Germany

Highlights European and global growth will rebound in the fourth quarter but the rebound will lack longevity. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. Equities: a tug of war between growth and valuation will leave the broad equity market index in a sideways channel. But with the higher yield, prefer equities over bonds. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225. Feature Comfort and discomfort are not absolute, they are relative. Put your hand in cold water, and whether it feels comfortable or uncomfortable depends on where your hand has come from. If your hand has come from room temperature, the cold water will feel uncomfortable. But if your hand has come from an ice bucket, the cold water will feel like bliss! The same principle applies to how we, and the financial markets, perceive short-term economic growth. After a strong expansion, a pedestrian growth rate of 1 percent feels uncomfortable. But after an economic contraction, 1 percent growth feels very pleasant. This leads to two important points: In the short term, the market is less concerned about the rate of growth per se, it is more concerned about whether the rate of growth is accelerating or decelerating. When it comes to the short term drivers of growth – bond yields, credit, and the oil price – we must focus not on their changes, we must focus on their impulses, meaning the changes in their changes. This is because it is the impulses of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth, often with a useful lead time of a few months. The Chart of the Week combined with Chart I-1-Chart I-4 should leave you in no doubt. In the euro area, United States, and China, the domestic bond yield 6-month impulses have led their domestic 6-month credit impulses with near-perfect precision. Chart of the WeekCredit Growth To Rebound In The Fourth Quarter, Then Fade Chart I-2The Euro Area Bond Yield Impulse Leads Its Credit Impulse Chart I-3The U.S. Bond Yield Impulse Leads Its Credit Impulse Chart I-4The China Bond Yield Impulse Leads Its Credit Impulse Based on this near-perfect precision, the credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter. But expect much less of a rebound, if any, in China. While bond yields have collapsed in the euro area and the U.S., resulting in tailwind credit impulses, they have moved much less in China. Indeed, China’s bond yield 6-month impulse has been moving deeper into headwind territory in the past few months (Chart I-5). Chart I-5Bond Yield Impulses Were Tailwinds In The Euro Area And U.S., But Not In China It follows that a credit growth rebound in the fourth quarter will be sourced in Europe and the U.S. rather than in China. From a tactical perspective, this will favour non-China cyclical plays over China plays. But moving into the early part of 2020, expect the credit impulses to fade across all the major economies – unless bond yields now fall very sharply everywhere. Investing On Impulse Many people still find it confusing that it is the impulses – and not the changes – of bond yields, credit, and the oil price that drive the accelerations and decelerations of economic growth. To resolve this confusion, let’s clarify the point. The credit impulses in the euro area and the U.S. should briefly rebound in the fourth quarter.  A bond yield decline will trigger new borrowing. For example, a given decline in the U.S. bond yield, say 0.5 percent, will trigger a given increase in the number of mortgage applications (Chart I-6). New borrowing will add to demand, meaning it will generate growth. But in the following period, a further bond yield decline of 0.5 percent will generate the same further new borrowing and growth rate. The crucial point is that, if the decline in the bond yield is the same, growth will not accelerate. Chart I-6A Given Decline In The Bond Yield Triggers A Given Increase In New Borrowing Growth will accelerate only if the first 0.5 percent bond yield decline is followed by a bigger, say 0.6 percent, decline – meaning a tailwind impulse. Conversely and counterintuitively, growth will decelerate if the first 0.5 percent decline is followed by a smaller, say 0.4 percent, decline – meaning a headwind impulse. Don’t Blame Autos For A German Recession Chart I-7German Car Production Rebounded In The Third Quarter If the German economy contracts in the third quarter and thereby enters a technical recession, the knee-jerk response will be to blame the troubles in the auto industry. But the evidence does not support this story. German new car production rebounded in the third quarter (Chart I-7). Begging the question: if not autos, what is the true culprit for the deceleration? The likely answer is that Germany recently suffered a severe headwind from the oil price impulse. Germany has one of the world’s highest volumes of road traffic per unit of GDP, second only to the U.S. (Table I-1). A possible explanation for Germany’s high traffic intensity is that, just like the U.S., Germany is a decentralised economy with multiple ‘hubs and spokes’ requiring a lot of criss-crossing of traffic. But unlike the U.S., German transport is highly dependent on oil imports, which tend to be non-substitutable and highly inelastic to price. As the value of German oil imports rise in lockstep with the oil price, Germany’s net exports decline, weighing on growth. Table I-1Germany Has A Very High Road Traffic Intensity   The upshot is that the oil price impulse has a major bearing on Germany’s short term growth accelerations and decelerations. The six month period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price in that period followed a 40 percent decline in the previous six month period, equating to a headwind impulse of 70 percent.1  Germany has one of the world’s highest volumes of road traffic per unit of GDP. Allowing for typical lags of a few months, this severe headwind impulse was a major contributor to Germany’s recent deceleration. Oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky accuracy (Chart I-8). The good news is that the oil price’s severe headwind impulse has eased – allowing a rebound in German economic growth during the fourth quarter. Chart I-8The Oil Price Impulse Explains Oscillations In German Growth Nevertheless, a putative rebound could be nullified by a wildcard: the ‘geopolitical risk impulse’. To be clear this is not an impulse in the technical sense, but it is a similar concept: are the number of potential tail-events increasing or decreasing? For the fourth quarter, our subjective answer is they are decreasing. In Europe, the formation of a new coalition government in Italy has removed Italian politics as a possible tail-event for the time being. Meanwhile, we assume that the Benn-Burt law in the U.K. has been drafted well enough to eliminate a potential no-deal Brexit on October 31. Elsewhere, the U.S/China trade war and Middle East tensions are most likely to be in stasis through the fourth quarter.  