical markets, which are highly concentrated outside of the US. Flows then gravitate from the US to other markets and the dollar declines. After a while, the dollar becomes cheap enough that these flows reverse. In the second half of 2016, three factors drove the dollar rebound. First, US manufacturing was improving at a faster pace than that of the rest of the world. Second, the Fed resumed its interest rate hikes, so interest rate differentials suddenly flattered the dollar anew. Finally, the election of President Trump, who campaigned on large scale fiscal stimulus, elicited memories of the Reagan dollar bull market of the first half of the 1980s. These factors eventually faded as global growth rebounded. Today, the Fed’s policies are hurting the dollar. Aside from recent interest rate cuts, the Fed has been injecting liquidity into the banking system through repurchase agreements and renewed asset (T-Bills) purchases. Moreover, the rate cuts are also easing global funding conditions and promoting a re-steepening of the yield curve. This will incentivize banks to lend and boost the US money supply. As growth re-accelerates and demand for imports (machinery, commodities, and consumer goods) rises, the current account deficit will widen further. This process will increase the international supply of dollars. Historically, these dynamics usually hurt the dollar. What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. Like you, we are deeply uncomfortable with negative interest rates. Thankfully, the nascent pickup in global economic activity is lifting global bond yields. So far, foreign bond markets have led this move. More specifically, countries that have suffered most from the global manufacturing slowdown are now seeing their bond yields rise the quickest (Chart 53). For example, yields in Germany, Norway, Sweden, Switzerland and Japan have risen by a lot more than those in the US since global yields troughed in September. Should the initial signals of stabilization in global growth morph into a synchronized recovery, the US yield advantage will evaporate. In a nutshell, interest rates might be negative in Europe and Switzerland, but the positive carry offered by US assets is rapidly fading. Chart 53AAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Chart 53BAre Interest Rate Differentials Flashing A Signal About Exchange Rates?   Chart 54Foreigners Are Selling Treasuries For international investors, the currency risk inherent in owning US bonds is just too large at the current juncture. Remember, the trade-weighted dollar stands 25% above its long-term equilibrium and the US twin deficits are expanding. Markets priced in cheap currencies with some potential upside, such as Australia, Canada, Norway or even the European periphery, might be better bets. Flows highlight just how precarious the situation is for the US dollar. Since last August, overall flows into the US Treasury market have been negative. Net foreign purchases by private investors are still positive at an annualized US$180 billion, but they are clearly rolling over. Moreover, official net outflows are running at $350 billion, easily cancelling out the private sector’s inflows (Chart 54). Essentially, foreigners’ appetite for US fixed-income assets is waning exactly as interest rate differentials have started moving against the dollar. Ms. X: I share my father’s concerns, but how would you implement your negative dollar view. Which currencies should I be loading up on as we enter the business cycle’s end game? BCA: The more export-dependent economies (and currencies) should benefit the most from a rebound in global growth. Within the G-10, we particularly like the Swedish krona, the Norwegian krone and the British pound. Bond yields for these currencies are rising the fastest vis-à-vis the US. As a result, the currencies themselves should soon follow (previously mentioned Chart 53). We also expect commodity currencies to benefit, but only upon clearer signs that the resource-thirsty Chinese economy is improving. Until then, they are likely to lag the pro-cyclical European currencies, which are less directly dependent on Chinese stimulus. The euro could become the greatest beneficiary from a weaker dollar because a large headwind for European economic activity is disappearing for now. For the past ten years, European real interest rates have been too low for the most productive, competitive exporter – Germany – but too high for others such as Spain and Italy. Consequently, the euro has been caught in a tug-of-war between a rising neutral rate of interest for Germany and a very low one for the peripheral economies. Via its rate cuts, asset purchase programs, and aggressive TLTRO packages, the ECB may have now finally eased policy to the point where nearly all Eurozone countries enjoy an accommodative monetary environment. 10-year government bond yields in France, Spain, Portugal and even Italy now all sit close to the neutral rate of interest for the entire eurozone (Chart 55). Chart 55The ECB Has Eased Policy Enough Finally, the euro is likely to benefit from inflows into European equity markets. The euro’s drop since 2018 has eased financial conditions and made euro area businesses more competitive. This is an important tailwind for European corporate profits and thus stocks. Moreover, European equities, especially those in the periphery, remain unloved, as illustrated by their cheap valuations compared to other advanced economies. Additionally, analysts’ earnings expectations for eurozone equities are perking up relative to US stocks. If the sell-side is right, powerful inflows into the region will lift the euro in 2020. Mr. X: Thank you. I find it difficult to share your enthusiasm for the euro, a currency backed by such a flimsy edifice. While I would agree that it could rebound next year, I find currencies highly unpredictable on such a time horizon. I prefer to think about them on a long-term basis, and while the euro is cheap, its weak institutional underpinning is too concerning. Let’s move on to commodities. Following our meeting last year, we took your advice on oil and gold. Overall, these calls helped our portfolio. Going forward, these markets are extremely perplexing. There is so much risk in oil markets, such as the tensions in the Middle East and the uncertainty stemming from the trade war between the US and China. How would you recommend playing the oil market in 2020? Chart 56Inventory Drawdown Will Support Oil BCA: Your assessment of these markets is spot on. Yet, price risk is skewed to the upside because fiscal and monetary stimulus will revive commodity demand. The oil-producer coalition led by Saudi Arabia and Russia will continue to restrain production, and will probably extend its 1.2mm b/d production cut due to expire at the end of March to year-end 2020. In the US, market-imposed capital discipline will keep reducing the growth of US shale-oil supply. Additionally, US shale-oil supply growth is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off at oil-production sites could provide the environmental lobby an opening to challenge growth. Ms. X: What about the demand side of the oil markets? The fall in the growth rate of demand this year caught most participants off guard. What do you make of that? BCA: Demand data shows a lot of lingering weakness, much of which was caused by tight financial conditions last year in the US and China. But now, most global central banks are pursuing highly accommodative monetary policy and many governments are also easing fiscal policy. As a result, this demand weakness will fade next year. We think next year growth will clock in at 1.4mm b/d. Not as robust as 2017, but still respectable. This should stop the downward pressure on oil prices that has prevailed since May (Chart 56). Mr. X: You’re describing a fairly strong market for next year. What are the downside risks to your view? BCA: Global economic policy uncertainty remains elevated. Uncertainty is one of the key factors driving demand for USD, which is one of the most popular safe havens in the world (Chart 57). A strong dollar creates a headwind for commodity demand. It raises the local-currency costs of consumers in the EM economies that drive oil demand, and lowers production costs outside of the US, encouraging supply growth at the margin. Chart 57Elevated Global Economic Uncertainty Has Kept The USD Well Bid Chart 58Gold: A Valuable Portfolio Hedge Ms. X: So, pulling it all together, what is your call for 2020? BCA: The weaker 2019 demand data and the upward revisions to global oil inventories pushed our 2020 Brent Oil forecast to $67/bbl from $70/bbl. We still expect WTI to trade at a $4/bbl discount to Brent. As we mentioned earlier, the risk to our forecast is to the upside: a resolution of the US-China trade war, and lower global economic policy uncertainty could trigger a sharp rally in crude prices. Mr. X: Thank you for your insight on oil. I would like to hear your thoughts on gold. You can tell that I see little absolute value in stocks or bonds at the moment, so I have an outsized preference for the yellow metal this year. Also, how could the US dollar and gold both rally at the same time in 2019? BCA: Let’s start with your dollar/gold question. It is very rare to see gold and the dollar rally together. Normally a strong dollar hurts gold. As you know, we’ve been recommending an allocation to gold since 2017, mostly as a portfolio hedge. We like that gold strongly outperforms other safe havens in equity bear markets and can participate in the upside (even if to a limited extent) in bull markets. We think the safe-haven properties of gold and the US dollar really have come to the fore over the past couple of years (Chart 58). Economic policy uncertainty, and divisive politics globally have raised the level of uncertainty to record levels. In such an environment, the dollar and gold both provide a safe haven and a portfolio hedge. Hence, their joint popularity this past year. We should also remember that gold is a good inflation hedge, and is particularly negatively correlated with real interest rates. A Fed that is willing to let the economy overheat is a Fed that will limit how high real rates climb. Moreover, global liquidity is plentiful. Finally, EM central banks have been slowly divesting from Treasuries and diversifying into gold lately, buying most of the new supply in the process. This backdrop, along with our forecast of a weaker dollar, should support gold again in 2020. That being said, because gold is tactically overbought and could face temporary headwinds if global uncertainty recedes, we prefer silver, which is not as stretched. Furthermore, silver’s higher industrial use means that it should also benefit from a global manufacturing recovery. Geopolitics Chart 59Multipolarity Creates An Unstable Environment Mr. X: Let’s return to geopolitical and policy risks, both of which abound. Global economic policy uncertainty is the highest it has been since academics began measuring it. The world is fraught with populism, authoritarianism, war, immigration, technological disruption, inequality, and corruption. With so much chaos, and so little consensus, is there anything solid for an investor to grasp about the political backdrop next year? BCA: Geopolitics is the likeliest candidate to short circuit this long bull market, given that the Federal Reserve, the usual culprit, has paused its rate tightening campaign. On a secular basis, geopolitical risk is rising because the United States’ national power is declining relative to that of other world powers (Chart 59). China’s rise, in particular, is stirring conflict with the US and its allies in the western Pacific. Beijing’s technological and military advance is generating fear across the American political establishment. Russia and China continue to deepen their relationship in the face of an increasingly unpredictable United States. These strategic tensions will persist despite any tariff ceasefire with China. Chart 60Globalization Has Peaked Competition among the great powers makes for a world of contested authority. As the rules of the road have become less certain, the tailwind behind international trade and investment has weakened (Chart 60). Deglobalization is a headwind for the earnings of large cap global companies in the long run. Emerging markets, which are exposed to trade, face persistent unrest. Mr. X: Given the above, how can an investor take an optimistic view of the global economy and markets next year? BCA: We have a framework for analyzing politics: constraints over preferences. We cannot predict what the chief politicians will prefer at any given time, but we can try to identify and measure the constraints that will restrict their freedom of movement. With global growth slowing, world leaders have become more sensitive to their constraints. The Fed has reversed rate hikes; China is easing policy; President Trump has refrained from attacking Iran; and President Trump and President Xi are negotiating a ceasefire. The UK has avoided a “no deal” Brexit – not once but twice. In short, the risk of recession (or conflict) has been sufficient to alter the policy trajectory. As a result, there is a prospect for global geopolitical risks to abate somewhat in 2020. Both the American and Chinese administrations need to see growth stabilize despite their ongoing strategic conflict. Both the British and European governments need to avoid a disorderly Brexit despite their lack of clarity beyond that. Geopolitical risk is declining, albeit from an extremely elevated level. Mr. X: The US and China have already come close to a deal only to get cold feet and back away from it. The British Prime Minister is committed to leaving the EU with or without a deal. Surely you cannot believe that the Middle East, Russia, other emerging markets, or North Korea will be any bastion of stability. BCA: The US-China trade war is still the single greatest threat to the equity bull market. Brexit is not resolved and a new deadline for a trade deal looms at the end of 2020. Investors must remain vigilant and hedge their portfolios, particularly with gold. Nevertheless, one cannot ignore this year’s reaffirmation of the Fed put, the China put, and Trump’s “Art of the Deal.” The base case for next year should be constructive, albeit with vigilant attention to the major risks: President Trump, China and Iran. The other issues you mention have varying degrees of market relevance. Russia is focusing on pacifying domestic discontent. North Korea is on a diplomatic track with the United States. Emerging market unrest is particularly relevant where it can have a bearing on global stability: Iraq, Iran and Hong Kong in particular. Ms. X: If I may interject: It seems to me that the worst of the trade war has passed, that the risk of a no-deal Brexit is negligible, and that Iran is unlikely to outdo its attack against Saudi Arabia in September. Doesn’t this imply that geopolitical risk is overrated and that investors should rush to capture the risk premium in equities? BCA: What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. After all, any fall in global risks will be amply made up for by the impending rise in US domestic political risk. Indeed, US politics are the chief source of global political risk in 2020. First, if President Trump becomes a “lame duck” then he could take actions that are hugely disruptive to global markets in a desperate attempt to win reelection as a “war president.” Chart 61European Political Risk Is Now Low Second, if President Trump is reelected, then his disruptive populism will have a new mandate and his “America First” foreign and trade policy will be unshackled. Third, if the opposition Democrats succeed in unseating an incumbent president, they will likely take the Senate too, removing the main hurdle to a dramatic policy change. That would mark the third 180-degree reversal in national policy in 12 years. Moreover, investors may find the country merely exchanged right-wing populism for left-wing populism, which has a more negative impact on corporate earnings prospects. Polarization and institutional erosion will continue. The election results may be razor thin; swing states may have to recount votes; and the outcome could hinge on rare or unprecedented developments in the Electoral College, the Supreme Court or cyberspace. A crisis of legitimacy could easily afflict the next administration. In short, there are few scenarios in which US political risk does not rise over the next 12-24 months. Rising American risk stands in stark contrast to Europe (Chart 61), where the will to integrate has overcome several challenges since the sovereign debt crisis. Substantial majority of voters support the euro and the European Union. Germany is on the brink of a major political succession but it is not turning its back on the European project. France is successfully pursuing structural reforms. Italy remains the weakest link, but even the populist Northern League accepts the euro. This leaves two remaining global risks: China and Iran. Chinese political risk is generally understated. President Xi Jinping, lacking President Trump’s electoral constraint, could overestimate his leverage. He could overreach in the trade talks, in his battle to prevent excessive debt growth, or in his handling of Hong Kong, Taiwan, North Korea, or Iran. The result could be a breakdown in the trade talks or a separate strategic crisis with the United States. Another cold war-style escalation in tensions could easily kill the green shoots in global growth. As for Iran, the regime is under crippling American sanctions and faces unrest both at home and within its regional sphere of influence. There is a non-negligible risk that it will lash out and cause an extended oil supply shock. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned that staying invested in risk assets today is akin to picking-up pennies in front of a steamroller. I accept your opinion that a recession is unlikely in 2020, but valuations of both stocks and bonds are uncomfortably stretched for my taste. As a result, I believe stocks could suffer whether growth is good or bad next year. Finally, since so many things need to go right for the global economy to continue to defy gravity, a recession may hit faster than you envision. To me, there is simply not enough margin of safety in stocks to compensate me for the risk! Ms. X: I agree with my father that the risks are high because we are entering the end game of the cycle. But I also see pockets of value, some of which you have mentioned today. Moreover, I am sympathetic to your view that global growth will recover next year. Corporate earnings should therefore expand. Hence, I fear that being out of the market will be very painful, especially because policy is quite accommodative. While stocks may not perform as well as they did in 2019, I expect them to outperform bonds handily. I’m therefore willing to continue holding risk assets, even if I need to be more judicious in my sector and regional allocation. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term return prospects. Because so many assets have become more expensive this year, long-term returns are likely to be uninspiring compared to recent history. Table 6 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.4% over the next ten years, or 2.4% after adjusting for inflation. That is a noticeable deterioration from our inflation-adjusted estimate of 2.8% from last year, and also still well below the 6.5% real return that a balanced portfolio earned between 1982 and 2019. Table 6Asset Market Return Projections Our outlook for next year hinges on global growth rebounding and policy uncertainty receding. Monetary policy is less of a threat to equities than it was last year because central banks have already eased considerably and have been very open about their willingness to let inflation run above target for a while before retightening the monetary screws. We propose the following list of easy-to-track milestones to monitor whether or not our central scenario for the global economy and asset markets is playing out, and how close we are to the end of the cycle: Chinese money and credit numbers. Chinese credit growth must stabilize for the economy to do so. If credit origination continues to decelerate, this will indicate that Beijing has decided to tolerate the slowdown and prioritize its reform and deleveraging agenda. In this case, the Chinese debt supercycle is over sooner and the global economy will pay the price. Our China Investment Strategy Activity Index. Global policy is accommodative and liquidity conditions have improved significantly. However, if the Chinese economy continues to deteriorate, global growth will not rebound. The China Activity Index must stabilize and even improve somewhat for our global growth view to come to fruition. Progress in the “phase one” deal. China and the US must agree to a trade détente. As long as uncertainty around immediate tariffs remain high and retaliation risks stay alive, global capital spending intentions and thus the global manufacturing sector will be hamstrung. Surveys of global growth. The Global manufacturing PMI and the global growth expectation component of the ZEW survey must both recover. If these variables cannot gain any traction, the global economy is sicker than we estimate and risk assets will suffer. Commodity prices and the dollar. In the first quarter, industrial commodity prices must rebound and the dollar must start to depreciate. These two developments will not only reflect an improvement in global growth. They will also alleviate deflationary pressures around the world, revive profits and sponsor a business spending recovery. Moreover, a weaker dollar will also ease global financial conditions by decreasing the global cost of capital. 10-year inflation breakeven rate. If US breakevens move above the 2.3% to 2.5% zone, the Fed will become more proactive about raising rates. This would provoke a quicker end to the business cycle. President Trump’s approval rating. If President Trump’s approval rating stabilizes below 42%, he could give up on the economy and instead bet on a “rally around the flag” as his best strategy for re-election. This would result in a much more hawkish and confrontational White House that would become an even greater source of uncertainty for the economy, and thus risk asset prices. Ms. X: Thank you for this comprehensive list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It will be our pleasure. The key points are as follow: Global equities are entering the end game of their nearly 11-year bull market. Stocks are expensive, but bonds are even more so. As a result, if global growth can recover and the US can avoid a recession in 2020, earnings will not weaken significantly and stocks will again outperform bonds. Low rates reflect the end of the debt supercycle in the advanced economies. However, the debt supercycle is still alive in EM in general, and in China, in particular. The global economic slowdown that begun more than 18 months ago started when China tried to limit debt growth. If Beijing continues to push for more deleveraging, global growth will continue to suffer as the EM debt supercycle will end. Nonetheless, we expect China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should promote a worldwide re-acceleration in economic activity. Policy uncertainty will recede next year. Domestic constraints are forcing China and the US toward a trade détente. The risk of a no-deal Brexit is now marginal, and President Trump is still the favorite in 2020. A decline in policy risk will foster a global economic rebound. That being said, some pockets of risk remain, such as in the Middle East. Global central banks are highly unlikely to remove the punch bowl anytime soon. Not only will it take some time before global deflationary forces recede, monetary authorities in the G10 want to avoid the Japanification of their economies. As a result, they are already announcing that they will allow inflation to overshoot their 2% target for a period of time. This will ultimately raise the need for higher rates in 2021, which will push the global economy into recession in late 2021, or early 2022. These dynamics are key to our categorization of 2020 as the end game. US growth will re-accelerate. The US consumer remains in good shape thanks to healthy balance sheets and robust employment and wage growth prospects. Meanwhile, corporate profits and capex should benefit from a decline in global uncertainty and a pick-up in global economic activity. China will continue to stimulate its economy but will not do so as aggressively as it did over the past 10 years. Consequently, EM growth will also bottom but is unlikely to boom. Europe and Japan will re-accelerate in 2020. Bond yields will grind higher in 2020. However, Treasury yields are unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures won’t resurface quickly, so the Fed is unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds are particularly unattractive. Corporate bonds are a mixed offering. Investment grade credit is unattractive owing to low option-adjusted spreads and high duration, especially when corporate health is deteriorating. Agency mortgage-backed securities and high-yield bonds offer better risk-adjusted value. Global stocks will enjoy their last-gasp rally in 2020. As global growth recovers, favor the more cyclical sectors and regions which also happen to offer the best value. US stocks are the least attractive bourse; they are very expensive and loaded with defensive and tech-related exposure, two groups that could suffer from higher bond yields. We are neutral on EM equities. Investors should pare exposure to equities after inflation breakevens have moved back into their 2.3% to 2.5% normal range and the Fed funds rate has moved closer to neutral. We anticipate this to be a risk in 2021. The dollar is likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations are also becoming headwinds. The pro-cyclical European currencies and the euro should be the main beneficiary of any dollar depreciation. Oil and gold will have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold will strengthen as global central banks limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2019. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 22, 2019