How To Position For The Fourth Quarter After a disappointing third quarter for global and European growth, we expect a rebound in the fourth quarter. But at the moment, we do not have any conviction that the rebound’s momentum will take it deeply into 2020. Position for the fourth quarter as follows:  Expect a rebound in the fourth quarter. Bonds: Expect bond yields to edge modestly higher, especially for those yields that are deeply in negative territory. Underweight German bunds in a European or global bond portfolio. Currencies: Zero/negative yielding currencies have the most to gain, and our preference remains the yen. With a Brexit denouement, the pound could be the biggest mover and our inkling is to the upside. But we await more clarity before pulling the trigger. Equities: a tug of war between growth and valuation will leave the broad equity market index in the sideways range in which it has existed over the past two years (Chart I-9). But with a higher yield than bonds, equities are the preferred asset-class in the ugly contest. Equity sectors: Non-China cyclical plays will outperform China plays. Continue to overweight banks versus resources and/or industrials. Equity regions: Continue to overweight the Eurostoxx 50 versus the Shanghai Composite and/or the Nikkei 225 (Chart I-10). Chart I-9Global Equities Have Gone Nowhere For Two Years Chart I-10Stay Overweight Europe ##br##Versus China   Fractal Trading System* The recent surge in the nickel price is due to scares about supply disruption, specifically an Indonesian export ban. However, the extent of the rally appears technically stretched. We would express this as a pair-trade versus gold: long gold / short nickel. Chart I-11Nickel VS. Gold Set a profit target of 11 percent with a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading Model Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights President Trump’s support among Republicans and lack of smoking gun evidence will prevent his removal from office. Trade risk will increase if Trump’s approval benefits from impeachment proceedings and the U.S. economy is resilient. Political risk on the European mainland is falling. However, watch out for Russia and Turkey, and short 10-year versus 2-year gilts. A new election in Spain may not resolve the political deadlock. Book gains on our Hong Kong Hang Seng short. Feature Impeachment proceedings against U.S. President Donald Trump, the brazen Iranian attack on Saudi Arabia, the persistence of trade war risk, and additional weak data from China and Europe all suggest that investors should remain risk averse for now. Specifically, Trump’s impeachment could drive him to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Geopolitical risk outside of the hot spots is falling, especially in Europe. The risk of a no-deal Brexit has collapsed in line with our expectations. Italy and Germany have pleased markets by providing some fiscal stimulus sans populism. In France, President Emmanuel Macron’s popularity is recovering. And – as we discuss in this report – Spain’s election will not add any significant fear factor. In what follows we introduce a new GeoRisk Indicator, review the signal from all of our indicators over the past month, and then focus on Spain. Fear U.S. Politics, Not Impeachment The House Democrats’ decision to impeach Trump gives investors another reason to remain cautious on risk assets. Why not be bullish? It is true that impeachment without smoking gun evidence increases Trump’s chances of reelection, which is market positive relative to a Democratic victory. President Trump is virtually invulnerable to Democratic impeachment measures as long as Republicans continue to support him at a 91% rate (Chart 1). Senators will not defect in these circumstances, so Trump will not be removed from office. Trump is invulnerable to impeachment measures as long as GOP support remains high. Moreover the transcript of his phone conversation with Ukrainian President Volodymyr Zelenskiy did not produce a bombshell: there is no explicit quid pro quo in which President Trump suggests he will withhold military aid to Ukraine in exchange for an investigation into former Vice President Joe Biden’s and his son Hunter’s doings involving Ukraine. Any wrongdoing is therefore debatable, pending further evidence. This includes evidence beyond the “whistleblower’s complaint,” which suggests that the Trump team attempted to stifle the transcript of the aforementioned phone call. The point is that the grassroots GOP and Senate are the final arbiters of the debate. The problem is that scandal and impeachment will still likely feed equity market volatility (Chart 2). The House Democrats could turn up new evidence now that they are fully focused on impeachment and hearing from whistleblowers in the intelligence community. Chart 1GOP Not Yet Willing To Impeach Trump Impeachment also has a negative market impact via the Democratic Party’s primary election. Elizabeth Warren has not dislodged Biden in the early Democratic Primary yet. Chart 2Impeachment Proceedings Likely To Raise Vol If she does, it will have a sizable negative impact on equity markets, as President Trump will still be only slightly favored to win reelection. Under any circumstances, this election will be extremely close, it has significant implications for fiscal policy and regulation, and therefore it will create a lot of uncertainty between now and November 2020. The whistleblower episode has if anything aggravated this uncertainty. As mentioned at the top of the report, if impeachment proceedings ever gain any traction they could drive Trump to seek distractions abroad – abandoning the tactical retreat from aggressive foreign and trade policy that had only just begun. Finally, Trump’s reelection, while more market-friendly than the alternative and likely to trigger a relief rally, is not as bullish as meets the eye. Trump’s policies in the second term will not be as favorable to corporates as in the first term. Unshackled by electoral concerns yet still facing a Democratic House, Trump will not be able to cut taxes but he will be likely to conduct his foreign and trade policy even more aggressively. This is not a market-positive outlook, regardless of whether it is beneficial to U.S. interests over the long run. Bottom Line: President Trump’s approval among Republican voters is the critical data point. Unless they abandon faith, the senate will not turn, and Trump’s support may even go up. But this is not a reason to turn bullish. The coming year will inevitably see a horror show of American political dysfunction that will lead to volatility and potentially escalating conflicts abroad. Introducing … Our Sino-American Trade Risk Indicator This week we introduce a new GeoRisk Indicator for the U.S.-China trade war (Chart 3). The indicator is based on the outperformance of overall developed market equities relative to those same equities that have high exposure to China, and on China’s private credit growth (“total social financing”). As our chart commentary shows, the indicator corresponds with the course of events throughout the trade war. It also correlates fairly well with alternative measures of trade risk, such as the count of key terms in news reports. Chart 3Trade Risk Will Go Up From Here As we go to press, our indicator suggests that trade-war related risk is increasing. Over the past month Trump has staged a tactical retreat on foreign and trade policy in order to control economic risks ahead of the election. Our indicator suggests this is now priced. The problem is that Trump’s re-election risk enables China to drive a harder bargain, which is tentatively confirmed by China’s detainment of a FedEx employee (signaling it can trouble U.S. companies) and its cancellation of a tour of farms in Montana and Nebraska. These were not major events but they suggest China smells Trump’s hesitation and is going on the offensive in the negotiations. Principal negotiators are meeting in early October for a highly significant round of talks. If these result in substantive statements of progress – and evidence that the near-finished draft text from April is being completed – they could set up a summit between Presidents Xi Jinping and Donald Trump in November at the APEC summit in Santiago, Chile. At this point we would need to upgrade our 40% chance that a deal is concluded by November 2020. If the talks do not conclude with positive public outcomes then investors should not take it lightly. The Q4 negotiations are possibly the last attempt at a deal prior to the U.S. election. If there is no word of a Trump-Xi summit, it will confirm our pessimistic outlook on the end game. U.S.-China trade talks are unlikely to produce a durable agreement. Ultimately we do not believe that the U.S.-China trade talks will produce a conclusive and durable agreement that substantially removes trade war risk and uncertainty. This is especially the case if financial market and economic pressure – amid global monetary policy easing – is not pressing enough to force policymakers to compromise. But we will watch closely for any signs that Trump’s tactical retreat is surviving the impeachment proceedings and eliciting reciprocation from China, as this would point to a more sanguine outlook. Bottom Line: As long as the president’s approval rating benefits from the Democratic Party’s impeachment proceedings, and the U.S. economy is resilient, as we expect, Trump can avoid any capitulation to a shallow deal with China. Trade risk could go up from here. By the same token, impeachment proceedings could eventually force Trump to change tactics yet again and stake out a much more aggressive posture in foreign affairs. If impeachment gains traction, or a bear market develops, he could become more aggressive than at any stage in his presidency – and this aggression could be directed at China (or Iran, North Korea, Venezuela, or another country). The risk to our view is that China accepts Trump’s trade position in order to win a reprieve for its economy and the two sides agree to a deal at the APEC summit. European Risk Falls, While Russian And Turkish Risk Can Hardly Fall Further Elsewhere our measures of geopolitical risk indicate a decrease in tensions for a number of developed and emerging markets (see Appendix). In Germany, risk can rise a bit from current levels but is mostly contained – this is not the case in the United Kingdom beyond the very short run. In Russia and Turkey, risk can hardly fall further. Take, for starters, Germany, where political risk declined after Chancellor Angela Merkel’s ruling coalition agreed to a 50 billion euro fiscal spending package to battle climate change. This agreement confirms our assessment that while German politics are fundamentally stable, the administration will be reactive rather than proactive in applying stimulus. Europe will have to wait for a global crisis, or a new German government, for a true “game changer” in German fiscal policy. Perhaps the Green Party, which is surging in polls and as such drove Merkel into this climate spending, will enable such a development. But it is too early to say. Meanwhile Merkel’s lame duck years and external factors will prevent political risk from subsiding completely. We see the odds of U.S. car tariffs at no higher than 30%, at least as long as Sino-American tensions persist. By contrast, the United Kingdom’s political risks are not