Mr. X and his daughter, Ms. X, are long-time BCA clients who visit our office toward the end of each year to discuss the economic and financial market outlook for the year ahead. This report is an edited transcript of our recent conversation. Mr. X: I have been eagerly looking forward to this meeting given my many concerns about the outlook. Our portfolio has done well in the past year thanks to the surge in bond prices and the outperformance of defensive equities. However, I am deeply troubled by the amount of monetary stimulus required to support risk assets, and by how expensive bonds and equities are. Moreover, the global economy remains engulfed in deflationary risks, and policymakers are running out of ammunition. As always, there is much to talk about. Ms. X: Let me add that I am also pleased to once again be here to discuss the major risks and opportunities in the global marketplace. A year ago, I held a more positive market view than my father. Directly after our meeting, the deep market correction gave me second thoughts, but ultimately, the rebound in stock prices vindicated my view. Clearly, your assertion that markets would be turbulent proved correct. Since I joined the family firm in early 2017, I have been pushing my father to keep a higher equity exposure than he was normally comfortable with. We agreed to still favor stocks last year, albeit, with a bias toward defensive sectors, and this strategy paid off. But after the past year’s powerful rally in both bonds and stocks, we are again left wondering how to position our portfolio. Ultimately, I do not believe a recession is imminent. Yes, stocks are expensive, but bonds are even more so. Since I expect economic growth to pick up, I am inclined to tilt the portfolio further into equities and move away from our preference for defensive sectors. As usual, I am very interested to hear your views. BCA: Our core theme for 2019 was that we would face classic late-cycle turbulence. Despite this volatility, a run-up in asset prices was likely. Soon after we met, the stock market plunged, hitting a low on December 26, 2018. We anticipated the Federal Reserve to be much more hawkish than what actually transpired. Wage growth and even core inflation have remained firm in the US, but the weakness in global inflation expectations drove central banks’ reaction functions more powerfully than we anticipated. Moreover, the rapid escalation of the Sino-US trade war added a layer of uncertainty that exacerbated the economic slowdown that had started in mid-2018, forcing global central banks to ease policy as an indemnity against recession. Looking ahead, central bankers are highly unlikely to tighten monetary policy as long as inflation expectations remain below their normal range consistent with a 2% inflation target. We agree that the odds of a US recession in the coming year are still low because financial conditions are set to remain accommodative, Chinese authorities are setting policy to shore up growth, and a trade truce is likely. Global economic activity will rebound in early 2020. Instead, the most probable timeframe for a broad based recession is late 2021/early 2022. As a result, we remain positive on risk assets, especially foreign stocks. We are also underweighting bonds as they offer extremely poor absolute and relative value. Mr. X: I can see we will have a lively discussion because I do not share your or my daughter’s optimism. My list of concerns is long, I hope we have time to get through them all. But first, let’s briefly review your predictions from last year. BCA: This exercise is always interesting and often humbling, too. A year ago, our key conclusions were that: Tensions between policy and markets would be an ongoing theme in 2019. With the US unemployment rate at a 48-year low, it would take a significant slowdown for the Fed to stop hiking rates. Ultimately, the Fed would deliver more hikes in 2019 than discounted in the markets. This would push up the dollar and keep the upward trend in Treasury yields intact. The dollar would peak in mid-2019. China would also become more aggressive in stimulating its economy, which would boost global growth. However, until both of these things happened, emerging markets would remain under pressure. We favored developed market equities over their EM peers. We also preferred defensive equity sectors such as healthcare and consumer staples over cyclical sectors such as industrials and materials. Within the developed market universe, the US would outperform Europe and Japan over the next few quarters, especially in dollar terms. Stabilization in global growth would ignite a blow off rally in global equities. If the Fed was raising rates in response to falling unemployment, it would be unlikely to derail the stock market. However, once supply-side constraints began to bite fully in early 2020 and inflation began to rise well above the Fed’s target of 2%, stocks would begin to buckle. This would mean that a window would exist in 2019 for stocks to outperform bonds. We would maintain a benchmark allocation to stocks, but increase exposure if global bourses were to fall significantly from then (late 2018) current levels without a corresponding deterioration in the economic outlook. Corporate credit would underperform stocks as government bond yields rise. A major increase in credit spreads was unlikely as long as the economy remained in expansion mode, but spreads could still widen modestly. US shale companies had been the marginal producers in the global oil sector. With breakeven costs in shale close to $50/bbl, crude prices would be unlikely to rise much from current levels over the long term. However, we expected production cuts in Saudi Arabia would push prices up, with Brent crude averaging around $82/bbl in 2019. A balanced portfolio was likely to generate average returns of only 2.8% a year in real terms over the next decade. This compares to average returns of around 6.6% a year between 1982 and 2018. As already noted, our forecast for more Fed rate hikes was wrong. This meant that we were offside in our duration call. Ultimately, 10-year Treasuries have generated returns of 10.8% so far this year, and German bunds and Japanese government bonds returns of 5.8% and 1.0% in EUR and JPY terms, or 2.5% and 2.0% in USD terms, respectively (Table 1). Nonetheless, our expectation of a run-up in risk asset prices was spot on. Equities outperformed bonds, with global stocks climbing 22.2% in USD terms. We missed the initial outperformance of corporate bonds relative to Treasuries, as investment grade credit rose by 13.9%. However, our bond team took a more constructive stance on corporates as the year progressed. Table 1Market Performance Chart 12019 Was A Good Year For Stocks In terms of regional allocation recommendations, we were correct to overweight US equities which beat non-US stocks by 13.4%, partly thanks to the dollar’s appreciation. We were also right to underweight EM equities, with Asia and Latin America generating dollar returns of only 12.6% and 6.9%. Overall, it was a good year for financial markets (Chart 1). Our growth forecasts were mixed. We predicted global growth would slow in the first half of 2019 but improve thereafter. Instead, the slowdown extended and intensified into the second half of the year as the Sino-US trade war escalated more than expected, and Chinese policymakers were more reluctant to reflate than anticipated. The IMF also revised down its growth forecasts. In the October 2019 World Economic Outlook report, growth in advanced economies for the year was cut to 1.7% from 2.1% compared to 2018 forecasts, led by a downward revision to 1.5% from 2% in Europe (Table 2). They also pared down 2019 EM growth estimates to 3.9% from 4.7%. Consequently, inflation was softer than originally predicted. These trends in economic activity meant that our dollar call was partially right. The currency did not peak in the middle of the year as we foresaw, but has been flat since the spring and today trades where it was in April. Meanwhile, the weaker-than-expected growth put our oil call offside, with Brent averaging $62/bbl this year, not $82/bbl. Table 2IMF Economic Forecasts The Cycle’s End Game Mr. X: You mentioned that you remain positive on risk assets and stocks for 2020. You will not be surprised that I am extremely skeptical of this view. The Fed could only raise rates to 2.5% before all hell broke loose, and it has now cut them back to 1.75%. The European Central Bank has lowered its deposit rate to -0.5% and is resuming its asset purchase program, while the Bank of Japan is clearly out of ammunition. Yet global growth remains weak. Despite this lack of economic traction, US stocks are at a record high and are unequivocally expensive. This situation seems untenable. If global growth weakens further, there is little more policymakers can do. I think the risk of a recession is a lot more elevated than you believe, especially as we cannot count on a lasting trade détente. Meanwhile, the US presidential election makes me uncomfortable, and I cannot see how business leaders will want to deploy capital to expand capacity given the risk that the regulatory and tax environment could become hostile to the corporate sector. If I’m wrong about growth – and I hope I am – then inflationary pressures will build and central banks will have to tighten policy suddenly. As bond yields rise, stocks will be sold and yet bonds will not offer any protection since they yield so little. Also, I have not even talked about negative interest rates. $12.1 trillion of debt yields less than zero percent. This is obviously preventing creative destruction from purging the system of rot. It is also promoting capital misallocation and undue risk-taking by financial institutions who cannot meet fiduciary liabilities. Ms. X: Based on this tirade, you can easily imagine what life at the office has been like in recent months. I do share some of my father’s concerns. Negative rates cannot be a good thing, especially from a long-term perspective. If growth weakens further, I’m also concerned that central banks have few options left. However, I do not see these risks as imminent. There are nascent signs that the global economy will stabilize soon; both President Trump and President Xi have strong incentives to reach a trade truce; and central banks are nowhere near removing the proverbial punch bowl. While US stocks are expensive, other risk assets offer value if global growth rebounds. The wall of worry is high, but stocks can and will climb that wall. BCA: Your debate is similar to our own internal discussions. It is undeniable that the investing landscape looks shaky at the moment, especially with the S&P 500 currently trading at 18-times forward earnings. However, the situation you are describing is a direct consequence of one BCA’s long running macro themes: The end of the debt supercycle. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular. The private debt load in advanced economies has declined by 20% of GDP since 2009 (Chart 2A). Despite the burgeoning US federal government deficit, public debt accumulation has not been strong enough to cause total debt loads to increase. Instead, aggregate indebtedness has been stuck slightly above 260% of GDP for the past 10 years. Depressed, and in some cases, negative interest rates reflect weak demand for credit. Chart 2AThe Debt Supercycle Is Dead In DM... Chart 2B...But Not In EM   The end of the debt supercycle has both a negative and positive impact. Without increasing leverage, domestic demand cannot grow faster than trend GDP. Thus, it takes much more time for inflationary pressures to build. Concurrently, in the absence of inflationary pressure, more time passes before monetary policy reaches a restrictive level causing recession. The upshot is that the business cycle can last much longer. Moreover, a world less geared to credit accumulation reduces the fragility of the financial system, at the margin. While the debt supercycle is dead in advanced economies, it remains very much alive in emerging markets, and China in particular (Chart 2B), where the demand for credit is still very sensitive to changes in monetary settings. EM countries are the major source of volatility in the global business cycle. Chinese policymakers’ management of the tradeoff between growth and leverage will determine whether the global economy can avoid deflation. If they decide to tackle debt excesses head on, EM credit growth will contract and EM final demand will suffer. In this scenario, negative rates will persist in low-growth advanced economies, and the Fed will be incapable of raising rates because global deflationary forces will be too strong. Chart 3The World Is In The Midst Of A Deflationary Episode The second half of 2018 and the whole of 2019 gave us a taste of these forces. When China tightened credit conditions, the EM economies slowed first. Trade and manufacturing hubs like Europe, Australia and Japan quickly followed. A deflationary wave spread around the world, as evidenced by a drop in global producer prices (Chart 3). The US is a comparatively closed economy, but it could not avoid this gravitational pull. The ISM manufacturing survey ultimately started to contract in August 2018, converging to weakness in the rest of the world. The trade war’s hit to business confidence added insult to the injury of an already weak economic environment. Looking ahead, our optimism reflects an expectation that Chinese policymakers will adopt a more pro-growth policy stance because they too are spooked by the downtrend in their economy. While the Politburo Standing Committee has not abandoned its structural reform agenda, it realizes that aggressive deleveraging is dangerous. The Chinese economy is growing at its weakest pace in nearly 30 years and deflation is once again taking hold. In response to date, policymakers have lowered China’s reserve requirement ratio by 400 basis points, cut taxes by 2.8% of GDP, increased the issuance of local government bonds to finance public infrastructure projects, and boosted capex at state-owned enterprises. EM economies will respond to these stimulative measures. The Chinese credit and fiscal impulse has stabilized (Chart 4). Meanwhile, the Fed has pushed the real fed funds rate 74.4 basis points below the Holston-Laubach-Williams estimate of the neutral rate, and coordinated global policy easing points to a rebound in the global manufacturing sector (Chart 4, bottom panel). Moreover, the global inventory purge that magnified the industrial sector’s pain is getting exhausted and the auto sector is looking up. Finally, we agree with Ms. X that both President Trump and President Xi have their own incentives to deescalate trade policy uncertainty. We are entering the end game of this business cycle and bull market. Global borrowing rates will rise, but only to a limited extent. Rightly or wrongly, major central banks are terrified by the prospect of the Japanification of their economies. Practically speaking, this means that they want inflation expectations to move back up to normal levels (Chart 5). However, after undershooting their 2% targets for 11 years, achieving this objective will require central banks to let realized inflation overshoot these targets first. Thus, central banks are unlikely to tighten policy until late next year at the earliest, which will limit how far yields can climb in 2020. Chart 4…But Do Not Bet Against Reflation Chart 5Depressed Inflation Expectations   Equities and other risk assets should perform well if global growth re-accelerates but interest rates don’t rise much at first. Some benefit of this fertile backdrop is already priced in, but many pockets of value levered to stronger global growth still exist. We are entering the end game of this already long business cycle. While the general environment favors remaining invested in risk assets in 2020, this is likely the last window of opportunity to do so. Today’s accommodative monetary policy will revive inflationary pressures in 2021, and central banks will ultimately be forced to lift rates much more aggressively. China will continue to resist excessive leverage. Neither the business cycle nor the equity bull market will withstand these final assaults. Mr. X: Your benign outlook reminds me of when we met in December 2007. Do you remember? You told me that the housing slowdown and the credit market seizure were large risks, but central banks would put a floor under global growth. How did that turn out? I agree that in advanced economies, overall debt loads have been stable. But this belies major disparities. For example, US corporate debt has never represented a larger share of GDP than it does today. This must be a major vulnerability. While household balance sheets look healthy, I do not think consumption will save the day if companies are cutting capex and employment while they clean up their balance sheets. Countries like Canada and Australia are drowning in private sector debt. How can you ignore these vulnerabilities? BCA: A comparison with 2008 actually reveals why advanced economies, particularly the US, are not the powder keg that they once were. US corporate debt is elevated when compared to GDP, but profits also represent a much larger share of GDP than they did 10 or 20 years ago, and interest rates are close to historic lows. As a result, interest coverage ratios are still adequate (Chart 6). In 2007, household debt loads were large, but interest payments also accounted for 18.1% of disposable income, the highest proportion since 1972. Additionally, US firms’ debt-to-asset ratio is in line with the post-1970 average of 22.1%. Finally, US businesses have not used rising leverage to fund capital spending, as demonstrated by the elevated age of the capital stock. Thus, the US corporate sector continues to generate positive net savings. Ahead of recessions, US businesses typically generate negative net savings. The composition of the creditors is another important difference. In 2007, an extremely large share of the spurious borrowings resided on banks’ balance sheets. Moreover, the banking system was woefully undercapitalized with a leverage ratio of 17x. Weak banks had to absorb 2.2 trillion of losses after 2008. Consequently, the money creation mechanism broke down, and money multipliers collapsed (Chart 7). Today, US banks boast relatively stronger balance sheets, and they are still judicious about extending credit despite being less exposed to the corporate sector than they were to the mortgage market in 2008. Instead, most corporate debt is held by less levered entities such as ETFs, pension plans, and insurance companies. The leveraged losses that proved so debilitating in 2008 are less likely to be a source of systemic risk in this cycle. Chart 6US Businesses Can Still Service Their Debt Chart 72008 Heralded A Destruction Of Money   Countries like Australia and Canada have much more worrisome private sector debt dynamics, as their servicing costs are elevated (Chart 8). However, these economies are unlikely to collapse when global rates are low, as long as the global economy can avoid a recession, which would reduce export revenue in these trade-sensitive countries. You expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. The bottom line is that both the US corporate sector and at-risk countries like Canada should avoid a day of reckoning until interest rates rise meaningfully. As we have already mentioned, central banks are very clear that they will allow inflation to overshoot before tightening policy anew. We monitor US inflation breakeven rates to gauge the likely timing of that outcome. At 1.6%, they remain well below the 2.3% to 2.5% range, which is historically consistent with central banks durably achieving their inflation target (Chart 9). Until inflation expectations are re-anchored back up in that range, we will not worry about an imminent tightening in monetary conditions. Chart 8Canada And Australia Are Close To Their Debt Walls Chart 9The Fed Is In No Rush To Tighten   Chart 10Inflation Is A Lagging Indicator It is true that inflationary pressures are building in the US. Historical evidence points to a kink in the Phillips curve, the link between wage growth and the unemployment rate. Since the labor market is tight, we are already seeing average hourly earnings growth accelerate. Moreover, the output gap is mostly closed. However, keep in mind that inflation is also a lagging economic indicator (Chart 10). Consequently, the recent global economic slowdown is likely to keep US inflation at bay for most of 2020. The sharp fall in US capacity utilization along with the decline in imported goods and core producer price inflation corroborate this picture. Mr. X: So you believe that as long as rates stay low, the day of reckoning will be delayed. But ultimately, that it is unavoidable. BCA: Correct. No matter what, we are entering the end game of this already long business cycle. The current period of easy policy will allow cyclical spending to rise as a share of output, and debt to build up again over the coming 18 months. Because slack is clearly limited, this latest wave of policy easing will generate inflationary pressures. Ultimately, the Fed will be forced to play catch up and tighten more aggressively than expected in 2021. Paradoxically, the longer the onset of recession is delayed, the deeper it is likely to be… Mr. X: Because imbalances and vulnerabilities will only grow larger! BCA: Absolutely! Mr. X: That is something we can agree on. Ms. X: The way you complete one another’s sentences is a testament to how many years you have been talking to each other. For me, the most concerning issue is political risk. While I am more positive on the outlook for trade policy than my father, I do worry about the impact of US election risk on capital spending. Chart 11If The 2012 Election Is Any Guide, Trump Can Still Win A Second Term BCA: On the trade war, we would like to address your father’s concerns. All politicians, even unconventional ones like President Trump, seek re-election. Yet, President Trump’s overall approval rating is low (Chart 11). If the election were held today, his odds of winning would be minimal. However, US presidential elections do ultimately favor the incumbent. If the re-election of President Obama in 2012 is any guide, President Trump has enough time to boost his approval rating over the coming 12 months to secure a second term through the Electoral College. In order to achieve this outcome, he must reverse the large slowdown in wage growth currently plaguing the swing states he won by only a small margin in 2016 (Chart 12). Workers in states like Michigan, Pennsylvania and Wisconsin are suffering disproportionately from the uncertainty created by the trade tensions. President Trump will have to pause the tariffs – and even cut tariff rates – to support the economy and reassure voters. Chart 12Trump's Fear Is Coming True China is willing to accept a trade truce. The Chinese economy is weak and producer prices are once again deflating. President Xi doesn’t want to preside over another massive surge in leverage or a 1930’s Irving Fisher-style deflationary spiral. Reviving private sector investment sentiment via a reduction in trade policy uncertainty would help stabilize spending and avoid a disorderly economic slump. Moreover, President Xi may not trust the current White House, but the prospect of a Democratic administration that will be tough on both environmental standards and human rights would offer little solace. This brings us to the US election. The recent Bank of America Merrill Lynch positioning survey shows that the investment community shares your concerns. This risk is hard to quantify. The Democratic nomination is wide open. Former Vice President Joe Biden leads the opinion polls, and is a known quantity. Meanwhile, the rising progressive wing of the party, embodied in Senator Elizabeth Warren, is hostile to business and likely to cause concerns in boardrooms across the US, especially in the tech, energy, financial services and healthcare sectors. This could dampen animal spirits. Biden’s and Warren’s odds of beating President Trump are overstated by current polls, especially if the President softens his stance on trade to allow for a growth pick-up. Moreover, to be competitive nationally, Senator Warren will have to abandon some of her more progressive plans and pivot toward the center. The recent upbeat equity market performance of sectors like managed healthcare suggests that markets are discounting this shift. Thus, we doubt the election is currently really weighing on business intentions. The recent pick up in capital spending intentions in various Fed Manufacturing surveys fades this risk. Chart 13A Structural Tailwind Has Vanished What is clear though is that if the economy were to weaken further, Senator Warren’s chances would improve and CEOs would genuinely begin to worry about re-regulation, potentially unleashing a vicious cycle. Thus, the end game is an unstable equilibrium. On a structural basis, whether one looks at the rise of populism or the geopolitical rivalry between China and the US, trade tensions will remain a pesky feature of the global economy. In effect, the trade truce will not be a permanent deal. The global economy has therefore lost the tailwind of deepening global integration achieved through trade (Chart 13). This will limit global potential GDP growth. Ms. X: Thank you. I think the time is right to explore your economic outlook in more detail. The Economic Outlook Chart 14China: Modest Reflation Is Underway Mr. X: From your arguments, it seems that the outlook for China and Emerging Markets is critical, so let’s start there. My impression is that President Xi is not abandoning his structural reform agenda. Avoiding the middle-income trap will require decreasing China’s dependence on credit as a growth driver. Can economic activity really stabilize under those circumstances? BCA: You are correct: Senior Chinese administrators are reluctant to allow another major phase of debt accumulation to take hold. However, as we already highlighted, policymakers are taking steps to end the most severe economic slowdown since the first half of the 1990s. China is currently implementing a middling stimulus program. The positive impact of the lower bank reserve requirement ratio, the tax cuts and increased public infrastructure spending is being mitigated by strong regulatory constraints on the shadow banking system and small financial institutions, by efforts to limit real estate speculation, and by the cash crunch facing real estate developers. These crosscurrents make it unlikely that the credit impulse will rise as sharply as it did following the reflationary campaigns of 2009, 2012 or 2016. Nonetheless, the Chinese economy is indeed exhibiting some mildly positive signals. Our monetary indicator and state-owned enterprise capital spending point to a rebound in overall Chinese economic activity (Chart 14). Moreover, household spending is trying to bottom. If China stabilizes, then the EM slowdown will end soon. Without a deepening drag from the Chinese economy, EM countries should be able to take advantage of the easing in global financial and liquidity conditions. But the end of the Chinese drag on EM growth does not mean a massive tailwind will be forthcoming. Additionally, deflationary forces remain stronger in the emerging world than in the US. As a result, EM real rates will remain stubbornly above the level that real economic activity warrants, posing a headwind for capital and durable goods spending. Generally speaking, EM and China are moving from a headwind for the world to a mild tailwind. Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone. Ms. X: I’m somewhat more positive than you on global growth next year. The policy easing around the world looks very promising for economic activity. How do you factor the impact of improving global liquidity conditions into your outlook for 2020? BCA: It is undeniable that global liquidity conditions have eased massively. As we already highlighted, the majority of global central banks cutting rates is a very positive dynamic for global growth. Trends in measures of liquidity ratify this message. Foreign exchange reserves are again growing and our BCA US Financial Liquidity index has rallied sharply over the past 12 months. Historically, this indicator forecasts the trend in the BCA Global Leading Economic Indicator, commodity prices and EM export prices by 18 months (Chart 15). Moreover, money aggregates are growing faster than credit across the major advanced economies. Such developments typically foretell an acceleration in global economic activity (Chart 16). Chart 15Liquidity Dynamics: Fueling A Global Growth Recovery Chart 16Rising Money Supply Is A Good Thing   The duration of the current slowdown also warrants optimism. We have often highlighted that since the early 1990s, the global manufacturing sector evolves over 36-month symmetric cycles (Chart 17). The current soft patch has lasted more than 18 months. In the context of easing liquidity and depleted inventories, pent-up demand can easily translate into actual spending. The recent surge in the new orders-to-inventories ratio confirms that global manufacturing activity should soon pick up (Chart 18). The auto sector’s weakness, which was exacerbated by previous inventory buildups, changing emission standards, and rising borrowing costs, is also ebbing. Chart 17The Mid-Cycle Slowdown Is Long In The Tooth Chart 18The New Order-To-Inventory Ratio Points To A Global Rebound     Various growth indicators are sniffing out this positive inflection point. The recent trough in the global ZEW survey is revealing (Chart 19). It materialized quickly after Sino-US trade tensions began to ease. Enough positive global economic momentum exists such that a minor decline in policy uncertainty could unleash a large improvement in growth expectations. The rebound in Taiwanese equities and European luxury stocks confirms that the global economy should soon bottom. There are two things we cannot emphasis enough. First, this is the end game of the business cycle, after which a recession will ensue. Second, investors should not expect the kind of strong synchronized growth rebound witnessed in 2017. Without a Chinese and EM boom, a crucial source of demand will be wanting. Mr. X: What about US growth? The yield curve inverted this summer and deteriorating consumer and business confidence raised the specter of an imminent recession. Moreover, the fiscal stimulus that helped the economy in the first half of 2019 is now over. In fact, with a $1 trillion federal deficit despite an unemployment rate of only 3.6%, we have run out of fiscal room to support activity if and when a recession materializes. BCA: The recent yield curve inversion most likely overstated the risk of an economic contraction. First, in the mid-1990s, if the term premium had been as low as it is today, the curve would have also inverted without any recession materializing from 1995 to 2000. Second, this summer, the curve inverted up to the 5-year tenor and steepened for longer maturities. Prior to recessions, the curve inverts across all maturities. Recessions are not born out of thin air. They are caused by imbalances and tight monetary policy. The large debt buildup and other investment imbalances that have preceded prior US recessions are not yet apparent. Prior to the 1991, 2001 and 2008 recessions, the private sector debt load had increased by 20.6%, 14.6% and 25.6% of GDP in the previous five years, not the current 1.4% run rate. The Fed’s policy is now clearly accommodative. Not only is the real fed funds rate 74.4 basis points below the Fed’s favored estimate of the neutral rate of interest, but also real estate, the most interest-rate sensitive economic sector, is rebounding. In 2018, real estate activity collapsed in response to mortgage rates rising to 4.9%. Today, the NAHB Homebuilding index has retraced 79% of its losses; mortgage demand has improved; and housing starts and building permits have recovered (Chart 20). When policy is tight, real estate activity never recovers this quickly, even as yields fall. Chart 19Positive Signals For Global Growth Chart 20The Housing Market Signals That Policy Is Accommodative   Chart 21Robust Household Financial Health A counterargument is that real estate price appreciation is weak. However, tight monetary policy is not the cause. Two forces are dampening house prices. First, the Jobs and Tax Act of 2017 lowered allowable mortgage interest and state and local tax deductions. High-end properties in high-tax states such as California, New York and Massachusetts have suffered from this adjustment. Second, the US housing market has an overhang of large, pricey homes relative to strong demand for smaller, starter homes. Median home prices outpacing average ones show this divergence. We also to need to gauge if consumer spending is likely to follow the manufacturing sector lower. If it does, a recession will be unavoidable. On this front, we are hopeful because: The outlook for household income is positive. As you noted, the unemployment rate is still extraordinarily low, and more Americans will be working by the end of 2020 than today. Additionally, the rising employment-to-population ratio for prime-age workers is tightly linked to stronger wages (Chart 21). Also, the recent pick up in productivity growth points to higher real wage growth. The household savings rate is elevated and has limited upside. Households already have a large cushion insulating them from unforeseen shocks. At 8.1% of disposable income, the savings rate is in the 65th percentile of its post-1980 distribution. It is especially lofty if we take into account robust American households’ net worth (Chart 21, bottom panel). Consumer credit demand is rising, according to the Fed’s Senior Loan officer survey. Since household liquid assets are quickly expanding and the household formation rate is robust, consumption of durable goods should pick up, especially in light of the large decrease in borrowing costs. This is particularly true since the household debt-to-assets ratio is at its lowest level since 1985 and debt-servicing costs only represent 9.7% of disposable income, the lowest share for nearly 40 years. The corporate sector outlook should brighten soon. The modest rise in productivity protects margins from higher wages, an effect that will linger given that capacity expansion is consistent with further productivity gains (Chart 22). Crucially, the combined fiscal and monetary easing in China should bolster capital-spending intentions around the world, including the US (Chart 23). Rising productivity will only consolidate these trends. Chart 22Capacity Growth Provides Some Support For Productivity Chart 23Chinese Reflation Will Revive US Capital Spending   The most positive development for the US corporate sector is our outlook for non-US growth. If the global manufacturing sector mends itself, so will the US. Ample liquidity is a positive for the world economy, as well as for US manufacturing conditions (Chart 24). On the fiscal front, we appreciate your worries, but they are not a story for 2020. The US fiscal thrust will not be as positive as it was in 2018 or 2019, but it is set to remain a small tailwind, not a drag. Furthermore, given that 2020 is an election year it is unlikely that politicians will tighten purse strings over the coming 12 months. Fiscal risks are undoubtedly greater in the long run. However, a sudden fiscal consolidation is a remote probability because fiscal austerity has gone out of style. Instead, the federal debt burden will be a major source of long-term inflation because there is no other easy way to address this gigantic pile of liabilities. The path of least resistance will be more spending and financial repression. In other words, real rates will stay too low and excess government spending will push prices higher, conveniently eroding the real value of that high federal debt burden. This was a big story in the 20th century and it will remain so in the 21st (Chart 25), especially since an aging population and the peak in globalization will weigh on global savings. Chart 24The US Manufacturing Slowdown Has Run Its Course Chart 25Inflation Is About Political Decisions   Ms. X: Your point about demographics makes me think of Europe and Japan. Brexit has not been resolved; populism remains a concern in Italy; and the European banking system is still fragile. Japan suffers from an even worse demographic profile and the recent VAT increase was ill-timed, economically. Given these headwinds, can these regions participate in the global recovery you foresee? BCA: The short answer is yes, albeit to varying degrees. The outlook for Europe is more promising than Japan. A No-Deal Brexit is now a very low probability event, even after next month’s UK election. The conservatives’ support for Prime Minister Johnson’s Brexit plan will ensure as much. A large source of uncertainty is being lifted, which will allow European businesses to resume investment planning. The situation in the European periphery is also improving. Non-performing loans in Spain and Italy are falling (Chart 26), which is allowing for a normalization of credit origination. The narrowing Italian and peripheral spreads to German bunds will be helped by easing financial conditions in the European economies that need it most. Higher Italian bond prices improve banks’ solvency and cut borrowing costs for the private sector. Finally, populism is alive and well in Europe, rejecting fiscal austerity, but not embracing euro-skepticism. More generous fiscal spending would be a positive for Europe. European liquidity conditions are also generous. Deposit growth has strengthened and financial conditions have benefited from lower German yields and a cheap euro, which trades 15% below fair-value estimates. Our model for European banks’ return on tangible equity is rising, which is a clear indication that easy financial and liquidity conditions should deliver stronger incremental economic activity (Chart 27). Chart 26Declining Non-Performing Loans Are A Positive For The European Periphery Chart 27European Banks' Return On Equity Will Improve In 2020   The fiscal outlook is murkier. European fiscal thrust was a positive 0.4% of GDP in 2019, but it will decline to 0.1% in 2020. However, fiscal policy affects economic activity with a lag. The impact of this year’s easing has yet to be fully felt. Since European rates are so low and the economy is not operating at full capacity, the fiscal multiplier is greater than one. Therefore, Europe can still reap a substantial fiscal dividend next year. Finally, Europe remains a very pro-cyclical economy. A large share of euro area GDP is connected to manufacturing and exports. As a result, Europe will be one of the prime beneficiaries of a pickup in global growth. Already, the sharp rebound in the German and euro area ZEW survey expectation components point to a brighter outlook for the region. Japan is also a very pro-cyclical economy, which will reap a dividend from a bottom in global manufacturing activity. However, the Land of the Rising Sun is still subject to idiosyncratic constraints. Japanese financial conditions have not improved as much as those in Europe. The yen has appreciated 2.6% in trade-weighted terms this year, while Japanese yields have not melted as much as European ones (because Italian and peripheral yields fell so much in 2019). Japan will also have to reckon with the impact of the October VAT increase. Ahead of the tax hike, retail sales spiked by 9.1% on a year-on-year basis, or 7.1% compared to the previous month, a script similar to 2014. 2015 was a payback year where consumption was depressed. This scenario will play out again, even if the Abe government has implemented some fiscal offsets. Ultimately, the Japanese economy will lag Europe’s in the first half of the year but should catch up in the second half. The impact of the tax hike will dissipate. Most importantly, rebounding global growth will hurt the yen, at least on a trade-weighted basis, providing a lift to export prospects and easing Japanese financial conditions relative to the rest of the world, which will produce a growth dividend later in 2020. Ms. X: To summarize, you expect a moderate rebound in global growth next year, but not a sharp acceleration because Chinese stimulus will not be that aggressive. EM activity will also pick up but will not generate fireworks. The US will be okay but Europe will probably deliver the largest positive growth surprise as external and domestic conditions align positively. Japan will also stabilize on the back of stronger global growth, but domestic headwinds mean that a true reacceleration won’t happen until the latter part of the year. This recovery constitutes the business cycle’s end game as inflation will become a concern in 2021, forcing the Fed to tighten then. BCA: Yes, this is correct. Ms. X: Thank you! Bond Market Prospects Chart 28Global Bonds Are Extremely Overvalued Ms. X: I do not like US Treasuries at current yields. They do not protect me against an inflation surprise and will do nothing for me in an economic recovery. However, my bearishness is tempered by the large stock of bonds with negative yields in Europe and Japan. As long as this strange situation persists, I doubt US yields will experience much upside. US paper is too attractive to foreign asset managers right now. BCA: We share your view and are recommending an underweight to global government bonds. Global yields offer little value and are vulnerable to a rebound in economic activity or a trade détente. Our Global Bond Valuation index is flashing a clear sell signal (Chart 28). As yields rise, global yield curves are bound to steepen. We also agree that the upside for Treasury yields is limited, but we disagree with the limiting factor. Foreign investors are not the major buyers of Treasuries. Indeed, the data shows that European and Japanese investors have not been aggressive purchasers of US government securities. The US yield curve is flat and US short rates tower above European and Japanese ones, hedging currency exposure when buying Treasuries is expensive. In euro or yen terms, a hedged Treasury yields -67 basis points and -60 basis points, less than 10-year bunds or JGBs, respectively. Meanwhile, EM central banks are diversifying their FX reserves away from the US dollar into gold. Instead, our view is governed by the concept we dub the “Golden Rule of Treasury Investing.” According to this principle, the outperformance of Treasuries relative to cash is a direct function of the Fed’s ability to surprise the market. If the Fed cuts rates more than the OIS curve anticipated 12 months prior, Treasuries outperform. The opposite happens if the Fed delivers a hawkish surprise (Chart 29). Chart 29The Golden Rule Of Treasury Investing Treasury yields are unlikely to move significantly higher than the 2.25% to 2.5% zone, because the OIS curve is now only pricing in 28 basis points of rate cuts over the next year. It is not just the US OIS curve that has priced out a large amount of rate cuts; this phenomenon has materialized around the world over the past five weeks. Chart 30The Term Premium Is Too Low Any upside risk to that 2.25% to 2.5% forecast for 2020 will come from the inflation expectations and term premium components of yields. Central banks, including the Fed, have telegraphed an intention to allow inflation expectations to rise, initially, in response to stronger global growth. Moreover, declining risk aversion should also allow the exceptionally depressed term premium to normalize (Chart 30). Only in late 2020 or early 2021 will Treasury yields durably move above this 2.25-2.5% zone. Punching above these levels will require core PCE inflation to have been above target long enough to re-anchor inflation expectations back up to their 2.3% to 2.5% target zone. Only then will the Fed give the all-clear signal to the bond market to lift yields higher. Mr. X: You still have not directly addressed the question of negative yields in Europe and Japan. This story will not end well. Do you worry about these bond markets over the next year? BCA: Our answer is an emphatic yes. But we assume you will not let us leave it at that. Mr. X: You know me too well. BCA: Over the course of the past 50 years, we have learned a thing or two about you. In all seriousness, let’s start with our simple but effective valuation ranking. It compares the current level of real yields for each country to their historical averages and standard deviations. You can see that the most unattractive bond markets right now are all in Europe (Chart 31). Chart 31European Bonds Are Too Dear Chart 32Swiss Bonds Are A Lose-Lose Proposition The lower bound of interest rates is another reason to avoid these markets. This floor seems to lie around -1% in nominal terms. Because of these constraints, in recent months, Swiss, Swedish, Dutch and German 10-year bonds have failed to rally as much as their higher-yielding US, Canadian or Australian counterparts when global yields are declining. However, they also underperform when yields are rising (Chart 32). They have become a lose-lose proposition. The only pockets of value left in DM bond markets are Greece, Portugal or Italy. Despite their apparent risks, we still like them. Support for the euro in Greece and Italy is 70% and 65%, respectively. Even populist governments in these nations are reluctant to attack euro membership anymore. Moreover, the ECB remains committed to the survival of the euro area in its current form. Christine Lagarde will not change that. For 2020 or 2021, the risk of euro breakup is practically zero. The same may not be true on a 5- to 10-year investment horizon, but for the coming year, these bonds offer an attractive risk-adjusted carry. Ms. X: Unsurprisingly, my father does not like corporate bonds because of highly levered corporate balance sheets. I think this is a long-term problem, but not a risk for 2020, so I’m looking to stay overweight spread product relative to Treasuries. Where do you stand on this market? BCA: On this issue, we sit somewhere between you both. Our Corporate Health Monitor continues to deteriorate (Chart 33). The high debt load of the US business sector coupled with the decline of the return on capital worries us. Furthermore, the covenant-lite trend in recent issuance suggests that corporate borrowers, not lenders, are getting the good deals. Essentially, too much cash is still chasing too little available yield pick-up. In this environment, capital is sure to be misallocated, and money ultimately lost. We find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. On a short-term basis, the spreads will not widen much. An easy Fed, recovering global growth, and the gigantic pile of negative-yielding bonds around the world will make sure of that. We advocate a neutral stance on investment grade corporates because IG bonds have high modified duration such that breakeven spread compensation versus Treasuries is near the bottom of its historical distribution across the IG credit spectrum (Chart 34). This means that credit will generate poor returns if government bond yields rise. Chart 33Dangerous Long-Term Picture For US Corporates Chart 34No Value Left In IG   Chart 35EMs Still Experiencing Deflation Thankfully, they are ways around this problem: emphasizing exposure to high-yield (HY) bonds and agency mortgage-backed securities (MBS) instead. HY breakeven spreads remain much more attractive than in the IG space, and option-adjusted spreads will benefit if our growth and inflation forecasts materialize. Investors reluctant to commit capital to these products should look into high quality agency MBS. After the recent wave of mortgage refinancing, these securities’ duration has collapsed to 3.0 compared to 7.9 for IG corporates. These securities therefore offer much better protection in a rising-yield environment. Ms. X: Before we move on to equities, where do you stand on EM bonds? BCA: We need to differentiate between EM local-currency bonds and EM USD-denominated bonds. We do like some EM local currency bonds. Inflation in EM countries is low and dropping. Money and credit growth is slowing, which implies that the disinflationary trend will remain in place through 2020 (Chart 35). Weaker nominal growth means that central banks in EM will continue to cut rates, providing a nice tailwind for local-currency bond prices. This comes with a caveat. Lower policy rates will boost bond prices but hurt EM currencies, especially because most EM currencies are not cheap and are already over-owned. Next year, it will be preferable to garner exposure to those countries interest rate moves via the swap market rather than the cash bond market. Chart 36The Mexican Peso Is Cheap There are some exceptions, like Mexico. The MXN is already very cheap because of fears surrounding the economic policies of President Andres Manual Lopez Obrador (AMLO) (Chart 36). However, we doubt he will turn out to be as dangerous as feared. Hence, MXN Mexican bonds are attractive to foreign investors in unhedged terms. We are currently avoiding EM USD-denominated debt, corporate and sovereign. Since emerging markets sport $5.1 trillion of dollar-denominated debt, falling EM exchange rates will increase the cost of servicing this debt, which makes it riskier. Mr. X: I think we will continue to underweight corporate and EM bonds in our fixed income portfolio. Spread levels still make no sense in terms of providing compensation for credit risk. I must admit that I find your recommendation to overweight MBS intriguing. We will need to ponder this idea further. Ms. X: And please wish me luck trying to convince my father to buy some high-yield bonds. Equity Market Outlook Mr. X: US stocks are too expensive for my taste, with the S&P 500 trading at a forward P/E ratio of 18. I’m well aware of the argument that equities may be expensive but that they are actually cheap compared to bonds, which implies that I should favor stocks over bonds. However, you know that I emphasize capital preservation. With stocks this rich already, equities offer no margin of safety. If I own stocks, I am therefore exposed to any unexpected shocks. Because I do not share your optimism on the economy, I am more worried about