contained despite a marked improvement this month. The Supreme Court’s decision on September 25 to nullify Prime Minister Boris Johnson’s prorogation of parliament drove another nail into the coffin of his threat to pull the country out of the EU without a deal. This was a gambit to extract concessions from the EU that has utterly flopped.1 Since it was the most credible threat of a no-deal exit that is likely to be mounted, its failure should mark a step down in political risk for the U.K. and its neighbors. However, paradoxically, our GeoRisk indicator failed to corroborate the pound’s steep slide throughout the summer and now, as no-deal is closed off, it has stopped falling. The reason is that the pound’s rate of depreciation remained relatively flat over the summer, while U.K. manufacturing PMI – one of the explanatory variables in our indicator – dropped off much faster as global manufacturing plummeted. As a result, our indicator registered this as a decrease in political risk. The world feared recession more than it feared a no-deal Brexit – and this turned out to be the right call by the market. But the situation will reverse if global growth improves and new British elections are scheduled, since the latter could well revive the no-deal exit risk, especially if the Tories are returned with thin majority under a coalition. The truth is that the Brexit saga is far from over and the U.K. faces an election, a possible left-wing government, and ultimately resilient populism once it becomes clear that neither leaving nor staying in the EU will resolve the middle class’s angst. Our long GBP-USD recommendation is necessarily tactical and we will turn sellers at $1.30. In emerging markets, Russia and Turkey have seen political risk fall so low that it is hard to see it falling any further without some political development causing an increase. Based on our latest assessment, Turkey is almost assured to see a spike in risk in the near future. This could happen because of the formation of a domestic political alliance against President Recep Erdogan or because of the increase in external risks centering on the fragile U.S.-Turkey deal on Syria. Tensions with Iran could also produce oil price shocks that weaken the economy and embolden the opposition. As for Russia, our base case is that Russia will continue to focus internal domestic problems to the neglect of foreign objectives, which helps geopolitical risk stay low. With U.S. politics in turmoil and a possible conflict with Iran on the horizon, Moscow has no reason to attract hostile attention to itself. Nevertheless Moscow has proved unpredictable and aggressive throughout the Putin era, it has no real loyalty to Trump yet could fall victim to the Democrats’ wrath, and it has an incentive to fan the flames in the Middle East and Asia Pacific. So to expect geopolitical risk to fall much further is to tempt the fates. Bottom Line: European political risk is falling, but Merkel’s lame duck status and trade war make German risk likely to rise from here despite stable political fundamentals. The United Kingdom still faces generationally elevated political risk despite the happy conclusion of the no-deal risk this summer. Go short 10-year versus 2-year gilts. Russia should remain quiet for now, but Turkey is almost guaranteed to experience a rise in political risk. Spain: Election Could Surprise But Risks Are Low Spanish voters will head to the polls on November 10 for the fourth time in four years after political leaders failed to reach a deal to form a permanent government. The Spanish Socialist Workers’ Party (PSOE) has served as a caretaker government after winning 123 out of 350 seats in the snap election in April. A new Spanish election will not resolve the current political deadlock. Prime Minister and PSOE leader Pedro Sanchez failed to be confirmed in July, and has since attempted to make a governing deal with the left-wing, anti-establishment party Podemos. However, PSOE is not looking for a full coalition but merely external support to continue governing in the minority. Hence it is only offering Podemos non-ministerial agencies (rather than high-level cabinet positions) in negotiations, leaving Podemos and other parties ready for an election. The outcome of the upcoming election may not differ much from the April election. The Spanish voter is not demanding change. Unemployment and underemployment have been decreasing, and wage growth has been positive since 2014 (Chart 4). In opinion polls, support for the various parties has not shifted significantly (Chart 5, top panel). PSOE is still leading by a considerable gap. Chart 4Spanish Voter Is Not Demanding Change However, the election will increase uncertainty at an inconvenient time, and it could produce surprises. PSOE’s support has slightly decreased since late July, when negotiations with Podemos started falling apart. Chart 5Not Much Change In Polls... Even if PSOE and Podemos form a governing pact, their combined popular support is not significantly higher than the combined support for the three main conservative parties. These are the Popular Party, Ciudadanos, and Vox (Chart 5, bottom panel) – which recently showed they can work together by making a governing deal to rule the regional government in Madrid. Chart 6…But Lower Turnout Could Hurt The Left The Socialist Party hopes to capture borderline voters from Ciudadanos, namely those who are skeptical towards the party’s right-wing populist shift and hardening stance regarding Catalonia. However, even capturing as many as half of Ciudadanos’ voters would place PSOE support at ~37% – far short of what is needed to form a single-party majority government. Another factor that can hurt PSOE is voter turnout. Spanish voters have been less and less interested in supporting any party at all since the April election. A decrease in turnout would hurt left-wing parties the most, given that voters blame Podemos and PSOE more than PP and Ciudadanos for the failure to form a government (Chart 6). The most likely outcomes are the status quo, or a PSOE-Podemos alliance. But a conservative victory cannot