downside risk. Moreover, even if the economy performs better than I fear, I suspect stocks will respond poorly to higher yields. Chart 37The S&P Is Very Expensive Ms. X: I agree with my father that stocks are expensive. Nonetheless, as Keynes famously quipped, “Markets can stay irrational longer than you can stay solvent.” In today’s context, to me this means that stocks can ignore their overvaluation so long as liquidity is plentiful, rates are low, and a recession is avoided. BCA: On this question, we agree with Ms. X. We all agree that US equities are expensive. As you mentioned, their price-to-earnings ratio is 18. Only at the apex of the tech bubble and in early 2018 was the S&P 500 more expensive. Worryingly, the price-to-sales ratio is at 2.3, an even larger historical outlier than the P/E (Chart 37). Chart 38Low Yields And Plentiful Liquidity Are Still Fertile Ground For Stocks Ms. X is correct that we cannot look at stock valuations in isolation. Investing is about opportunity cost and the macroeconomic context. On this front, even US equities have their merit. Despite the S&P 500’s expensive multiples, our Composite Valuation Indicator is no more elevated than it was in 2013. Meanwhile, our Monetary Indicator has rarely been as supportive of stock prices as it is today, and our Speculation Indicator is in line with its January 2016 reading (Chart 38). Moreover, BCA’s Composite Sentiment indicator is still below its long-term historical average and margin debt has declined by $47.5 billion to the lowest share of US market capitalization since June 2005. These are hardly signs of irrational exuberance. Ultimately, bear markets and recessions travel together. A durable 20% drop in stock prices requires a significant and long-lasting decline in earnings. These developments happen during recessions (Chart 39). Our call is for a recession in the next 24 months or so. We must also remember that while equities perform poorly six months ahead of a recession, the end of a bull market, its last 12 to 18 months, tend to be very rewarding (Table 3). We are within this window. Chart 39Bear Markets And Recessions Travel Together Table 3The End Game Can Be Rewarding Based on our forecast for interest rates, we do not share the concerns that rising bond yields will topple stocks right away. Stock prices are an inverse function of risk-free rates, but a positive function of growth expectations. Higher yields will initially reflect stronger growth, not restrict it. But remember: the upside for yields is limited because central banks do not want to choke off the recovery. They will maintain accommodative policy. In other words, we expect real rates to lag behind growth expectations. Because long-term growth expectations, whether from sell-side analysts or extracted out of market prices using the Gordon Growth Model, are low, we are willing to make this bet (Chart 40). Equities will suffer if the global bond yield rises above 2.5%. This is more a story for 2021, and not our central scenario for 2020. It is nonetheless a reminder that we are entering the end game of the business cycle, so we are also entering the end-game of the bull market. Mr. X: I think you are playing with fire. Stocks are so expensive that if you are wrong on either the growth call or the yield call, they will suffer. I would rather miss the last melt-up in stocks than unnecessarily expose my portfolio to a meltdown. Additionally, you have not addressed the fact that S&P 500 margins have begun to soften but are still extremely elevated. Shouldn’t this dampen your optimism? BCA: Aggregate S&P 500 margins have some downside. Our Composite Margin Proxy, Operating Margins Diffusion index and Corporate Pricing Power indicator all remain weak (Chart 41). The deceleration in the crude PPI excluding food and energy and the past strength in the dollar confirm this insight, especially as the corporate wage bill climbs in a tight labor market. The biggest mitigating factor is that productivity is also on the mend, which curbs the negative impact of higher worker pay. Chart 40Growth Expectations Are Muted Chart 41US Margins Under Pressure   This danger must be put into perspective though. Margin expansion has been dominated by the tech sector (Chart 42). Excluding this industry, S&P 500 margins are roughly in line with their previous peak, and are not declining. The aggregate softness in margins is a reflection of the sharper decline in tech margins. Declining margins do not spell the imminent end of the bull market either. Table 4 shows that on average, the S&P 500 rises by 9.5% following the peak in margins. Equities can rise after margins crest because this is often an environment where wages are climbing, which boosts consumption. Consequently, top-line growth can accelerate and earnings can rise even if they represent a lower proportion of sales. This is the environment we foresee over 2020. Chart 42Tech Margins Have Likely Peaked Table 4Margin Peaks Do Not Spell S&P Doom   Chart 43Taiwanese Stocks Are Sniffing Out Better Global Growth Ms. X: You have talked about the tech sector being a drag on overall margins. How would you position a US stock portfolio? BCA: First, around the world, we prefer cyclical sectors to defensive ones. Cyclical stocks are depressed relative to defensive firms’ shares. Rebounding global growth and rising bond yields will favor cyclical sectors. Globally, the performance of cyclical equities relative to defensive ones correlates with Taiwanese equities, which are currently rallying smartly (Chart 43). This suggests that at the margin, the most cyclical asset markets are beginning to express optimism about global growth. Within the S&P 500, our favorite pair trade to express this bias is to overweight energy stocks at the expense of utilities. Utilities are bond proxies which will substantially underperform energy stocks when the rate of change of Treasury yields moves up (Chart 44). Moreover, based on our valuation indicators, energy stocks have never traded at such a deep discount to utilities, nor have they ever been as oversold. Chart 44Favor Energy Over Utilities Second, we are currently neutral on tech stocks but have put them on a downgrade alert. Tech equities are expensive, trading at a forward P/E ratio 21% above the other cyclicals. Moreover, since software spending has remained surprisingly resilient despite the global economic slowdown, it will likely lag investment in machinery and structures when industrial demand rebounds. Consequently, tech earnings will lag other traditional cyclical sectors. Tech multiples will also suffer when bond yields rise. As high-growth stocks, tech equities derive a large proportion of their intrinsic value from long-term deferred cash flows and their terminal value. Thus, tech multiples are highly sensitive to changes in the discount rate We implement this view by way of an underweight in tech and an overweight to industrials. Industrials have suffered disproportionately from the trade war. Any near term truce is unlikely to contain a grand bargain on intellectual property rights transfer that galvanizes tech exports, but it will remove some of the uncertainty weighing on industrials. Moreover, industrials are a much cheaper play on a global growth rebound. The global manufacturing slowdown has caused industrial equities to trade at their greatest discount to the tech sector since the financial crisis. Finally, the wage bill for the industrial sector is melting relative to tech, and our margin proxy is surging (Chart 45). This has created a very positive backdrop for this pair trade. We also like financials. They will be a key beneficiary of rising yields and a steepening yield curve. Additionally, household credit demand has picked up and overall credit growth should accelerate as central banks will maintain very accommodative monetary conditions. The yield impulse already points toward higher bank credit growth and companies are issuing an increasingly large stock of bonds (Chart 46). Chart 45Operating Metrics Will Boost Industrials Versus Tech Equities Chart 46Easing Financial Conditions Will Support Credit Creation   Ms. X: When combining valuation analysis with your fundamental sectoral slant, I am guessing that you must favor European, Japanese and EM stocks over the S&P 500? BCA: We do favor European and Japanese equities. Based on valuation alone, all the regions you mentioned offer higher expected long-term real rates of return than the US (Chart 47). Moreover, the dollar is expensive relative to advanced economies’ currencies. Hence, these markets are cheaper vehicles than the S&P 500 to bet on a global economic recovery. But valuation alone is not enough. US stocks are trading at unprecedented levels relative to global equities because of the FAANG craze (Chart 48). Looking at sector representation, our positive view on non-tech cyclicals also flatters exposure to Europe and Japan (Table 5). Chart 47Non US Equities Offer Better Value Chart 48FAANG-Driven US Outperformance   Table 5Equity Market Sector Composition Chart 49European Banks Are Cheap Europe is particularly attractive because of its large skew towards industrials and financials, which represent 32.3% of the market versus 22.3% in the US. Moreover, European financials are also a tantalizing bet because they trade at a 50% discount to US financials, according to their price-to-book ratio. Additionally, their return on tangible equity will benefit from higher German yields, easing financial conditions, declining non-performing loans in the periphery and rebounding global growth. Our RoE model for European banks already points to a resurgence in their stock prices (Chart 49). Of the major markets we track, Japan offers the highest prospective long-term real returns. Its strong cyclical slant and low share of tech stocks means it is another market investors should overweight to bet on a global recovery. The biggest problem for Japanese equities is the yen. When global yields climb higher, a weak JPY will clip some of the Nikkei’s gains for foreign investors. Finally, we are reluctant to overweight EM stocks just yet. In this space, median P/E ratios are much higher than on a market capitalization-weighted basis (Chart 50). State-owned companies explain this bifurcation, Chinese banks in particular. Since we expect Chinese banks to remain a conduit for policy, credit origination may flatter economic growth more than shareholders’ interests. Moreover, we have a negative outlook on EM currencies, and hedging this exposure is expensive. Finally, if China’s economic activity improves only modestly in 2020, the 2012 experience suggests that EM stocks can still underperform the global equity universe as global growth improves and yields rise (Chart 51). In other words, we find the reward-to-risk tradeoff more attractive in Europe and Japan than in emerging markets. Chart 50EM Stocks Are No Bargain Yet Chart 51EM Stocks Can Underperform When Global Growth Improves     Mr. X: Thank you. I am still not sure what share of our portfolio will be dedicated to stocks. However, I think that whatever this proportion will be, buying global equities makes more sense than US ones. Your valuation argument alone is swaying me, considering my more conservative instincts. Ms. X: I’m glad we will not have to argue on this point, but I know we will nonetheless battle on the stock/bond/gold split. Should we move on to your currency and commodity forecasts? BCA: It would be our pleasure. Currencies And Commodities Mr. X: You have often argued that the dollar is a countercyclical currency. Based on our discussion so far, you must expect the dollar to decline until we get closer to the next recession. I am not fully convinced. Specifically, I remember that in the back half of 2016 global growth was rebounding, but the dollar soared. Therefore, the growth/dollar relationship can be more complex than you argue. Meanwhile, with negative interest rates in Europe, Japan and Switzerland, why would I even consider divesting out of my positive yielding dollar assets? Chart 52The Dollar Is A Counter Cyclical Currency BCA: You raise interesting questions, and you are correct that we expect the dollar to depreciate if our constructive view on global growth pans out for 2020. The inverse relationship between global industrial production (excluding the US) and the trade-weighted dollar is unambiguous (Chart 52). As you also mentioned, the reality is a little bit more nuanced. To understand why, it is important to remember how currencies function. We can think of an exchange rate as an adjustment mechanism that solves for the gap in growth between any two countries. This is at the root of the dollar’s counter-cyclicality. When global growth is picking up, returns tend to be higher in cyclical markets, which are highly concentrated outside of the US. Flows then gravitate from the US to other markets and the dollar declines. After a while, the dollar becomes cheap enough that these flows reverse. In the second half of 2016, three factors drove the dollar rebound. First, US manufacturing was improving at a faster pace than that of the rest of the world. Second, the Fed resumed its interest rate hikes, so interest rate differentials suddenly flattered the dollar anew. Finally, the election of President Trump, who campaigned on large scale fiscal stimulus, elicited memories of the Reagan dollar bull market of the first half of the 1980s. These factors eventually faded as global growth rebounded. Today, the Fed’s policies are hurting the dollar. Aside from recent interest rate cuts, the Fed has been injecting liquidity into the banking system through repurchase agreements and renewed asset (T-Bills) purchases. Moreover, the rate cuts are also easing global funding conditions and promoting a re-steepening of the yield curve. This will incentivize banks to lend and boost the US money supply. As growth re-accelerates and demand for imports (machinery, commodities, and consumer goods) rises, the current account deficit will widen further. This process will increase the international supply of dollars. Historically, these dynamics usually hurt the dollar. What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. Like you, we are deeply uncomfortable with negative interest rates. Thankfully, the nascent pickup in global economic activity is lifting global bond yields. So far, foreign bond markets have led this move. More specifically, countries that have suffered most from the global manufacturing slowdown are now seeing their bond yields rise the quickest (Chart 53). For example, yields in Germany, Norway, Sweden, Switzerland and Japan have risen by a lot more than those in the US since global yields troughed in September. Should the initial signals of stabilization in global growth morph into a synchronized recovery, the US yield advantage will evaporate. In a nutshell, interest rates might be negative in Europe and Switzerland, but the positive carry offered by US assets is rapidly fading. Chart 53AAre Interest Rate Differentials Flashing A Signal About Exchange Rates? Chart 53BAre Interest Rate Differentials Flashing A Signal About Exchange Rates?   Chart 54Foreigners Are Selling Treasuries For international investors, the currency risk inherent in owning US bonds is just too large at the current juncture. Remember, the trade-weighted dollar stands 25% above its long-term equilibrium and the US twin deficits are expanding. Markets priced in cheap currencies with some potential upside, such as Australia, Canada, Norway or even the European periphery, might be better bets. Flows highlight just how precarious the situation is for the US dollar. Since last August, overall flows into the US Treasury market have been negative. Net foreign purchases by private investors are still positive at an annualized US$180 billion, but they are clearly rolling over. Moreover, official net outflows are running at $350 billion, easily cancelling out the private sector’s inflows (Chart 54). Essentially, foreigners’ appetite for US fixed-income assets is waning exactly as interest rate differentials have started moving against the dollar. Ms. X: I share my father’s concerns, but how would you implement your negative dollar view. Which currencies should I be loading up on as we enter the business cycle’s end game? BCA: The more export-dependent economies (and currencies) should benefit the most from a rebound in global growth. Within the G-10, we particularly like the Swedish krona, the Norwegian krone and the British pound. Bond yields for these currencies are rising the fastest vis-à-vis the US. As a result, the currencies themselves should soon follow (previously mentioned Chart 53). We also expect commodity currencies to benefit, but only upon clearer signs that the resource-thirsty Chinese economy is improving. Until then, they are likely to lag the pro-cyclical European currencies, which are less directly dependent on Chinese stimulus. The euro could become the greatest beneficiary from a weaker dollar because a large headwind for European economic activity is disappearing for now. For the past ten years, European real interest rates have been too low for the most productive, competitive exporter – Germany – but too high for others such as Spain and Italy. Consequently, the euro has been caught in a tug-of-war between a rising neutral rate of interest for Germany and a very low one for the peripheral economies. Via its rate cuts, asset purchase programs, and aggressive TLTRO packages, the ECB may have now finally eased policy to the point where nearly all Eurozone countries enjoy an accommodative monetary environment. 10-year government bond yields in France, Spain, Portugal and even Italy now all sit close to the neutral rate of interest for the entire eurozone (Chart 55). Chart 55The ECB Has Eased Policy Enough Finally, the euro is likely to benefit from inflows into European equity markets. The euro’s drop since 2018 has eased financial conditions and made euro area businesses more competitive. This is an important tailwind for European corporate profits and thus stocks. Moreover, European equities, especially those in the periphery, remain unloved, as illustrated by their cheap valuations compared to other advanced economies. Additionally, analysts’ earnings expectations for eurozone equities are perking up relative to US stocks. If the sell-side is right, powerful inflows into the region will lift the euro in 2020. Mr. X: Thank you. I find it difficult to share your enthusiasm for the euro, a currency backed by such a flimsy edifice. While I would agree that it could rebound next year, I find currencies highly unpredictable on such a time horizon. I prefer to think about them on a long-term basis, and while the euro is cheap, its weak institutional underpinning is too concerning. Let’s move on to commodities. Following our meeting last year, we took your advice on oil and gold. Overall, these calls helped our portfolio. Going forward, these markets are extremely perplexing. There is so much risk in oil markets, such as the tensions in the Middle East and the uncertainty stemming from the trade war between the US and China. How would you recommend playing the oil market in 2020? Chart 56Inventory Drawdown Will Support Oil BCA: Your assessment of these markets is spot on. Yet, price risk is skewed to the upside because fiscal and monetary stimulus will revive commodity demand. The oil-producer coalition led by Saudi Arabia and Russia will continue to restrain production, and will probably extend its 1.2mm b/d production cut due to expire at the end of March to year-end 2020. In the US, market-imposed capital discipline will keep reducing the growth of US shale-oil supply. Additionally, US shale-oil supply growth is threatened by flaring of associated natural gas in the Bakken and Permian basins. Failure to limit the burn-off at oil-production sites could provide the environmental lobby an opening to challenge growth. Ms. X: What about the demand side of the oil markets? The fall in the growth rate of demand this year caught most participants off guard. What do you make of that? BCA: Demand data shows a lot of lingering weakness, much of which was caused by tight financial conditions last year in the US and China. But now, most global central banks are pursuing highly accommodative monetary policy and many governments are also easing fiscal policy. As a result, this demand weakness will fade next year. We think next year growth will clock in at 1.4mm b/d. Not as robust as 2017, but still respectable. This should stop the downward pressure on oil prices that has prevailed since May (Chart 56). Mr. X: You’re describing a fairly strong market for next year. What are the downside risks to your view? BCA: Global economic policy uncertainty remains elevated. Uncertainty is one of the key factors driving demand for USD, which is one of the most popular safe havens in the world (Chart 57). A strong dollar creates a headwind for commodity demand. It raises the local-currency costs of consumers in the EM economies that drive oil demand, and lowers production costs outside of the US, encouraging supply growth at the margin. Chart 57Elevated Global Economic Uncertainty Has Kept The USD Well Bid Chart 58Gold: A Valuable Portfolio Hedge Ms. X: So, pulling it all together, what is your call for 2020? BCA: The weaker 2019 demand data and the upward revisions to global oil inventories pushed our 2020 Brent Oil forecast to $67/bbl from $70/bbl. We still expect WTI to trade at a $4/bbl discount to Brent. As we mentioned earlier, the risk to our forecast is to the upside: a resolution of the US-China trade war, and lower global economic policy uncertainty could trigger a sharp rally in crude prices. Mr. X: Thank you for your insight on oil. I would like to hear your thoughts on gold. You can tell that I see little absolute value in stocks or bonds at the moment, so I have an outsized preference for the yellow metal this year. Also, how could the US dollar and gold both rally at the same time in 2019? BCA: Let’s start with your dollar/gold question. It is very rare to see gold and the dollar rally together. Normally a strong dollar hurts gold. As you know, we’ve been recommending an allocation to gold since 2017, mostly as a portfolio hedge. We like that gold strongly outperforms other safe havens in equity bear markets and can participate in the upside (even if to a limited extent) in bull markets. We think the safe-haven properties of gold and the US dollar really have come to the fore over the past couple of years (Chart 58). Economic policy uncertainty, and divisive politics globally have raised the level of uncertainty to record levels. In such an environment, the dollar and gold both provide a safe haven and a portfolio hedge. Hence, their joint popularity this past year. We should also remember that gold is a good inflation hedge, and is particularly negatively correlated with real interest rates. A Fed that is willing to let the economy overheat is a Fed that will limit how high real rates climb. Moreover, global liquidity is plentiful. Finally, EM central banks have been slowly divesting from Treasuries and diversifying into gold lately, buying most of the new supply in the process. This backdrop, along with our forecast of a weaker dollar, should support gold again in 2020. That being said, because gold is tactically overbought and could face temporary headwinds if global uncertainty recedes, we prefer silver, which is not as stretched. Furthermore, silver’s higher industrial use means that it should also benefit from a global manufacturing recovery. Geopolitics Chart 59Multipolarity Creates An Unstable Environment Mr. X: Let’s return to geopolitical and policy risks, both of which abound. Global economic policy uncertainty is the highest it has been since academics began measuring it. The world is fraught with populism, authoritarianism, war, immigration, technological disruption, inequality, and corruption. With so much chaos, and so little consensus, is there anything solid for an investor to grasp about the political backdrop next year? BCA: Geopolitics is the likeliest candidate to short circuit this long bull market, given that the Federal Reserve, the usual culprit, has paused its rate tightening campaign. On a secular basis, geopolitical risk is rising because the United States’ national power is declining relative to that of other world powers (Chart 59). China’s rise, in particular, is stirring conflict with the US and its allies in the western Pacific. Beijing’s technological and military advance is generating fear across the American political establishment. Russia and China continue to deepen their relationship in the face of an increasingly unpredictable United States. These strategic tensions will persist despite any tariff ceasefire with China. Chart 60Globalization Has Peaked Competition among the great powers makes for a world of contested authority. As the rules of the road have become less certain, the tailwind behind international trade and investment has weakened (Chart 60). Deglobalization is a headwind for the earnings of large cap global companies in the long run. Emerging markets, which are exposed to trade, face persistent unrest. Mr. X: Given the above, how can an investor take an optimistic view of the global economy and markets next year? BCA: We have a framework for analyzing politics: constraints over preferences. We cannot predict what the chief politicians will prefer at any given time, but we can try to identify and measure the constraints that will restrict their freedom of movement. With global growth slowing, world leaders have become more sensitive to their constraints. The Fed has reversed rate hikes; China is easing policy; President Trump has refrained from attacking Iran; and President Trump and President Xi are negotiating a ceasefire. The UK has avoided a “no deal” Brexit – not once but twice. In short, the risk of recession (or conflict) has been sufficient to alter the policy trajectory. As a result, there is a prospect for global geopolitical risks to abate somewhat in 2020. Both the American and Chinese administrations need to see growth stabilize despite their ongoing strategic conflict. Both the British and European governments need to avoid a disorderly Brexit despite their lack of clarity beyond that. Geopolitical risk is declining, albeit from an extremely elevated level. Mr. X: The US and China have already come close to a deal only to get cold feet and back away from it. The British Prime Minister is committed to leaving the EU with or without a deal. Surely you cannot believe that the Middle East, Russia, other emerging markets, or North Korea will be any bastion of stability. BCA: The US-China trade war is still the single greatest threat to the equity bull market. Brexit is not resolved and a new deadline for a trade deal looms at the end of 2020. Investors must remain vigilant and hedge their portfolios, particularly with gold. Nevertheless, one cannot ignore this year’s reaffirmation of the Fed put, the China put, and Trump’s “Art of the Deal.” The base case for next year should be constructive, albeit with vigilant attention to the major risks: President Trump, China and Iran. The other issues you mention have varying degrees of market relevance. Russia is focusing on pacifying domestic discontent. North Korea is on a diplomatic track with the United States. Emerging market unrest is particularly relevant where it can have a bearing on global stability: Iraq, Iran and Hong Kong in particular. Ms. X: If I may interject: It seems to me that the worst of the trade war has passed, that the risk of a no-deal Brexit is negligible, and that Iran is unlikely to outdo its attack against Saudi Arabia in September. Doesn’t this imply that geopolitical risk is overrated and that investors should rush to capture the risk premium in equities? BCA: What we have described is a tentative abatement in geopolitical risk at best – but it would be cavalier to get overly enthusiastic. After all, any fall in global risks will be amply made up for by the impending rise in US domestic political risk. Indeed, US politics are the chief source of global political risk in 2020. First, if President Trump becomes a “lame duck” then he could take actions that are hugely disruptive to global markets in a desperate attempt to win reelection as a “war president.” Chart 61European Political Risk Is Now Low Second, if President Trump is reelected, then his disruptive populism will have a new mandate and his “America First” foreign and trade policy will be unshackled. Third, if the opposition Democrats succeed in unseating an incumbent president, they will likely take the Senate too, removing the main hurdle to a dramatic policy change. That would mark the third 180-degree reversal in national policy in 12 years. Moreover, investors may find the country merely exchanged right-wing populism for left-wing populism, which has a more negative impact on corporate earnings prospects. Polarization and institutional erosion will continue. The election results may be razor thin; swing states may have to recount votes; and the outcome could hinge on rare or unprecedented developments in the Electoral College, the Supreme Court or cyberspace. A crisis of legitimacy could easily afflict the next administration. In short, there are few scenarios in which US political risk does not rise over the next 12-24 months. Rising American risk stands in stark contrast to Europe (Chart 61), where the will to integrate has overcome several challenges since the sovereign debt crisis. Substantial majority of voters support the euro and the European Union. Germany is on the brink of a major political succession but it is not turning its back on the European project. France is successfully pursuing structural reforms. Italy remains the weakest link, but even the populist Northern League accepts the euro. This leaves two remaining global risks: China and Iran. Chinese political risk is generally understated. President Xi Jinping, lacking President Trump’s electoral constraint, could overestimate his leverage. He could overreach in the trade talks, in his battle to prevent excessive debt growth, or in his handling of Hong Kong, Taiwan, North Korea, or Iran. The result could be a breakdown in the trade talks or a separate strategic crisis with the United States. Another cold war-style escalation in tensions could easily kill the green shoots in global growth. As for Iran, the regime is under crippling American sanctions and faces unrest both at home and within its regional sphere of influence. There is a non-negligible risk that it will lash out and cause an extended oil supply shock. Conclusions Mr. X: This is a good place to conclude our discussion. We have covered a lot of ground but I remain deeply concerned that staying invested in risk assets today is akin to picking-up pennies in front of a steamroller. I accept your opinion that a recession is unlikely in 2020, but valuations of both stocks and bonds are uncomfortably stretched for my taste. As a result, I believe stocks could suffer whether growth is good or bad next year. Finally, since so many things need to go right for the global economy to continue to defy gravity, a recession may hit faster than you envision. To me, there is simply not enough margin of safety in stocks to compensate me for the risk! Ms. X: I agree with my father that the risks are high because we are entering the end game of the cycle. But I also see pockets of value, some of which you have mentioned today. Moreover, I am sympathetic to your view that global growth will recover next year. Corporate earnings should therefore expand. Hence, I fear that being out of the market will be very painful, especially because policy is quite accommodative. While stocks may not perform as well as they did in 2019, I expect them to outperform bonds handily. I’m therefore willing to continue holding risk assets, even if I need to be more judicious in my sector and regional allocation. BCA: Your family debate mirrors our own internal discussions. There is always a trade-off between maximizing short-term returns and taking a longer-term approach. Valuations are the ultimate guidepost for long-term return prospects. Because so many assets have become more expensive this year, long-term returns are likely to be uninspiring compared to recent history. Table 6 shows our baseline calculations of what a balanced portfolio will earn over the coming decade. We estimate that such a portfolio will deliver average annual returns of 4.4% over the next ten years, or 2.4% after adjusting for inflation. That is a noticeable deterioration from our inflation-adjusted estimate of 2.8% from last year, and also still well below the 6.5% real return that a balanced portfolio earned between 1982 and 2019. Table 6Asset Market Return Projections Our outlook for next year hinges on global growth rebounding and policy uncertainty receding. Monetary policy is less of a threat to equities than it was last year because central banks have already eased considerably and have been very open about their willingness to let inflation run above target for a while before retightening the monetary screws. We propose the following list of easy-to-track milestones to monitor whether or not our central scenario for the global economy and asset markets is playing out, and how close we are to the end of the cycle: Chinese money and credit numbers. Chinese credit growth must stabilize for the economy to do so. If credit origination continues to decelerate, this will indicate that Beijing has decided to tolerate the slowdown and prioritize its reform and deleveraging agenda. In this case, the Chinese debt supercycle is over sooner and the global economy will pay the price. Our China Investment Strategy Activity Index. Global policy is accommodative and liquidity conditions have improved significantly. However, if the Chinese economy continues to deteriorate, global growth will not rebound. The China Activity Index must stabilize and even improve somewhat for our global growth view to come to fruition. Progress in the “phase one” deal. China and the US must agree to a trade détente. As long as uncertainty around immediate tariffs remain high and retaliation risks stay alive, global capital spending intentions and thus the global manufacturing sector will be hamstrung. Surveys of global growth. The Global manufacturing PMI and the global growth expectation component of the ZEW survey must both recover. If these variables cannot gain any traction, the global economy is sicker than we estimate and risk assets will suffer. Commodity prices and the dollar. In the first quarter, industrial commodity prices must rebound and the dollar must start to depreciate. These two developments will not only reflect an improvement in global growth. They will also alleviate deflationary pressures around the world, revive profits and sponsor a business spending recovery. Moreover, a weaker dollar will also ease global financial conditions by decreasing the global cost of capital. 10-year inflation breakeven rate. If US breakevens move above the 2.3% to 2.5% zone, the Fed will become more proactive about raising rates. This would provoke a quicker end to the business cycle. President Trump’s approval rating. If President Trump’s approval rating stabilizes below 42%, he could give up on the economy and instead bet on a “rally around the flag” as his best strategy for re-election. This would result in a much more hawkish and confrontational White House that would become an even greater source of uncertainty for the economy, and thus risk asset prices. Ms. X: Thank you for this comprehensive list of variables to monitor. As always, you have left us with much to think about. We look forward to these discussions every year. Before we conclude, it would be helpful to have a recap of your key views. BCA: It will be our pleasure. The key points are as follow: Global equities are entering the end game of their nearly 11-year bull market. Stocks are expensive, but bonds are even more so. As a result, if global growth can recover and the US can avoid a recession in 2020, earnings will not weaken significantly and stocks will again outperform bonds. Low rates reflect the end of the debt supercycle in the advanced economies. However, the debt supercycle is still alive in EM in general, and in China, in particular. The global economic slowdown that begun more than 18 months ago started when China tried to limit debt growth. If Beijing continues to push for more deleveraging, global growth will continue to suffer as the EM debt supercycle will end. Nonetheless, we expect China to try to mitigate domestic deflationary pressures in 2020. As a result, a small wave of Chinese reflation, coupled with the substantial easing in global monetary and liquidity conditions should promote a worldwide re-acceleration in economic activity. Policy uncertainty will recede next year. Domestic constraints are forcing China and the US toward a trade détente. The risk of a no-deal Brexit is now marginal, and President Trump is still the favorite in 2020. A decline in policy risk will foster a global economic rebound. That being said, some pockets of risk remain, such as in the Middle East. Global central banks are highly unlikely to remove the punch bowl anytime soon. Not only will it take some time before global deflationary forces recede, monetary authorities in the G10 want to avoid the Japanification of their economies. As a result, they are already announcing that they will allow inflation to overshoot their 2% target for a period of time. This will ultimately raise the need for higher rates in 2021, which will push the global economy into recession in late 2021, or early 2022. These dynamics are key to our categorization of 2020 as the end game. US growth will re-accelerate. The US consumer remains in good shape thanks to healthy balance sheets and robust employment and wage growth prospects. Meanwhile, corporate profits and capex should benefit from a decline in global uncertainty and a pick-up in global economic activity. China will continue to stimulate its economy but will not do so as aggressively as it did over the past 10 years. Consequently, EM growth will also bottom but is unlikely to boom. Europe and Japan will re-accelerate in 2020. Bond yields will grind higher in 2020. However, Treasury yields are unlikely to break above the 2.25% to 2.5% range until much later in the year. Inflationary pressures won’t resurface quickly, so the Fed is unlikely to signal its intention to raise interest rates until late 2020 or later. European bonds are particularly unattractive. Corporate bonds are a mixed offering. Investment grade credit is unattractive owing to low option-adjusted spreads and high duration, especially when corporate health is deteriorating. Agency mortgage-backed securities and high-yield bonds offer better risk-adjusted value. Global stocks will enjoy their last-gasp rally in 2020. As global growth recovers, favor the more cyclical sectors and regions which also happen to offer the best value. US stocks are the least attractive bourse; they are very expensive and loaded with defensive and tech-related exposure, two groups that could suffer from higher bond yields. We are neutral on EM equities. Investors should pare exposure to equities after inflation breakevens have moved back into their 2.3% to 2.5% normal range and the Fed funds rate has moved closer to neutral. We anticipate this to be a risk in 2021. The dollar is likely to decline because it is a countercyclical currency. Balance of payment dynamics and valuation considerations are also becoming headwinds. The pro-cyclical European currencies and the euro should be the main beneficiary of any dollar depreciation. Oil and gold will have upside next year. Crude will benefit from both supply-side discipline and a recovery in oil demand on the back of the improving growth outlook. Gold will strengthen as global central banks limit the upside to real rates by allowing inflation to run a bit hot. A weaker dollar will flatter both commodities. A balanced portfolio is likely to generate average returns of only 2.4% a year in real terms over the next decade. This compares to average returns of around 6.5% a year between 1982 and 2019. We would like to take this opportunity to wish you and all of our clients a very peaceful, healthy and prosperous New Year. The Editors November 22, 2019

Special Report

Highlights US politics are the chief source of global geopolitical risk over the coming year – and likely beyond. President Trump’s reelection remains our base case – the sitting president rarely loses if the economy is expanding. Yet the risk of a Democratic victory is high – Trump’s low approval rating, impending impeachment trial, and various policy troubles threaten his reelection bid. Trump’s tactics and the Democrats’ turn to the progressive left pose threats to BCA Research’s cyclically bullish house equity view. Feature If a time-traveler had accosted you in the fall of 2014 and told you that Donald Trump, the host of the reality TV show The Apprentice, would be the next American president, would you have believed him? What if the time-traveler had gone on to say that President Trump’s unconventional behavior would get him into hot water and that in 2020 he would become the first president in US history to be impeached and removed from office? Granting the premise, the second proposition is easier to imagine. And yet Trump is highly unlikely to be removed from office. He is in fact favored to be reelected. Just as his victory in 2016 proved more likely than the consensus held at the time, so his reelection in 2020 is more likely than the consensus holds today. The reason comes down to political constraints. First, the bar for removal in the Senate is very high. Second, it is easier for a sitting president to get reelected than it is for the opposition to convince voters to start over with something entirely different. Especially if the economy is in decent shape. In what follows we present our quantitative 2020 election model and our qualitative, constraints-based analysis of the election and likely market responses. Trump's fate is only one factor. But US politics is the chief source of market-relevant global political risk over the next 12-24 months. Not A Lame Duck (Yet) After a harrowing year in which global manufacturing slumped due to China’s tight credit policy and Trump’s trade war, the probability of a US recession is now – tentatively – subsiding (Chart 1). This is good news for Trump, whose presidency is hanging by a thread. Chart 1Recession Averted? Or Trump's Death Knell? Chart 2Bookies Expect A Democrat Victory Betting markets like PredictIt.org suggest that Democrats are slightly more likely than Republicans to win the White House next November (Chart 2). The narrow spread is appropriate given that the balance of evidence is fairly even. However, if there is to be a tilt, it should go the opposite way, i.e. toward Republicans as the incumbent party. The history of US elections since 1860 shows a strong tendency for the incumbent party to hold the White House when the sitting president is running at the head of the ticket. This is especially true when there has not been a recession during the president’s four-year term. It is even true when the ruling party has lost seats in preceding congressional elections, as occurred in 2018 and as is often the case (Chart 3). Other than recession, the biggest exception to the sitting president’s victory – especially in modern times – is when a major scandal has occurred, as with Gerald Ford in 1976. This is clearly relevant to today. In these rare cases the incumbent president’s and incumbent party’s historic reelection rates are both 50/50. The implication of Chart 3 is that Trump’s odds, from a historical point of view, are slightly above 50%. Of course, history does not afford an example of a first-term president being impeached, acquitted, and running for election again.1 Yet this is the most likely outcome today, as there is not an overwhelming popular demand to remove Trump from office. Despite the revelations and public hearings in the impeachment inquiry so far, support for removal stands at 47%, while opposition to removal stands at 45% (Chart 4). In other words, there is no majority in favor of removal, but only a narrow plurality. Removal – nullifying an election result – requires more. Chart 3History Says Trump More Likely To Win Than Not Chart 4No Consensus On Removal From Office The spread is conspicuously close to the 46%-to-48% popular vote spread for Trump and Hillary Clinton, respectively, in 2016. The impeachment is not a tsunami of public opposition to the administration. It is a bare-knuckle power struggle: Trump tried to have his top rival investigated and tarred with corruption allegations, the Democrats are retaliating by trying to remove Trump prior to the election. Support for removal will fluctuate, but it will take more than 47% of the population to generate a 67-vote supermajority against Trump in a Republican-held Senate. Republican senators would be taking a grave risk in voting against their base when they have the option of deferring to voters in just 11 months’ time. Both Richard Nixon and Bill Clinton were in their second terms when Congress began moving articles of impeachment: the public had no other recourse in the event that they committed “high crimes and misdemeanors.” Trump is in his first term and is due for the public’s verdict shortly. Nixon resigned when it became clear that grassroots Republicans had lost faith in him and the Senate would not acquit. Trump’s political base has not yet lost faith – his approval among Republicans is still 90%, higher than the average of Republican presidents and at the high end of his term in office (Chart 5). When it comes to the final vote, some Republican senators may defect, but it would take 20 to remove Trump from office. This will require a Nixon-like hemorrhage of support. Remarkably Trump’s general approval rating has not been affected by the impeachment inquiry (Chart 6). His approval rating is still comparable to President Barack Obama’s rating at this stage in his first term (as well as Ronald Reagan’s). While Trump is highly unlikely to break above 50%, he is emphatically not a lame duck … at least not yet. Presidential approval tends to rise as the opposition nomination is settled and the election approaches. If Trump’s approval revives to the 46% of the popular vote he won in 2016, then he remains competitive in the swing states where the election will be fought and won. Chart 5Trump’s Political Base Geared Up For Battle Chart 6A Precarious Approval Rating What about the Republicans’ heavy losses in the midterm elections and special elections since 2016? Haven’t national voting trends already condemned Trump and the Republicans to a loss in 2020? Not necessarily. Democrats lost elections more dramatically in 2009-11 than Republicans lost in 2017-19 – both in voter support and turnout (Table 1) – and yet President Obama secured the victory in 2012. Presidential elections are a different beast. Table 1Democrats Suffered More Post-2008 Than Republicans Post-2016 … Yet Obama Won Reelection Chart 7GOP Governorships At Low End Of Rising Trend The same goes for Republican losses in recent gubernatorial races. In Kentucky the incumbent governor was a Republican and lost; in Louisiana the incumbent governor was a Democrat and won. The catch is that the number of Republican governors was extremely elevated prior to 2018. Recent losses have merely brought the Republicans back to the bottom of their upward channel as a share of the nation’s 50 governors (Chart 7). Thus while the interim elections are a warning sign to Trump and the GOP, they are not a death knell – as long as the economy rebounds and President Trump’s approval rises as the election approaches. Bottom Line: Trump is not a lame duck yet. His administration is embattled and the impeachment process could permanently damage his standing. But so far his general approval rating and the specific impeachment polling suggest that he will stay in office and remain competitive in the 2020 race. If the election were today he would almost surely lose, but a lot can change in 12 months. If the economy avoids recession, then investors should take reelection as their base case. Cyclical Constraints Will Prevail A recession is the surest way to render a president a lame duck. It does not have to be a technical recession. The contraction in the manufacturing sector – and corresponding cutbacks in lending in the manufacturing-heavy and electorally vital Midwest – are extremely threatening to a president who promised to revive manufacturing and trade (Chart 8). Incumbency, economic growth, failed impeachment, and partial policy victory are enough to win the key swing states. Having declared that “trade wars are good and easy to win,” President Trump will not be able to hide from a deeper slowdown in the industrial heartland. State-level wage growth is positive, but swing states, particularly Trump swing states, are seeing a sharp drop-off from the highs prior to the trade war (Chart 9). The solution is the trade ceasefire being pursued with China. Trump is now in the position of the Federal Reserve Chairman: he can no longer afford to hike (tariff) rates, and the equity market may force him to cut, as long as he can reasonably hope to improve the economy. If the economy is lost, the trade war is back on. Chart 8An Urgent Need For A Trade Ceasefire Chart 9Trump Swing States Took A Hit From The Trade War Chart 10Buttigieg And Warren More Favorable Than Others Are incumbency, economic growth, failed impeachment, and partial policy victories enough to get Trump over the line in the key swing states?2 Subjectively, we think so. The Democrats have to win all of the states they won in 2016 plus Michigan and Florida (or two other states in place of Florida, such as Wisconsin and Pennsylvania). President Trump can afford to lose Michigan and one other state (but not Florida). This assessment has little to do with the Democratic presidential nominee – as yet unknown – and everything to do with whether the incumbent president or party has been fundamentally discredited. Democratic candidates like Senator Elizabeth Warren and Mayor Pete Buttigieg are generally more competitive than consensus holds. Warren, for instance, is one of the few candidates in recent elections who has a net positive favorability rating (Chart 10). But her favorability is not enough to overturn a sitting president – that will most likely require a shock that renders the status quo intolerable. The cyclical constraints on Trump and his opponents are thus clear. What of the structural constraints? Trump’s 2016 victory is often attributed to long-running structural trends in the US such as deindustrialization, immigration, and racial attitudes. The Democrats’ “blue wall” in the Rust Belt crumbled because Trump courted the working-class voter there and/or stoked racial anxieties. The implication, however, is that Trump still has an advantage in these swing states. Older