be ruled out. In the former two cases, the implication is slightly more positive fiscal accommodation that is beneficial in the short-term, but at the risk of a loss of reform momentum that has long-term negative implications. To put this into context, Spanish politics remains domestic-oriented, not a threat to European integration. Voters in Spain are some of the most Europhile on the continent, both in terms of the currency and EU membership (Chart 7). Spain is a primary beneficiary of EU budget allocations, along with Italy. Even Spain’s extreme right-wing party Vox is not considered to be “hard euroskeptic.” Within Spain, however, political polarization is a problem. Inequality and social immobility are a concern, if not as extreme as in Italy, the U.K., or the United States. Moreover the Catalan separatist crisis is divisive. While a new Catalonian election is not scheduled until 2022, the pro-independence coalition of the Republican Left of Catalonia and Catalonia Yes has been gaining momentum in the polls, and Ciudadanos’s support plummeted since the party hardened its stance on Catalonia earlier this year (Chart 8). Catalonia is by no means going independent – support for independence in the region peaked in 2013 – but it remains a driving factor in Spanish politics. Chart 7Spaniards Love Europe Chart 8Catalonia Is A Divisive Issue In the very short term, election paralysis introduces fiscal policy crosswinds. On one hand, regional governments may be forced to cut spending. The regions were expecting to receive EUR 5 billion more than last year, which was promised to be spent in part on healthcare and education. Until a stable (or at least caretaker) government can approve a 2019 budget, the regions will base their 2019 budgets on last year’s numbers, meaning they will have to cut any projected increases in spending. Yet on the other hand, the budget deficit will widen as taxes fail to be collected. In late 2018 Spain approved increases in pensions, civil servants’ salaries, and minimum wage by decree, but any corresponding revenue increases that were to be implemented in the 2019 budget will fail to materialize until government is in place, putting upward pressure on the deficit. Beyond the election the trend should be slightly greater fiscal thrust due to the continental slowdown. Spain has some fiscal room to play with – its budget deficit is projected to decrease to 2% in 2019 and 1.1% in 2020.2 The more conservative estimate by the European Commission forecasts the 2019 and 2020 deficits to be 2.3% and 2%, respectively (Chart 9). This means that Spain can provide roughly 10-15 billion euros worth of additional stimulus in 2020 without so much as hinting at triggering Excessive Deficit Procedures, a welcome change after nearly a decade of austerity. The risk is that Spain’s structural reform momentum could be lost with negative long-term consequences. In 2012 Spain undertook painful labor and pension reforms that underpinned its impressive economic recovery. The economy continues to grow faster than the average among its peers, unemployment has fallen by 12% in the past six years, and export competitiveness has had one of the sharpest recoveries in Europe since 2008 (Chart 10). This recovery has now begun to slow down, and the current political deadlock means that reforms could be rolled back farther than the market prefers. Chart 9Spain Has Some Fiscal Room This is more likely to be avoided if a surprise occurs and the conservatives come back into power, although that would also mean less accommodative near-term policies. Chart 10Recovery Starting To Slow Bottom Line: Our geopolitical risk indicator is signaling subdued levels of risk for Spain. This is fitting as the election may not change anything and at any rate the country will remain in an uneasy equilibrium. Politics are fundamentally more stable than in the populist-afflicted developed countries – the U.S., U.K., and Italy. However, an outcome that produces a left-wing government will lead to greater short-term fiscal accommodation at the expense of Spain’s recent outstanding progress on structural reforms. Housekeeping We are booking gains on our Hong Kong Hang Seng short. Unrest is not yet over, but is about to peak as we approach October 1, the National Day of the People’s Republic of China, and Beijing will look to avoid an aggressive intervention.   Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 The Supreme Court deemed Johnson’s government’s prorogation of parliament an unlawful frustration of parliament’s role as sovereign lawgiver and government overseer without reasonable justification. The court was larger than usual, with 11 judges, and they ruled unanimously against the prorogation. We had expected the vote at least to be narrow – given the historic uses of prorogation, the fact that parliament still had time to act prior to October 31 Brexit Day, and the prime minister’s historical authority over foreign affairs and treaties. But the Supreme Court has risen to fill the power vacuum created by parliament’s paralysis amid the Brexit saga; it has “quashed” what might have become a neo-Stuart precedent that prime ministers can curtail parliament’s role at important junctures. The pragmatic, near-term consequence is the reduction in the political and economic risks of a no-deal exit; but the long-term consequence may be the rise of the judiciary to greater prominence within Britain’s ever-evolving constitutional system. 2 Please see “Stability Programme Update 2019-2022, Kingdom of Spain,” available at www.ec.europa.eu. U.K.: GeoRisk Indicator France: GeoRisk Indicator Germany: GeoRisk Indicator Spain: GeoRisk Indicator Italy: 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