voters and especially white voters have drifted toward Republicans for several years – the trend was interrupted only by the Great Recession, which saw a surge in Democratic support that has now subsided (Chart 11). Chart 11Old And White People Drifting To GOP Over Time ... Excepting The Great Recession While the white share of the swing states is falling over time, that trend is not sufficient to prevent Trump from winning the Electoral College in the year 2020. Instead the rapidly changing racial and ethnic composition of society should be seen as motivating the attitudes that Trump exploits. Trump’s electoral strategy of maximizing white turnout and support for the Republican Party, which we dubbed “White Hype” in 2016, is still the only way for him to achieve a popular vote victory in 2020, and hence the clearest pathway for him to achieve an Electoral College victory (Chart 12). Needless to say, tensions and controversies over race and immigration will swell in the coming year. Chart 12Electoral College Scenarios Show Trump Win Still Possible Chart 13Swing State Turnout Follows Unemployment By the same token, demographic change means that the Democrats can theoretically win by performing no better than they did in 2016 in terms of voter turnout and support rates (see the “Status Quo” scenario in Chart 12). This is a low hurdle for Democrats – suggesting once again that the election will be extremely close, that Trump can win only through the Electoral College (not the popular vote), and that the election outcome will ultimately swing on the cyclical factors outlined above, particularly the state of the economy. A final word about voter turnout. The greatest electoral risk to President Trump is an increase in voter turnout among traditionally low turnout groups that heavily favor the Democratic Party, such as young people and minorities. Given the surge in turnout for the 2018 midterm elections, and the extremely controversial and heated environment surrounding Trump’s presidency, there is considerable reason to suspect that 2020 will be a high-turnout election. Other things being equal, this would likely penalize Trump’s reelection prospects. However, it is important to recognize that voter turnout in swing states is fairly well correlated with the unemployment rate (Chart 13). Depending on the state, surges in turnout occurred in 1992, in the wake of recession; 2004, in the wake of recession, terrorism and war; and 2008, in the wake of the great financial crisis. The exception is Pennsylvania, where a surge in white voter turnout helped Trump pull off a surprise win in the state. Turnout is the hardest political variable to predict, so it is not clear whether Trump’s scandals and impeachment will do the trick. But an increase in the unemployment rate would virtually destroy Trump’s bid, being negatively correlated with presidential approval and positively correlated with voter turnout. Bottom Line: Trump’s executive powers give him the potential to achieve some additional policy victories that could boost his approval rating – namely a trade ceasefire with China that simultaneously improves the economic outlook. Meanwhile structural factors such as demographics do not forbid Trump from winning the Electoral College – on the contrary, aging and the decline in the white share of the population mean that Trump’s electoral strategy could succeed again in 2020, but will be much harder to pull off after 2020. Introducing … BCA’s Geopolitical Strategy 2020 US Presidential Election Model The BCA Geopolitical Strategy Presidential Election Model is a state-by-state model that uses political and economic variables to predict the Electoral College vote. What differentiates our model from that of others is that it attempts to predict the probability of the incumbent party winning the Electoral College votes in each of the 50 states. The model would have predicted the past five elections correctly on an out-of-sample basis, even the controversial win of George W. Bush over Al Gore in 2000. Why do we predict the electoral vote rather than the popular vote? First, the winner of the presidential election is determined by the Electoral College, not the popular vote. Second, in recent history, two candidates who lost the popular vote (George W. Bush in 2000 and Donald Trump in 2016) won the election. It is possible that we will see a similar result in 2020, given President Trump’s low national popularity yet distinctive policy pitch for the Midwestern states (e.g. economic patriotism, hardline on immigration). With only minor exceptions, electoral votes are allocated based on a winner-take-all process, as opposed to proportionately to the popular vote. Hence the best way to forecast the presidential election winner is to predict the probability of winning each state, i.e. receiving all the electoral votes assigned to each state.3 Due to the data availability of our input variables, our sample size includes nine elections (1984 to 2016) across 50 states, making for a total of 450 observations. We designed the model to be as succinct as possible. It includes four explanatory variables: A weighted average of the Federal Reserve Bank of Philadelphia State Leading Index, from the beginning of the previous presidential term until September of the election year. The state leading indexes predict the 6-month growth rate of the state coincident indexes, which include nonfarm payroll employment, average hours worked in manufacturing by production workers, the unemployment rate, and wage and salary disbursements deflated by the consumer price index (U.S. city average).4 Chart 14Voters Make Up Their Minds Ahead Of Time We use a weighted average of all the monthly forecasts in the presidential term preceding an election, where later months are weighted more heavily than earlier months. Our sample includes 6-month growth rates up to and including September of the election year, which means it includes a rough forecast of the direction of the state’s economy in Q1 of the new president’s term. Since we weigh recent months more heavily, our model assigns more importance to forward-looking factors. It is sufficient to end our calculations of the average state leading indexes in September of the election year. First, the October data comes out in early November, just days before the election, which would be an insufficient lead-time for our final forecast. Second, most voters make their decision at least one month in advance of the election and last-minute changes in economic forecasts will likely not influence their decision (Chart 14). The incumbent party’s margin of victory in the previous presidential election in each state. This is measured as the incumbent party vote share minus the non-incumbent party vote share. Simply put, if the incumbent party failed to secure a solid win in a given state in the previous election, the probability of securing a solid win in the current election is much smaller. Average national approval level of the incumbent president in July of the election year. We tested the correlation between presidential approval in every month leading up to the election versus the election outcome and found that July approval levels have the second-highest correlation with the popular vote and Electoral College vote (Chart 15). Average October approval levels have slightly higher correlation with election outcomes, but not sufficiently so to sacrifice three months of lead-time. A “time for change” variable. This is a categorical variable indicating whether the incumbent party has been in the White House for one or more terms. Academic literature shows that a party that has occupied the White House for two terms or more is much less likely to win an election than a party that is running for a second term.5 Chart 15Voters Mostly Decided By July The output of our model is the probability of an incumbent win in each state. There are two ways of aggregating these probabilities to produce a national-level outcome: Allocate the number of Electoral College votes won by the incumbent proportionally to their probability of victory in each state, and then sum them up across all states. This method would smooth out potential errors in our forecast. The Republican Party is expected to win with 279 Electoral College votes in 2020. Assume a probability threshold of 50%: any state with an incumbent win that is at least 50% likely is fully assigned to the incumbent. While this method could significantly sway our forecast towards one of the parties because of small changes in probability, it is closer to the political reality. Even the smallest majority in a given state will (usually) result in the winning candidate getting all of the state’s Electoral College votes. We therefore adopt this method in our aggregation.6 Our model performs well in back tests: it correctly predicted every election in in-sample tests and every election from 2000 to 2016 in out-of-sample tests (Chart 16). Chart 16BCA Research Geopolitical Strategy Election Model: Back Tests Accurate Chart 17 shows our initial 2020 prediction. Overall, the Republican Party is expected to win 279 Electoral College votes, a 25-vote decrease from its 2016 result. Chart 17Trump Narrowly Slated To Win 2020 With 279 Electoral College Votes As of the latest available data, our model predicts that the Republicans will lose Michigan and Wisconsin (critical victories in 2016). Wisconsin, Pennsylvania, and New Hampshire become borderline or “toss-up” states: the probability of a Republican win in these states is 48.77%, 50.17%, and 46.90%, respectively. Even the smallest change in our inputs can shift these states to either party. The two inputs that can affect our forecast are the state leading index and President Trump’s approval level, since the other two inputs – the time for change variable and last election’s margin of victory – are fixed. Table 2 shows the predicted Electoral College votes for the Republican Party for various scenarios of these two variables. According to the model, President Trump is currently at the lowest level of approval and weakest state-by-state economy that he can afford. If one of these factors stabilizes below today’s level, Trump will lose his reelection bid. Table 2Small Decline In State Economies Could Ruin Trump’s 2020 Bid In the worst-case scenario for Trump – if his approval and the state leading indexes drop to the lowest levels they have touched in Trump’s presidency – the Republican Party will only manage to secure 230 Electoral College votes. The opposite, optimistic scenario would see them winning with 329 votes. An interesting takeaway from our model is that it captures the increase in American political polarization that has been widely observed by scholars. The 2020 forecast shows that many states will be won or lost by the incumbent party with extreme certainty (0% or 100%). Results of in-sample predictions show that this trend has been increasing since 1992 (Chart 18, top panel), which is also in line with our own measure of polarization (Chart 18, bottom panel). Since the results are based on in-sample estimations, the coefficients remain constant, so the differences in the results can be attributed to the underlying data. The impression of ever-intensifying polarization in the US is correct. What does this mean for Trump? He cannot be written off simply because he has a relatively low approval rating. Structural political factors that propelled him to the White House are still in place. His approval and the economy must deteriorate to change this base case. The chief risk to our model is the accuracy and interpretation of presidential approval polling. While polling data always has a margin of error, it is possible that approval polling is underestimating Trump’s support, particularly on the state level, as was witnessed in 2016 (Chart 19). Chart 18Rising Polarization – It’s Empirical Chart 19State-Level Polling Still A Risk We have a high degree of confidence in professional pollsters, who have also made improvements since 2016.   But asking Americans whether they “approve” of the unorthodox Trump may be a different proposition than in the past, disguising voting intentions to some degree. By choosing the level of Trump’s approval in our model (see Appendix), we are guarding against overstating his support and not allowing much room for any dampening effects or self-censorship, which is thus a risk to our model. Bottom Line: Quantitative modeling, entirely independent of our qualitative assessment, suggests that Trump is favored to win the 2020 election. However, he is skating on very thin ice with regard to key cyclical variables such as state-level economic performance and popular approval rating. If his approval level suffers from a slowing economy, or scandal and impeachment, then he will lose the critical toss-up states and the White House. Investment Conclusions In this report we have outlined a case where President Trump, despite his extreme unorthodoxy in general, and acute vulnerability at this moment in time, is still the most likely winner of the 2020 election. Elections are a Bayesian process in which investors should establish a clear prior, or starting place, and update their probabilities according to reliable data streams. This report establishes our prior and our key data streams. So what? Does it matter if Trump is reelected? Is it relevant to investors? From a bird’s eye view, Trump has made a few decisions that clearly distinguish his term in office from that of previous presidents. First, by replacing Janet Yellen with Jerome Powell at the Federal Reserve, Trump arguably accelerated the normalization of monetary policy, which contributed to a rise in bond yields, an increase in market volatility, a strong dollar, and a global slowdown. Second, by embracing sweeping Republican tax reform, Trump initiated pro-cyclical fiscal stimulus that widened the US’s monetary and economic divergence from the rest of the world, while exacerbating the US’s long-term fiscal woes. Third, by adopting protectionist trade policy to confront China’s mercantilism, Trump rattled global sentiment and contributed to a manufacturing recession. As long as our view remains correct, investors will have a base case that is cyclically bullish. Of these three macro developments, the only one that the election could substantially change is trade policy – and yet the Democrats are also taking a more hawkish approach to China. On the fiscal front, the Democrats will raise taxes, but they will not impose austerity – instead they propose large expansions of entitlements that the populace increasingly demands. Populist social spending combined with geopolitical struggle with China ensures that the deficit/GDP ratio will go up regardless of the party in power. From a market point of view, the historical record suggests that presidential elections – specifically elections that lead to gridlock between the White House and Congress, since we do not expect the Democrats to lose the House of Representatives – usually see a rising US stock market beforehand and a higher degree of volatility afterwards (Chart 20). Relative to developed market equities, US stocks typically underperform, and only resume their rise in the second half of the following year (i.e. 2021). Comparing Trump to other first-term presidents, it is clear that his “pluto-populism” (populism plus tax cuts for the rich) has exerted a reflationary effect on the equity market (Chart 21). As long as the data show that he has a fair chance of reelection, investors will have a base case that is cyclically bullish, despite the volatility to come from the Democrats’ taxation and regulation proposals. Chart 20Equity Outcomes Surrounding US Presidential Votes Chart 21Trump A Reason To Be Bullish What is most striking about Trump’s presidency is the low real total return on US Treasuries. This is despite his aggressive foreign and trade policy, which has motivated safe-haven flows into Treasuries this year (Chart 22). The bottom line is that the output gap is closed, the labor market is tight, and fiscal policy is expansive, putting upward pressure on yields. Given that Trump needs to cultivate a China ceasefire and economic improvement for reelection, this trend should continue until the next recession looms. Chart 22Trump Marks End Of Bull Market In Bonds The risk, however, is that Trump’s precarious China negotiations fall through, or that his scandals cause a permanent downshift in his approval rating, rendering him a lame duck. Not only would this free him of the election constraint that currently forces him to pursue pro-market policies, but it would also make a Democratic victory more likely. The Democratic nomination, meanwhile, could easily produce a progressive populist in the figure of Elizabeth Warren, who is still a frontrunner in the Democratic nomination. A bear market could develop quite easily if a normal equity market correction, which improves the odds of a Democratic victory becomes entangled in expectations that Warren is set to win the nomination. If the opposition can summon enough votes to unseat an incumbent president, chances are that the circumstances will include a “blue wave” that also sees the Democrats take the Senate. This would institute another sweeping change to American policy, this time in a direction that is unfriendly to corporate profits. As the probability of such a scenario rises, the equity market will have to discount it. Expectations of a Trump victory will spur the market upward – but investors should be wary. If this very long bull market has continued all the way to November 3, 2020, and President Trump is confirmed in office, the positive stock market reaction will likely provide an excellent time for booking profits and reducing risk. In a second term, Trump will be unshackled from his electoral constraints – very much unlike a first-term Democrat. This would free him to pursue his trade wars with fewer inhibitions – against China but also likely against Europe. A continuation of the trade war has important impacts across the full slate of global assets, as outlined in Chart 23, which depicts the movement of assets on days in which US equities reacted negatively to trade war developments. Chart 23A Trump Second Term Means Trade War With Fewer Constraints With 11 months to go, we are a world away from the election. The party nomination process, or third-party candidates, could overturn all expectations. But if there is one certainty, it is that polarization and political risk will rise in the coming 12-24 months. The losing side of the population will have deep heartburn. A crisis of legitimacy could easily haunt the next administration. There could be hanging chads, vote recounts, faithless electors, or contested results. The outcome of the election could turn upon unprecedented developments in the Electoral College, Supreme Court, or even in cyberspace. If the Democrats win, redistribution will amplify partisanship. If Trump wins, inequality will rise. There is no easy way forward for the United States.   Matt Gertken Vice President Geopolitical Strategist mattg@bcaresearch.com   Ekaterina Shtrevensky Research Analyst ekaterinas@bcaresearch.com Appendix 1: The Approval Question: Level Or Change? Chart 24Trump’s Historically Low Approval Rating The chief risk to our model is the interpretation of the presidential approval rating and its impact on the election. President Trump’s approval rating is notoriously low compared to the average president (Chart 24). While many authors use approval rating (or popularity) in their models, some argue that it is not the approval level, but the change in approval leading up to the election that matters.7 Consider the following: if President Trump’s approval increases from today’s level of 43% by 5%, he would be at the same level of approval as the average president if their approval were to drop by 5%. A model based on approval level would place these two presidents equally, while a model based on the change in approval would favor Trump. So which one is correct? We compare the incumbent’s popular vote in post-WWII elections with four different “variations” of incumbent president approval: the average level in July of the election year (as in our model); the deviation of the average October level from the election-year average, the change during the last two years of the term; and the range throughout the entire term. Directionally, the results are as expected. Level and change in approval are positively correlated with the popular vote, while a less stable approval (higher range) is negatively correlated (Chart 25A). We also find that approval level has the best fit with the election outcome, followed by the change in approval in the two years leading up to the election. However, if we restrict the sample size to the range of elections used in our model, 1984 to 2016, we find that the change in approval has a much better fit than the level (Chart 25B). In other words, in modern elections the presidential candidate’s momentum matters more in the final outcome. Chart 25AHigh, Rising, And Stable Approval Ratings … Chart 25B… Help Presidents Win Elections We tested each variation of approval as an input in our model instead of the July approval level. Table 3 summarizes the results. Trump wins in all four versions. Table 3All Measures Of Approval Favor Trump In 2020 Our current model penalizes Trump the most, while the model based on approval range favors him. This makes sense, given that President Trump’s approval is relatively low but very stable (Chart 26). Chart 26Trump Approval Very Low … And Very Stable We will continue to use approval level in our model to generate updated predictions, given that this measure has the best long-term historical fit with the election outcome. However, given that President Trump is performing relatively well on these other measures of approval, there is upside risk to his 2020 performance. Appendix 2: A Word About The Probit Model Table 4 presents the regression coefficients of our model. Since this is a probit model, the coefficients cannot be directly interpreted as they would in an ordinary regression. The coefficients in a probit regression model measure the change in the Z-score associated to each independent variable for a one-unit change in that variable. Table 4BCA 2020 US Presidential Election Model Statistics The sign of the coefficient corresponds to the direction of change in probability. So increases in the state leading index, presidential approval, or the incumbent’s margin of victory in the last election increase the probability of the incumbent winning a state. Of course, the latter variable is fixed and will not change until the election. At the same time, having occupied the White House for two terms or more decreases the probability of an incumbent win. But this is not the case in the current election. Footnotes 1 Andrew Johnson, the first to be impeached, did not run in 1868; Ulysses Grant bowed out after two terms in 1876, amid the “Great Barbecue” scandal; Warren Harding died before the election of 1924, amid the infamous “Teapot Dome” scandal; Harry Truman stepped down amid scandal after two terms in 1952; Richard Nixon resigned before the election of 1976; Bill Clinton was impeached and hit the two-term limit before the election of 2000. For these examples, and the electoral impact of great scandals in general, please see Allan J. Lichtman, Predicting The Next Presidency: The Keys To The White House 2016 (Rowman and Littlefield, 2016). 2 Trump’s policy record contains one major legislative victory, the Tax Cut and Jobs Act of 2017, along with a number of works in progress. The Republicans’ failed attempt to repeal and replace the Affordable Care Act (Obamacare) exacted an opportunity cost: it deprived Trump and the GOP Congress of time needed to legislate a southern border wall, while mobilizing the opposition for all subsequent elections. As for other policies, the renegotiation of NAFTA is only a partial success as the USMCA has not been ratified. The promised infrastructure package will become a campaign pledge for the second term. We expect some kind of North Korea deal. 3 To this end, we use a probit model, where the dependent variable is stated as 1 = incumbent party won all Electoral College votes in this state, or 0 = incumbent party did not win any Electoral College votes in this state. This model allows us to measure the probability that a state with certain characteristics will fall into one of these two categories. 4 “The leading index for each state predicts the six-month growth rate of the state’s coincident index. In addition to the coincident index, the models include other variables that lead the economy: state-level housing permits (1 to 4 units), state initial unemployment insurance claims, delivery times from the Institute for Supply Management (ISM) manufacturing survey, and the interest rate spread between the 10-year Treasury bond and the 3-month Treasury bill.” See the Federal Reserve Bank of Philadelphia, www.philadelphiafed.org. 5 Alan I. Abramowitz, “Forecasting the 2008 Presidential Election with the Time-for-Change Model,” Political Science and Politics, Vol. 41, No. 4 (Oct., 2008), pp. 691-695. 6 We also assume that the Democrats always win the District of Columbia. 7 Please see Michael S. Lewis-Beck, Charles Tien, “Forecasting presidential elections: When to change the model,” International Journal of Forecasting, Volume 24, Issue 2, April–June 2008, Pages 227-236, and Mark Zandi, Dan White, Bernard Yaros, “2020 Presidential Election Model,” Moody’s Analytics, September 2019.