Dear Client, BCA’s New York conference takes place next week on September 26-27, and I look forward to meeting some of you there. Because of the conference, our next report will come out on October 3. Dhaval Joshi Highlights If the WTI crude oil price breached $70, Germany’s net export growth would suffer a short-term relapse. If the WTI crude oil price breached $90, Germany’s economic growth would suffer a much longer setback. The WTI crude oil price is now trading at $59, well below even the first pain threshold. Hence, at the moment, the oil price ‘spike’ is a minor irritant rather than a major risk to a German (and European) economic rebound in the fourth quarter. Stay overweight the Eurostoxx50 versus the Shanghai Composite and Nikkei225. If the WTI price stabilises well below $70, we intend to initiate an overweight to the DAX versus global equities. German bunds are a structural short relative to U.S. T-bonds. Feature Chart of the WeekOil Price Oscillations Have Explained German Growth Oscillations With A Spooky Precision It is touch and go whether Germany suffered a technical recession through the second and third quarters.1 We will know in about six weeks’ time, once the statisticians have finished crunching the numbers. But for the financial markets, this is old news. A technical recession in Germany during the second and third quarters is already baked in the market cake. The economy and financial markets are entwined in a perpetual dance. In a dance, sometimes one person decides the steps and sometimes the other person does, but the couple always moves together. And so it is with the economy and markets. The ZEW indicator of (German) economic sentiment recently hit its lowest level since 2011, and the performance of the DAX versus global equities has moved in near perfect lockstep (Chart I-2). Chart I-2A German Recession Is Already Baked In The Market Cake Some people try to predict the movement of markets based on the releases of backward-looking economic data or even supposedly real-time economic data, such as sentiment surveys. Good luck with that. The markets instantaneously discount those releases. To predict the markets, the key question is: what will the future releases look like? If the German economy rebounds in the fourth quarter, then the stark underperformance of the DAX constitutes a compelling buying opportunity versus other equity markets. That said, a new potential risk has emerged: the spike in the crude oil price. Germany Is Highly Sensitive To The Oil Price Europeans are large importers of energy, with 55 percent of all energy needs met by net imports. Moreover, the volume of energy they import tends to be price inelastic. Hence, when energy prices plunge, it boosts net exports and thereby it boosts growth. Conversely, when energy prices soar – as they have recently – it depresses net exports and thereby it depresses growth.2  98 percent of Germany’s consumption of oil depends on imports. This is especially true for Germany whose energy import dependency, at 65 percent, is well above the European average. The most important energy source is still oil which accounts for over a third of Germany’s primary energy use (Chart I-3). Moreover, 98 percent of Germany’s consumption of oil depends on imports.3   Chart I-3Germany Is Highly Sensitive To The Oil Price Most of Germany’s oil consumption is for transport. On a timeframe of decades, the planned decarbonisation of all sectors by 2050 should all but eliminate fossil oil from German energy consumption. However, on a timeframe of quarters, oil consumption for transport is highly inelastic and non-substitutable. Hence, in recent years, swings in the oil price have always caused swings in Germany’s net exports (Chart I-4). Based on this excellent relationship, a likely rebound in German net exports in the fourth quarter would be threatened if the WTI crude price reached and stayed in the mid $70s. Chart I-4Swings In The Oil Price Cause Swings In Germany's Net Exports For Economic Growth, The Oil Price Impulse Is What Matters Empirically, we have found that the German economy is much more sensitive to the oil price than other European economies (Chart I-5 and Chart I-6). This could be because other drivers of the economy such as credit developments are less significant in Germany. Chart I-5Germany Is More Sensitive To The Oil Price... Chart I-6...Than Other European ##br##Economies Most analysts argue that it is the change in the oil price that is relevant for the economy. This is obviously correct for the impact on inflation, which is, by definition, the change in a price. However, it is incorrect to argue that the change in the oil price drives economic growth. Instead, it is the impulse of the oil price – the change in its change – that drives economic growth. To understand why, consider a simplified example. Let’s say a 20 percent drop in the oil price added to Germany’s net exports, causing the economy to grow 1 percent. In the following period, another 20 percent drop in the oil would cause the economy to grow again by 1 percent, so growth would stay unchanged. On the other hand, if the oil price dropped by 10 percent, the economy would still grow, but now at a reduced rate of 0.5 percent. Therefore somewhat paradoxically, though the oil price has declined by 10 percent, growth has slowed. This is because the second drop in the price (10 percent) is less than the first (20 percent) – which means the tailwind impulse has faded.   Now let’s put in the actual numbers for the oil price’s 6-month impulse. The period ending around June 2019 constituted a severe headwind impulse. This is because a 30 percent increase in the oil price followed a 40 percent decline in the previous period, equating to a headwind impulse of 70 percent.4 Allowing for typical lags of a few months, this severe headwind impulse is a likely culprit, or at least a contributing culprit, for Germany’s slowdown during the second and third quarters. As the Chart of the Week compellingly illustrates, oscillations in the oil price’s 6-month impulse have explained the oscillations in Germany’s 6-month economic growth with a spooky precision. Empirically, other explanatory factors are not needed.  The period ending June 2019 constituted a severe headwind impulse from the oil price. Now the good news. Until the last few days, the oil price’s severe headwind impulse had eased – and this fading of the headwind strongly suggested a rebound in German economic growth during the fourth quarter and beyond. This raises a crucial question: to what level would the crude oil price have to spike for the maximum headwind impulse to return, and thereby extinguish the chance of such a rebound? By reverse engineering the price from the maximum headwind impulse, the answer is the WTI crude price at $90. Pulling all of this together, the first pain threshold is WTI breaching $70, at which Germany’s net export growth could suffer a short-term relapse. The second and greater pain threshold is WTI breaching $90, at which Germany’s economic growth could be stifled for much longer.  Having said all that, WTI is now trading at $59, well below even the first pain threshold. Hence, at the moment, this is a minor irritant rather than a major risk to a German (and European) economic rebound. Stay overweight the Eurostoxx50 versus the Shanghai Composite and Nikkei225. And in the coming week or so, if the WTI price stabilises well below $70, we intend to initiate an overweight to the DAX versus global equities. The ECB Fired A Dud So much for the ECB’s promise to ‘shock and awe’ the markets. The bazooka ended up firing a dud! Unlimited QE is not really unlimited when the ECB’s asset purchase program is running close to its individual issuer limit, and its country composition cannot deviate too far from the ECB’s capital key. QE is nothing more than a signal of intent to keep policy interest rates ultra-low for a protracted period. In any case, QE is nothing more than a signal of intent to keep policy interest rates ultra-low for a protracted period. But once the markets have fully discounted this intent – as they have in the euro area and Japan – the monetary policy armoury is effectively out of ammunition (Chart I-7-Chart I-10). So it is not surprising that the ECB fired a dud. Chart I-7Monetary Policy Is Exhausted In The Euro Area... Chart I-8...But The U.S. Still Has ##br##Ammunition Chart I-9Monetary Policy Is Exhausted In Japan... Chart I-10...But China Still Has Ammunition Some people counter that there are even more exotic monetary policy options in the pipeline, such as ‘helicopter money’. However, as Mario Draghi correctly pointed out, “giving money to people in whatever form is not a monetary policy task, it’s a fiscal policy task.” Helicopter money might be a step too far, but its notion encapsulates the shape of things to come in Europe. With euro area monetary policy exhausted, the baton is passing to fiscal policy. The upshot is that in a bond portfolio, German bunds are a structural short relative to U.S. T-bonds. Fractal Trading System* Although we are structurally overweight Italian long-dated BTPs, the 130-day fractal dimension is signalling that the pace of the rally is now technically extended and therefore vulnerable to a countertrend correction. This week’s trade recommendation is to express this via a short position in the Italian 10-year BTP, setting a profit target of 3 percent with a symmetrical stop-loss. In other trades, short the U.S. 10-year T-bond quickly achieved its profit target, while short financial services versus market reached the end of its holding period in slight loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 We define a technical recession as two consecutive quarters of contraction in real GDP. 2 Energy dependence = (imports – exports) / gross available energy. 3 According to the Federal Institute for Geosciences and Natural Resources. 4 The 6-month steps in the WTI crude oil price were $74.15, $45.21, and $58.24. The first change equated to a 40 percent decrease and the second change equated to a 30 percent increase. So the 6-month impulse was 70 percent. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

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

Highlights Today’s equity risk premium of 1.6 percent makes equities the preferred long-term asset-class versus bonds at the current level of bond yields. The caveat is that this conclusion would quickly change if bond yields were to rise significantly. German equities are offering a more attractive risk premium of 3.7 percent versus German bunds. We closed our tactical short in equities at its 4 percent profit-target, and are now tactically neutral. Fractal analysis suggests that bonds are now technically overbought… …but developments in the coming weeks warrant a degree of caution. With trade tensions still simmering, the Italian government in chaos, the ECB likely to unveil new stimulus in September, and the no-deal Brexit deadline looming at the end of October, there is too much event risk to short bonds with high conviction right now. Feature Chart of the WeekStocks Set To Return 3 Percent, Bonds Set To Return 1.4 Percent Bonds Set To Return 1.4 Percent This year’s rally in bonds has dragged down bond yields to unprecedented lows. Indeed, in many markets, the term ‘bond return’ should more truthfully be called ‘bond penalty’. For example, with the German 10-year bund now yielding -0.7 percent, buying and holding it for its ten year life will lose you 7 percent of your money.1 Or will it? Unlike in most jurisdictions where the currency cannot disintegrate, euro area bond yields are complicated by ‘redenomination’ discounts and premiums. If you were certain that the euro was going to break up within the next ten years, and that the German bund would pay you back in new deutschmarks worth 7 percent more than euros, then the currency redenomination gain would more than cancel out the cumulative loss from the negative yield. For this reason a better measure of the euro area bond yield comes from the single currency bloc’s average yield – because in a break up, the expected currency gains and losses for the average euro area bond yield must sum to zero. To avoid the onerous calculation of this euro area average yield, a useful proxy turns out to be the French OAT yield. While not as depressed as the German bund yield, the 10-year OAT yield, at -0.35 percent, still constitutes a bond penalty (Chart I-2). The global bond yield has reached a new record low. Meanwhile, although the global 10-year bond yield is still positive, it recently fell to an all-time low of 1.40 percent – breaking the