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

Special Report

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

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

Highlights The investors we met last week were ready to hear some good news: The constructive story we told across three days of client meetings is more sanguine than the consensus view, but clients were open to considering it. Global economic weakness and the elevated risk of a U.S. recession were primary concerns, … : As our Global Investment Strategy colleagues have suggested, it will take some time for investors to be convinced that global manufacturing really has seen the bottom and that the U.S. isn’t flirting with a recession. … followed by trade tensions and corporate indebtedness, … : Our small sample suggests that investors may have become de-sensitized to the daily ebb and flow of the U.S.-China conflict, though we continue to believe it looms large in the minds of corporate managements. … but nothing matches the anxiety provoked by Elizabeth Warren’s ascent: Every client asked about the potential consequences of a Warren White House. Feature We spent most of last week meeting with a subset of wealth management and family office clients. They are more focused on absolute returns than relative returns, but their primary concerns are nearly identical to their relative-return peers’. Our meetings touched on a broad constellation of questions about the fate of the expansion, the equity bull market, global growth and the U.S.-China trade negotiations. Clients also asked about the credit outlook and if inflation should be on their radar, but the topic that they raised with the most fervor, in every single one of our meetings, was the prospect of a Warren or Sanders presidency. Q: What is the bond market telling us? We think of the bond market as having two distinct components, rates (Treasuries) and credit (spread product). We have gotten used to regular retracements in the 10-year Treasury yield since it bottomed in July 2016, but watching it melt from 3.25% last November to 1.5% this August has challenged our constructive take on the U.S. economy. Falling yields are not necessarily signaling imminent economic trouble, however, so we continue to hold the view that a recession won’t occur before late 2021 or early 2022. We see this year’s falling Treasury yields as a coincident reflection of decelerating growth, not a harbinger of a recession. On a purely domestic basis, the principal driver of the decline in yields has been the shift in monetary policy expectations. The Fed’s dovish pivot did not occur in a vacuum, of course. Clear signs of decelerating growth set the stage for easier policy, both here and abroad. Whether or not the Fed was always calling the tune, all three step-function declines in 12-month forward fed funds rate expectations occurred as it was guiding markets to expect easier policy: ahead of the March FOMC meeting, when Fed speakers began warning of the danger of inflation expectations becoming unanchored on the downside; in May, when they were busily preparing the ground for a rate cut; and after the July meeting raised the prospect that the July cut would not be a one-off event (Chart 1). Chart 1The Fed's Dovish Pivot, ... Sovereign rates are not entirely determined domestically, and much of the softness in Treasury yields reflects the softness in yields in the rest of the world. So far this year, 10-year sovereign yields have moved in lockstep on either side of the Atlantic (Chart 2), preserving no-arbitrage conditions in currency-hedged Treasuries, gilts and bunds. Crude prices are another global variable, and their decline has weighed on inflation break-even rates (Chart 3), dampening the inflation compensation demanded by Treasury buyers. From a rates perspective, we think the bond market is telling us that global growth has slowed, central banks have taken monetary accommodation up a notch, and oil prices have slid. That’s not exactly an ideal growth backdrop, but it hardly spells the end of the expansion. Chart 2... And European Sovereigns' Gravitational Pull Have Dragged Treasury Yields Lower The credit market concurs. It doesn’t betray a whit of concern that the expansion is in trouble. Spreads quickly unwound last year’s fourth-quarter spike, and have since hung around their post-crisis lows (Chart 4). Non-financial corporations have become more indebted throughout the expansion, but servicing the debt is not at all onerous with yields at rock-bottom levels (Chart 5). Our U.S. Bond Strategy service’s proprietary corporate health monitor is signaling that corporate balance sheets have weakened (Chart 6, third panel), but the other elements required for a meaningful widening of spreads – a completed monetary tightening cycle1 (Chart 6, second panel), and a tightening of lending standards (Chart 6, bottom panel) – are not yet in place. Chart 3Falling Oil Prices Have Smothered Inflation Worries Chart 4Spreads Are Tight, ...   Chart 5... And Debt Service Is Easy Q: Isn’t it time to reduce credit exposures? Tight spreads may be a contrarian warning sign. Though it is sensible to shift some of a company’s financing burden to debt when it is so much cheaper than equity, combining a larger debt burden with degraded covenant protections is a concern. Low interest rates will keep debt service costs from chafing, and help keep defaults in check for now, but the bond market is increasingly vulnerable. Chart 6Spread Widening Conditions Aren't Yet In Place Chart 7Income Investors Need Not Apply Despite that vulnerability, when the next default cycle arrives, it will not have anywhere near the impact of the housing bust because it will deal no more than a glancing blow to the banks. Single-family homes collateralize the American banking system; corporate bonds are held by a diffuse assortment of unlevered players. It stinks for any unlevered investor when it loses money, but it doesn’t cause much of a ripple in the overall economy. Today’s buildup in corporate borrowing is not analogous to 2006-7’s residential mortgage Superfund site, and suggestions to the contrary are ill-founded. Elevated corporate leverage is a vulnerability, but it is not enough for an investor to identify a vulnerability; s/he also has to identify the catalyst that will cause it to snap. Nonfinancial corporate debt levels are a fissure that has been made longer by debauched covenants. Markets won’t suffer until the fissure lengthens and widens enough to turn into a crack that no investor can ignore. It is our view that easy monetary conditions will keep the fissure out of sight and out of mind for several months at least. Defaults only occur when a borrower is unable to refinance its maturing obligations. As long as there is at least one lender willing to extend new credit at manageable terms, the borrower won’t go bust. The current monetary policy backdrop, featuring zero/negative interest rate policy in much of the major economies, all but ensures a steady supply of willing lenders. Life insurers, pension funds and endowments with a need for income to offset fixed liabilities have been forced out the risk curve to source income sufficient to meet them (Chart 7). The net result has been to provide even wobbly credits offering an incremental 50 or 75 basis points with a line of would-be lenders out the door and around the corner. The global manufacturing sector has already succumbed to recession, but stout performance in the service sector has allowed developed economies to keep expanding. The weakest credits will not find lifelines, but plenty of dubious ones will. The current ultra-loose monetary policy environment is simply not a backdrop in which defaults pick up in earnest. Until central banks get a little less prodigal, the marginal lender won’t become more selective, the plates will keep spinning, and spread product will continue to generate excess returns over cash and Treasuries. Q: Things look worse outside the U.S. What’s your global growth outlook? Chart 8Manufacturing May Be Bottoming, ... The global manufacturing sector is in recession, but the overall global economy is not (Chart 8). A manufacturing recession does not necessarily lead to a full-blown recession, and the ongoing expansion in developed economies’ much larger service sector provides a formidable bulwark against manufacturing’s struggles (Chart 9). While it is too early to conclude if or when global activity will accelerate, our global leading economic indicator, and the diffusion index that leads it, suggest that it is in the process of bottoming (Chart 10). Chart 9... And Services May Have Stopped Decelerating ... Chart 10... If Leading Indicators Have Found A Footing Chart 11From Headwind To Tailwind Our China Investment Strategy team sees scope for Chinese growth to gather some steam in the first quarter of 2020, when local governments will be freed from the budget constraints imposed by Beijing through the end of this year. In the meantime, September money and credit growth topped expectations, and policymakers have been undertaking modest stimulus measures like trimming bank reserve requirement ratios. Changes in Chinese credit growth lead changes in global growth (Chart 11), via China’s credit-reliant import channel. Its imports are Europe’s, Japan’s, Asian EMs’, and Australia’s, Brazil’s and Chile’s exports. As their exports rise, so too does their aggregate demand, giving rise to a self-reinforcing virtuous circle. Q: What would President Warren mean for markets? Investors’ concerns about a Warren presidency are surely justified; Senator Warren has openly, and often gleefully, expressed hostility for banks, defense contractors, drug companies, oil companies engaged in fracking, and big tech. That’s quite a list, and it accounts for a considerable share of S&P 500 market capitalization. It is fair to say that a Warren administration would be unfriendly to equity investors, but there are several points to keep in mind before liquidating one’s portfolio and fleeing the country. It’s too early to award her the Democratic nomination. In October 2007, the smart money was certain that Hillary Clinton had already locked up a berth in the finals against the eventual Republican nominee. Very few Americans could have named the freshman senator from Illinois, known for little more than a well-received speech at the 2004 convention, but he became President Obama. A lot could still happen between now and the Iowa caucuses on February 3rd. Unseating an incumbent president is a tall order. As long as the economy does not enter a recession between now and next November, and the administration can achieve a policy victory without suffering a high-profile policy failure, our Geopolitical Strategy colleagues argue that Trump should be the presumed winner of the 2020 election. Their presumption applies no matter who captures the Democratic nomination, even as the U.S. electorate is shifting to the left over time (Chart 12). Transforming Washington is easier said than done. The framers designed the federal government to be fairly resistant to sweeping change. The Electoral College tamps down popular passions in the presidential election, and Congress and the courts limit the power of the executive branch. Administrations with majorities in the House and Senate routinely find themselves with less freedom than they would like, especially after they exhaust political capital achieving one major legislative initiative (as with the Obama Administration and the Affordable Care Act). Even if the Democrats ride President Warren’s coattails to control over Capitol Hill next November, legislators from conservative or swing districts and states will balk at her entire suite of proposals. Chart 12Democratic Voters Are Leaning More Left Investment Implications Our sunnier view of the global economic outlook translates into more constructive equity allocations across global regions and blocs. The BCA house view recommends equal weight allocations to Emerging Markets and the Eurozone within global equity portfolios across tactical (0-3-month) and cyclical (3-12-month) timeframes. We expect to upgrade EM and Eurozone equities to overweight, and downgrade U.S. equities from overweight, across those timeframes once global growth begins to accelerate. We would also favor higher-beta currencies versus the dollar, and limit or avoid exposure to lower-beta currencies like the yen or the Swiss franc, if the data are poised to validate our base-case growth scenario. BCA’s recommendations have become especially data dependent because global investors seem to be firmly ensconced in “show-me” mode. It has been our sense as a firm, supported by the impression we got from last week’s meetings, that investors are reluctant to give growth prospects, and risk assets, the benefit of the doubt. Ground down by trade-related tweets, and skeptical that the latest wave of extraordinary monetary policy measures will have a perceptible impact on growth or inflation, they want to see definitive evidence of a turn before they’ll adjust their portfolio positioning to accommodate it. The wariness is also a reflection of the conflicting signals issued late in the business cycle and the elevated levels of geopolitical uncertainty. If the global economy turns as we think it soon will, global investors should be prepared to add cyclical exposures to their portfolios, even if Elizabeth Warren solidifies her current status as the front-runner for the Democratic nomination. That sense of wariness keeps us recommending benchmark duration exposure in fixed income portfolios over the 0-to-3-month tactical timeframe, though we have little appetite for interest-rate exposure looking out beyond the near term, and are below-benchmark duration over the 3-to-12-month cyclical and greater-than-12-month strategic timeframes. We still like spread product over the full 12-month horizon, as we expect stronger growth will make viable U.S. corporations better credits and that ZIRP/NIRP will continue to protect some of the rest. We endorse the house view that relative U.S. equity returns may slow, but global growth should give a boost to absolute equity returns, and we continue to recommend that investors remain at least equal weight equities in balanced portfolios. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 We are in accord with Chair Powell’s stated view that the rate cuts are mid-cycle cuts, not the beginning of a new easing cycle.

Highlights The interim “phase 1” trade agreement reached last week represents a significant step forward towards reaching a détente in the China-U.S. trade war. Regardless of what happens next in the Brexit negotiations, a hard exit will be avoided. Stay long the pound. U.S. earnings growth is likely to be flat in the third quarter, in contrast to bottom-up expectations of a year-over-year decline. Earnings growth should pick up as global growth reaccelerates by year end. Stronger global growth will put downward pressure on the U.S. dollar. Remain overweight global equities relative to bonds over a 12-month horizon. Cyclical stocks should start to outperform defensives. Financials will finally have their day in the sun. Favorable Tradewinds In our Fourth Quarter Strategy Outlook published two weeks ago, we argued that global equities had entered a “show me” phase, meaning that tangible evidence of a de-escalation in the trade war and a recovery in global growth would be necessary for stock indices to move higher.1  We received some positive news on the trade front last Friday. In exchange for suspending the planned October 15th hike in tariffs from 25% to 30% on $250 billion of Chinese imports, China agreed to purchase $40-$50 billion of U.S. agricultural products per year, improve market access for U.S. financial services companies, and enhance the transparency of currency management. Admittedly, there is still much to be done. The text of the agreement has yet to be finalized. Both sides are aiming to conclude the deal by the time of the APEC summit in Santiago, Chile on November 16-17. Considering that a number of key issues remain unresolved, including what sort of enforcement and resolution mechanisms will be included in the deal, further delays or even a breakdown in the talks are possible. The interim deal agreed upon last week also punts the thorny issue of how to handle intellectual property protections to a “phase 2” of the negotiations slated to begin soon after “phase 1” is wrapped up. According to the independent and bipartisan U.S. Commission on the Theft of American Intellectual Property, U.S. producers lose between $225 and $600 billion annually from IP theft.2 China has often been considered among the worst offenders. Given the importance of the IP issue, meaningful progress will be necessary to ensure that tariffs of 15% on about $160 billion of Chinese imports are not introduced on December 15th. Trump Wants A Deal Despite the many hurdles that remain, last week’s developments significantly raise the prospects of a détente in the 18 month-long trade war. As a self-professed “master negotiator,” President Trump has put his credibility on the line by describing the negotiations as a “love fest,” calling the trade pact “the greatest and biggest deal ever made for our Great Patriot Farmers,” and saying that he has “little doubt” that a final agreement will be reached. Just as he did with NAFTA’s successor USMCA – a deal that is substantively similar to the one it replaced – Trump is likely to shift into marketing mode, trumpeting the “tremendous” new deal that he has negotiated on behalf of the American people. From a political point of view, this makes perfect sense. Rightly or wrongly, President Trump gets better marks from voters on his handling of the economy than anything else (Chart 1). A protracted trade war would undermine the U.S. economy, thereby hurting Trump’s re-election prospects. Chart 1Trump Gets Reasonably High Marks On His Handling Of The Economy, But Not Much Else Chart 2Chinese Business Are Not Paying The Bulk Of The Tariffs Notwithstanding his claims to the contrary, the evidence firmly suggests that U.S. consumers, rather than Chinese businesses, are paying the bulk of the tariffs. Chart 2 shows that U.S. import prices from China have barely declined, even as tariff rates on Chinese imports have risen. To the extent that the latest rounds of tariffs are focused on Chinese goods for which there is little U.S. or third-country competition, the ability of Chinese producers to pass on the cost of the tariffs will only increase. If all the tariff hikes that have been announced were implemented, the effective tariff rate on Chinese imports would rise from around 15% as of late August to as high as 25% in December (Chart 3). Such a tariff rate would reduce U.S. household disposable incomes by over $100 billion, wiping out most of the gains from the 2017 tax cuts. Trump can’t let the trade war reach this point. Chart 3Successive Rounds Of Tariffs Have Started To Add Up Will China Play Hardball? One risk to a favorable resolution to the trade war is that China will increasingly see Trump as desperate to make a deal. This could lead the Chinese to take a hardline stance in the negotiations. While this risk cannot be dismissed, we would downplay it for three reasons: First, even though China’s exporters have been able to maintain some degree of pricing power during the trade war, trade volumes have still suffered, with exports to the U.S. down nearly 22% year-over-year in September. Second, as the crippling sanctions against ZTE have demonstrated, China remains highly dependent on U.S. technologies. This gives Trump a lot of leverage in the trade negotiations. Chart 4Who Will Win The 2020 Democratic Nomination? Third, as Trump himself likes to say, China will find it easier to negotiate with him in his first term in office than in his second. Hoping that Trump would lose his re-election bid might have made sense for China a few months ago when Joe Biden was riding high in the polls; but now that Elizabeth Warren has emerged as the favorite to secure the Democratic nomination, that hope has been dashed (Chart 4). As we noted several weeks ago, China is likely to find Warren no less vexing on trade matters than Trump.3  All this suggests that China, just like Trump, will look for ways to cool trade tensions over the coming weeks. Brexit Breakthrough? As we go to press, the prospects for a Brexit deal have brightened. Although the details have yet to be released, the proposed deal would effectively put Northern Ireland in a veritable quantum superposition where it is both in the European common market and in the U.K. at the same time. This feat will be achieved by keeping Northern Ireland within the U.K. political jurisdiction but still aligned with EU regulatory standards. Negotiations could still go awry. Despite Prime Minister Boris Johnson’s assurance that he secured “a great new deal,” the Conservative’s coalition partner, the Northern Irish Democratic Unionist Party, is still withholding its support for the accord. Labour leader Jeremy Corbyn has also rejected the deal, saying that it is even worse than Theresa May’s originally proposed pact. Regardless of what transpires over the coming days, we continue to think that a hard Brexit will be avoided. Throughout the entire Brexit ordeal, we have argued that there was insufficient political support within the British ruling class for a no-deal Brexit. That conviction has only grown as polling data has revealed that an increased share of voters would choose to stay in the EU if another referendum were held (Chart 5). We have been long the pound versus the euro since August 3, 2017. The trade has gained 6.6% over this period. Investors should stick with this position. Based on real interest rate differentials, GBP/EUR should be trading near 1.30 rather than the current level of 1.16 (Chart 6). We expect the cross to move towards its fair value as hard Brexit risks diminish further. Chart 5Brexit Angst: A Case Of Bremorse Chart 6Substantial Upside In The Pound   Global Growth Prospects Improving Chart 7Growth Slowdown Has Been More Pronounced In The Soft Data Chart 8Manufacturing Output Rebounds Amid The ISM Slump A détente in the trade war and a resolution to the Brexit saga should help support global growth. The weakness in the economic data has been much more pronounced in so-called “soft” measures such as business surveys than in “hard” measures such as industrial production (Chart 7). Notably, U.S. manufacturing output has stabilized over the past three months, even as the ISM manufacturing index has swooned (Chart 8). As sentiment rebounds, the soft data should improve. Global financial conditions have eased significantly over the past five months, thanks in large part to the dovish pivot by most central banks (Chart 9). The net number of central banks cutting rates generally leads the global manufacturing PMI by 6-to-9 months (Chart 10). In addition, the Fed’s decision to start buying Treasurys again will increase dollar liquidity, thus further contributing to looser financial conditions. Chart 9Easier Financial Conditions Will Boost Global Growth   Chart 10The Effects Of Easing Monetary Policy Should Soon Trickle Down To The Economy Stepped-up Chinese stimulus should also help jumpstart global growth. Chinese money and credit growth both came in above expectations in September. The PBoC has been cutting reserve requirements, which has helped bring down interbank rates. Further cuts to the medium-term lending facility are likely over the remainder of this year. Changes in Chinese credit growth lead global growth by about nine months (Chart 11). Chart 11Chinese Credit Should Support The Recovery In Global Growth Stay Overweight Global Equities While the road to finalizing a “phase 1” trade deal in time for the APEC summit is likely to be a bumpy one, we continue to reiterate our recommendation that investors overweight global stocks relative to bonds over a 12-month horizon. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out. Ultimately, the trajectory of stocks will hinge on what happens to earnings. The U.S. earnings season began this week. As of last week, analysts expected S&P 500 EPS to decline by 4.6% in Q3 relative to the same quarter last year according to data compiled by FactSet. Keep in mind, however, that EPS growth has beaten estimates by around four percentage points since 2015 (Chart 12). Thus, a reasonable bet is that U.S. earnings will be flat this quarter, clearing a low bar of expectations. Chart 12Actual EPS Has Generally Beaten Estimates Chart 13Earnings And Nominal GDP Growth Tend To Move In Lock-Step The fact that 83% of the 63 S&P 500 companies that have reported earnings thus far have beaten estimates – better than the historic average of 64% – supports the view that current Q3 estimates are too dour. Looking out, earning growth should pick up as nominal GDP growth accelerates (Chart 13). European and EM equities generally outperform the global benchmark when global growth is speeding up (Chart 14). This is due to the more cyclical nature of their stock markets. In addition, as a countercyclical currency, the dollar tends to weaken in a faster growth environment. A weaker dollar disproportionately benefits cyclical stocks (Chart 15).   Chart 14EM And Euro Area Equities Usually Outperform When Global Growth Improves Chart 15Cyclical Stocks Will Outperform If The Dollar Weakens We would include financials in our definition of cyclical sectors. As global growth improves, long-term bond yields will increase at the margin. Since central banks are in no hurry to raise rates, yield curves will steepen. This will boost bank profits and share prices (Chart 16). Cyclical stocks are currently quite cheap compared to defensives (Chart 17). Likewise, non-U.S. equities are quite inexpensive compared to their U.S. peers, even if one adjusts for differences in sector composition across regions. While U.S. stocks trade at 17.5-times forward earnings, international stocks trade at a more attractive forward PE ratio of 13.7. The combination of higher earnings yields and lower interest rates abroad implies that the equity risk premium is roughly two percentage points higher outside the United States (Chart 18). Chart 16Steeper Yield Curves Will Benefit Financials Chart 17Cyclical Stocks Are More Attractive Than Defensives   Chart 18The Equity Risk Premium Is Quite High, Especially Outside The U.S. We expect to upgrade EM and European equities over the coming weeks once we see a bit more evidence that global growth is bottoming out.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy, “Fourth Quarter 2019 Strategy Outlook: A ‘Show Me’ Market,” dated October 4, 2019. 2 “Update to IP Commission Report: The Report of the Commission on the Theft of American Intellectual Property,” The National Bureau of Asian Research, 2017. 3Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets,” dated September 13, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Highlights Geopolitical risks are starting to abate as a result of material constraints influencing policymakers. China needs to ensure its economy bottoms and a debt-deflationary tendency does not take hold. President Trump needs to avoid further economic deterioration arising from the trade war. The U.K. is looking to prevent a recession induced by leaving the EU without an agreement. Iran and the risk of an oil price shock is the outstanding geopolitical tail risk. Feature Readers of BCA’s Geopolitical Strategy know that what defines our research is our analytical framework – specifically the theory of constraints. Chart 1The Electoral College – An Overlooked Constraint The theory holds that policymakers are trapped by the pressures of their office, their nation’s global position, and the stream of events. These pressures emerge from the material world that we inhabit and as such are measurable. If a leader lacks popular approval, cannot command a majority in the legislature, rides atop a sinking economy, or suffers under stronger or smarter foreign enemies, then his policy preferences will be compromised. He will have to change his preferences to accommodate the constraints, rather than the other way around. Case in point is the U.S. electoral college: it proved an insurmountable political constraint on the Democratic Party in 2016. The college is intended to restrain direct democracy or popular passions; it also restrains the concentration of regional power. In 2012, Barack Obama won a larger share of the electoral college than the popular vote, while in 2016 Hillary Clinton won a smaller share (Chart 1). Clinton’s lack of appeal in the industrial Midwest turned the college and deprived her of the prize. The rest is history. In this report we highlight five key constraints that will shape the direction of the major geopolitical risks in the fourth quarter. We recommend investors remain tactically cautious on risk assets, although we have not yet extended this recommendation to the cyclical, 12-month time frame. China’s Policy: The Debt-Deflation Constraint We have a solid record of pessimism regarding Chinese President Xi Jinping’s willingness and ability to stimulate the economy – but even we were surprised by his tenacity this year. His administration’s effort to contain leverage, while still stimulating the economy, has prevented a quick rebound in the global manufacturing cycle. The constraint limiting this approach is the need to avoid a debt-deflation spiral. This is a condition in which households and firms become pessimistic about the future and cut back their spending and borrowing. The general price level falls and drives up real debt burdens, which motivates further cutbacks. A classic example is Japan, which saw a property bubble burst, destroying corporate balance sheets and forcing the country into a long phase of paying down debt amid falling prices. China has not seen its property bubble burst yet. Prices have continued to rise despite the recent pause in the non-financial debt build-up (Chart 2). Looser monetary and fiscal policy have sustained this precarious balance. But the result is a tug-of-war between the government and the private sector. If the government miscalculates, and the asset bubble bursts, then it will be extremely difficult for the government to change the mindset of households and companies bent on paying down debt. It will be too late to avoid the vicious spiral that Japan experienced – with the critical proviso that Chinese people are less wealthy than the Japanese in 1990 and the country’s political system is less flexible. A Japan-sized economic problem would lead to a China-sized political problem. This is why the recent drop in Chinese producer prices below zero is a worrisome sign (Chart 3). Policymakers have loosened monetary and fiscal policy incrementally since July 2018 and they are signaling that they will continue to do so. This is particularly likely in an environment in which trade tensions are reduced but remain fundamentally unresolved – which is our base case. Chart 2China's Property Bubble Intact Chart 3China's Constraint Is Debt-Deflation Are policymakers aware of this constraint? Absolutely. If the trade talks collapse, or the global economy slumps regardless, then China will have to stimulate more aggressively. Xi Jinping is not truly a Chairman Mao, willing to impose extreme austerity. He oversaw the 2015-16 stimulus and would do it again if he came face to face with the debt-deflation constraint. Is China still capable of stimulating? High debt levels, the reassertion of centralized state power, and the trade war have all rendered traditional stimulus levers less effective by dampening animal spirits. Yet policymakers are visibly “riding the brake,” so they can remove restraints and increase reflation if necessary. Most obviously, authorities can inject larger fiscal stimulus. They have insisted that they will prevent easy monetary and credit policies from feeding into property prices – and this could change. They could also pick up the pace when it comes to reducing average bank lending rates for small and medium-sized businesses.1 In short, stimulus is less effective, but the government is also preferring to save dry powder. This preference will be thrown by the wayside if it hits the critical constraint. The implication is that Chinese stimulus will continue to pick up over a cyclical, 12-month horizon. There is impetus to reduce trade tensions with the U.S., discussed below, but a lack of final resolution will ensure that policy tightening is not called for. Bottom Line: China’s chief economic constraint is a debt-deflation trap. This would engender long-term economic difficulties that would eventually translate into political difficulties for Communist Party rule. If a trade deal is reached, it is unlikely alone to require a shift to tighter policy. If the trade talks collapse, stimulus will overshoot to the upside. Trade War: The Electoral Constraint The U.S. and China are holding the thirteenth round of trade negotiations this week after a summer replete with punitive measures, threats, and failed restarts. Tensions spiked just ahead of the talks, as expected. Immediately thereafter President Trump declared he will meet with Chinese negotiators to give a boost to the process and reassure the markets.2 Trump’s major constraint in waging the trade war is economic, not political. Americans are generally sympathetic to his pressure campaign against China. Public opinion polls show that a strong majority believes it is necessary to confront China even though the bulk of the economic pain will be borne by consumers themselves (Chart 4). Yet Americans could lose faith in Trump’s approach once the economic pain fully materializes. Critically, the decline in wage growth that is occurring as a result of the global and manufacturing slowdown is concentrated in the states that are most likely to swing the 2020 election, e.g. the “purple” or battleground states (Chart 5). Chart 4Americans To Confront China Despite The Costs? Chart 5Trump Faces Pressure To Stage A Tactical Trade Retreat Furthermore, a rise in unemployment, which is implied by the recent decline in the University of Michigan’s survey of consumer confidence regarding the purchase of large household goods, would devastate voters’ willingness to give Trump’s tariff strategy the benefit of the doubt (Chart 6). Wisconsin and Pennsylvania, two critical states, have seen a net loss of manufacturing jobs on the year. The fear of an uptick in U.S. unemployment will prevent Trump from escalating the trade war. An uptick in unemployment would be a major constraint on Trump’s trade war – he cannot escalate further until the economy has stabilized. And that may very well require tariff rollback while trade talks “make progress.” We expect that Trump is willing to do this in the interest of staying in power. As highlighted above, the Xi administration is not without its own constraints. Our proxies for China’s marginal propensity to consume show that Chinese animal spirits are still vulnerable, particularly on the household side, which has not responded to stimulus thus far (Chart 7). Since this constraint is less immediate than Trump’s election date, Xi cannot be expected to capitulate to Trump’s biggest demands. Hence a ceasefire or détente is more likely than a full bilateral trade agreement. Chart 6Waning Consumer Confidence On Big Ticket Items Foreshadows Rise In Unemployment Trump’s electoral constraint also suggests that he needs to remove trade risks such as car tariffs on Europe and Japan (which we expect he will do). We have been optimistic on the passage of the USMCA trade deal but impeachment puts this forecast in jeopardy. Chart 7China's Trade War Constraint? Animal Spirits   Bottom Line: Trump will stage a tactical retreat on trade in order to soften the negative impact on the economy and reduce the chances of a recession prior to the November 3, 2020 election. China’s economic constraints are less immediate and it is unlikely to make major structural concessions. Hence we expect a ceasefire that temporarily reduces tensions and boosts sentiment rather than a bilateral trade agreement that initiates a fundamental deepening of U.S.-China economic engagement. U.S. Policy: The Economic Constraint The 2020 U.S. election is a critical political risk both because of the volatility it will engender and because of what we see as a 45% chance that it will lead to a change in the ruling party governing the world’s largest economy. Will Trump be the candidate? Yes. If Trump’s approval among Republicans breaks beneath the lows plumbed during the Charlottesville incident in 2017 (Chart 8A), then Trump has an impeachment problem, but otherwise he is safe from removal. Judging by the Republican-leaning pollster Rasmussen, which should reflect the party’s mood, Trump’s approval rating has not broken beneath its floor and may already be bouncing back from the initial hit of the impeachment inquiry (Chart 8B). The rise in support for impeachment and removal in opinion polls is notable, but it is also along party lines and will fade if the Democrats are seen as dragging on the process or trying to circumvent an election that is just around the corner. Chart 8ARepublican Opinion Precludes Trump’s Removal Chart 8BRepublican-Leaning Pollster Shows Support Holding Thus Far How will all of this bear on the 2020 election? Turnout will be high so everything depends on which side will be more passionate. A critical factor will be the Democratic nominee. Former Vice President Joe Biden, the establishment pick, has broken beneath his floor in the polling. His rambling debate performances have reinforced the narrative that he is too old, while the impeachment of Trump will fuel counteraccusations of corruption that will detract from Biden’s greatest asset: his electability. According to a Harvard-Harris poll from late September, 61% of voters believe it was inappropriate for Biden to withhold aid from Ukraine to encourage the firing of a Ukrainian prosecutor even when the polling question makes no mention of any connection with Biden’s son’s business interest there. Moreover, 77% believe it is inappropriate that Biden’s son Hunter traveled with his father to China while soliciting investments there. With Vermont Senator Bernie Sanders’s candidacy now defunct as a result of his heart attack and old age, Elizabeth Warren, the progressive senator from Massachusetts, will become the indisputable front runner (which she is not yet). In the fourth primary debate on October 15, she will face attacks from all sides reflecting this new status. Given her debate performances thus far, she will sustain the heightened scrutiny and come out stronger. This is not to say that Warren is already the Democratic candidate. Biden is still polling like a traditional Democratic primary front runner (Chart 9), while Warren has some clear weaknesses in electability, as reflected in her smaller lead over Trump in head-to-head polls in swing states. Nevertheless Warren is likely to become the front runner. Chart 9Biden Polling About Average Relative To Previous Democratic Primary Front Runners The recession call remains the U.S. election call. Two further considerations: Impeachment and removal of President Trump ensure a Democratic victory. There are hopes in some quarters that President Trump could be impeached and removed and yet his Vice President Mike Pence could go on to win the 2020 election, preserving the pro-business policy status quo. The problem with this logic is that Trump cannot be removed unless Republican opinion shifts. This will require an earthquake as a result of some wrongdoing by Trump. Such an earthquake will blacken Pence’s and the GOP’s name and render them toxic in the general election. Not to mention that Pence’s only act as president in the brief interim would likely be to pardon Trump and his accomplices. He would suffer Gerald Ford’s fate in 1976. Which means that a significant slide in Trump’s approval among Republicans will translate to higher odds of a Democratic win in 2020 and hence higher taxes and regulation, i.e. a hit to corporate earnings expectations. We expect this approval to hold up, but the market can sell off anyway because … The market is overrating the Senate as a check on Warren in the event she wins the White House. It is true that relative to Biden, Warren is less likely to carry the Senate. Democrats need to retain their Senate seat in Alabama, while capturing Maine, Colorado, and Arizona (or Georgia) in addition to the White House in order to control the Senate. Biden is more competitive in Arizona and Georgia than Warren. But this is a flimsy basis to feel reassured that a Warren presidency will be constrained. In fact, it is very difficult to unseat a sitting president. If the Democrats can muster enough votes to kick out an incumbent and elect an outspoken left-wing progressive from the northeast, they most likely will have mustered enough votes to take the Senate as well. For instance, unemployment could be rising or Trump’s risky foreign policy could have backfired. Chart 10Business Sentiment Threatens Trump Re-Election In our estimation the Democrats have about a 45% chance of winning the presidency, and Warren does not significantly reduce this chance. The resilient U.S. economy is Trump’s base case for success. But Trump’s trade policy and the global slowdown are rapidly eating away at the prospect that voters see improvement (Chart 10). This speaks to the constraint driving a ceasefire with China above, but it also speaks to the broader probability of policy continuity in the U.S. As Warren’s path to the White House widens, there is a clear basis for equities to sell off in the near term. Bottom Line: Trump’s approval among Republicans is a constraint on his removal via impeachment. But the status of the economy is the greater constraint. The recession call remains the election call. While we expect downside in the near term, we are still constructive on U.S. equities on a cyclical basis. War With Iran: The Oil Price Constraint The Senate will remain President Trump’s bulwark amid impeachment, notwithstanding the controversial news that Trump is moving forward with the withdrawal of troops from Syria, specifically from the so-called “safe zone” agreed with Turkey, giving Ankara license to stage a larger military offensive in Syria. This abandonment of the U.S.’s Kurdish allies at the behest of Turkey (which is a NATO ally but has been at odds with Washington) has provoked flak from Republican senators. However, it is well supported in U.S. public opinion (Chart 11). Trump is threatening to impose economic sanctions on Turkey if it engages in ethnic cleansing. The Turkish lira is the marginal loser, Trump’s approval rating is the marginal winner. The withdrawal sends a signal to the world that the U.S. is continuing to deleverage from the Middle East – a corollary with the return of focus on Asia Pacific. While the Iranians are key beneficiaries of this pivot, the Trump administration is maintaining maximum sanctions pressure on the Iranians. The firing of hawkish National Security Adviser John Bolton did not lead to a détente, as President Rouhani has too much to risk from negotiating with Trump. Instead the Iranians smelled U.S. weakness and went on the attack in Saudi Arabia, briefly shuttering 6 million barrels of oil per day. The response to the attack – from both Saudi Arabia and the U.S. – revealed an extreme aversion to military conflict and escalation. Instead the U.S. has tightened its sanctions regime – China is reportedly withdrawing from its interest in the South Pars natural gas project, a potentially serious blow to Iran, which had been hyping its strategic partnership with China. This reinforces the prospect for a U.S.-China ceasefire even as it redoubles the economic pressure on Iran. As long as the U.S. maintains the crippling sanctions on Iran, there is no guarantee that Tehran will not strike out again in an effort to weaken President Trump’s resolve. The fact that about 18% of global oil supply flows through the critical chokepoint of the Strait of Hormuz is Iran’s ace in the hole (Chart 12). It is the chief constraint on Trump’s foreign policy, as greater oil supply disruptions could shock the U.S. economy ahead of the election. Trump can benefit from minor or ephemeral disruptions but he is likely to get into trouble if a serious shock weakens the economy at this juncture. Chart 11U.S. Opinion Constrains Foreign Policy Chart 12Oil Price Constrains U.S. Policy Toward Iran An oil shock does not have to originate in Hormuz shipping or sneak attacks on regional oil infrastructure. Iran is uniquely capable of fomenting the anti-government protests that have erupted in southern Iraq. The restoration of stability in Iraq has resulted in around 2 million barrels of oil per day coming onto international markets (Chart 13). If this process is reversed through political instability or sabotage, it will rapidly push up against global spare oil capacity and exert an upward pressure on oil prices that would come at an awkward time for a global economy experiencing a manufacturing recession (Chart 14). Chart 13Iran's Leverage Over Iraq Chart 14Global Oil Spare Capacity Constrains Response To Crisis Bottom Line: Iran’s power over regional oil production is the biggest constraint on Trump’s foreign policy in the region, yet Trump is apparently tightening rather than easing the sanctions regime. The failure of the Abqaiq attack to generate a lasting impact on oil prices amid weak global demand suggests that Iran could feel emboldened. The U.S. preference to withdraw from Middle Eastern conflicts could also encourage Iran, while the tightening of the sanctions regime could make it desperate. An oil shock emanating from the conflict with Iran is still a significant risk to the global bull market. Brexit: The No-Deal Constraint The fifth and final constraint to discuss in this report pertains to the U.K. and Brexit. We do not consider the October 31 deadline a no-deal exit risk. Parliament will prevail over a prime minister who lacks a majority. Nevertheless the expected election can revive no-deal risk, especially if Boris Johnson is returned to power with a weak minority government. Chart 15U.K.: Public Opinion Constrains Parliament And No-Deal Brexit While parliament is the constraint on the prime minister, the public is the constraint on parliament. From this point of view, support for Brexit has weakened and the Conservative Party is less popular than in the lead up to the 2015 and 2017 general elections. The public is aware that no-deal exit is likely to cause significant economic pain and that is why a majority rejects no-deal, as opposed to a soft Brexit. Unless the Tory rally in opinion polling produces another coalition with the Northern Irish, albeit with Boris Johnson at the helm, these points make it likely that a no-deal Brexit will become untenable when all is said and done (Chart 15). If Johnson achieves a single party majority the EU will be more likely to grant concessions enabling him to get a withdrawal deal over the line. We remain long GBP-USD but will turn sellers at the $1.30 mark. Investment Implications The path of least resistance is for China’s stimulus efforts to increase – incrementally if trade tensions are contained, and sharply if not. This should help put a floor beneath growth, but the Q1 timing of this floor means that global risk assets face additional downside in the near term. We continue to recommend going long our “China Play” index. U.S.-China trade tensions should decline as President Trump looks to prevent higher unemployment ahead of his election. China has reason to follow through on small concessions to encourage Trump’s tactical trade retreat, but it does not face pressure to make new structural concessions. We expect a ceasefire – with some tariff rollback likely – but not a big bang agreement that removes all tariffs or deepens the overall bilateral economic engagement. Stay long our “China Play” index. We remain short CNY-USD on a strategic basis but recognize that a ceasefire presents a short term (maximum 12-month) risk to this view, so clients with a shorter-term horizon should close that trade. We are long European equities relative to Chinese equities as a result of the view that China will stimulate but that a trade ceasefire will leave lingering uncertainties over Chinese corporates. U.S. politics are highly unpredictable but constraint-based analysis indicates that while the House may impeach, the Senate will not remove. This, combined with Warren’s likely ascent to the head of the pack in the Democratic primary race, means that Trump remains favored to win reelection, albeit with low conviction (55% chance) due to a weak general approval rating and economic risks. The risk to U.S. equities is immediate, but should dissipate. The U.S. is rotating its strategic focus from the Middle East to Asia Pacific, which entails a continued rotation of geopolitical risk. However, recent developments reinforce our argument in July that Iranian geopolitical risk is frontloaded relative to the China risk. This is true as long as Trump maintains crippling sanctions. Iran may be emboldened by its successes so far and has various mechanisms – including Iraqi instability – by which it can threaten oil supply to pressure Trump. This is a tail risk, but it does support our position of being long EM energy producers.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 Please see BCA Research, China Investment Strategy Weekly Report, “Mild Deflation Means Timid Easing,” October 9, 2019, available at cis.bcaresearch.com. 2 China knows that Trump wants to seal a deal prior to November 2020 to aid his reelection campaign, while Trump needs to try to convince China that he does not care about election, the stock market, or anything other than structural concessions from China. Hence the U.S. blacklisted several artificial intelligence companies and sanctioned Chinese officials in advance of the talks. The U.S. opened a new front in the conflict by invoking China’s human rights abuses in Xinjiang, which is also an implicit warning not to create a humanitarian incident in Hong Kong where protests continue to rage. These are pressure tactics but have not yet derailed the attempt to seal a deal in Q4.