previous record low of 1.43 percent set in the aftermath of the 2016 shock vote for Brexit (Chart I-3). Chart I-2The French OAT Is A Good Proxy For The Average Euro Area Bond Chart I-3Bonds Set To Return##br## 1.4 Percent Stocks Set To Return 3 Percent    The long term prospective return from most asset-classes is well-defined: for the bond asset-class it is the yield to maturity, now at 1.4 percent;2 for the equity asset-class it comes from the starting valuation, which tends to be an excellent predictor of the long term prospective return. But which valuation metric? Equity valuations based on earnings are problematic – because valuations appear deceptively attractive when profit margins are structurally high, as they are now (Chart I-4). The problem is that earnings will face a structural headwind when margins normalise, depressing prospective returns. Some people suggest adjusting the earnings to derive a cyclically adjusted price to earnings multiple (CAPE), but by definition this only corrects for the cycle and does not correct for any structural trend. Chart I-4Structurally High Profit Margins Flatter Equity Earnings Equity valuations based on assets are also problematic. Nowadays, such assets comprise intellectual capital or intangibles or ‘virtual’ assets, which are extremely difficult to quantify accurately. Hence, our preferred long-term valuation metric is price to sales – because sales are quantifiable, objective, and unambiguous. Indeed, the starting price to sales multiple of the global equity asset-class has been a near-perfect predictor of its prospective 10-year nominal return (Chart I-5). The method is to regress historic starting price to sales with (the known) prospective 10-year returns. Then apply the established relationship to the current price to sales to predict the (the unknown) prospective return. Chart I-5Stocks Set To Return 3 Percent On this basis, today’s prospective 10-year annualised return from global equities is 3 percent.  Is The 1.6 Percent Excess Return Enough? So the prospective 10-year return from equities, at an annualised 3 percent, is 1.6 percent more than that from bonds, at 1.4 percent.3 Is this excess return – the so-called ‘equity risk premium’ – enough (Chart of the Week)? Price to sales has been a near-perfect predictor of long term equity returns.   Yes, because at ultra-low bond yields, the risk of owning bonds converges with the risk of owning equities. The asymmetry in the future direction of bond yields makes bonds riskier investments. The short-term potential for capital appreciation – nominal or real – diminishes, while the potential for vicious losses increases dramatically. The technical term for this unattractive asymmetry is negative skew. Recent breakthroughs in risk theory and behavioural economics conclude that our perception of an investment’s risk does not come from its volatility or correlation characteristics. It comes from the investment’s negative skew. The upshot is that today’s excess prospective return of 1.6 percent does make equities the preferred long-term asset-class at the current level of bond yields. The caveat is that this conclusion would quickly change if bond yields were to rise significantly (Chart I-6). Interestingly, German equities are an excellent long-term proxy for global equities, producing near-identical returns (Chart I-7). This is not surprising given the very similar international and sector focusses. We can infer that the German stock market, just like the global equity asset-class, is set to deliver an annualised 10-year return of 3 percent. But in Germany, the 10-year bond yield is -0.7 percent, implying that German equities are offering a more attractive risk premium of 3.7 percent versus German bunds. Chart I-7German Equities Are An Excellent Proxy For Global Equities Some Other Asset Allocation Thoughts The rally in bonds has hurt our cyclical overweight to the DAX versus long-dated German bunds. However, given the aforementioned long-term analysis, we are sticking with it, albeit switching it from a cyclical to a structural recommendation. Our other recent asset allocation recommendations have worked. In May, we pointed out that the simultaneous strong rallies in equities, bonds, and oil was extremely rare, and that at least one of the rallies would soon break down. This is precisely what happened. While bonds rallied a further 5 percent, equities corrected by 5 percent, and the crude oil price plunged 20 percent. However, our portfolio construction could have been better as our weightings in the three assets left the combined short position roughly flat. The position is now closed. Our tactical short in equities achieved its 4 percent profit-target. Likewise in June, fractal analysis suggested that the double-digit rally in stock markets was vulnerable to a countertrend reversal. This is precisely what happened. Our tactical short position in the MSCI AC World Index achieved its 4 percent profit-target and is now closed (Chart I-8). Stay tactically neutral to equities. Chart I-8Stocks Were Overbought, And Reversed Interestingly, the same fractal analysis is suggesting that it is the stellar rally in bonds that is now vulnerable to a countertrend reversal (Chart I-9), implying a tactical short position in bonds. Having said that, developments in the coming weeks warrant a degree of caution. With trade tensions still simmering, the Italian government in chaos, the ECB likely to unveil new stimulus in September, and the no-deal Brexit deadline looming at the end of October, there is too much event risk to short bonds with high conviction right now. Chart I-9Bonds Are Overbought Fractal Trading System* This week we note that the sharp underperformance of Spain (IBEX 35) versus Belgium (BEL 20) is technically extended and susceptible to a liquidity-triggered reversal. Accordingly, the recommended trade is to go long Spain versus Belgium setting a profit-target of 3.5 percent with a symmetrical stop-loss. In the other trades, short MSCI All-Country World achieved its 4 percent profit-target and is now closed. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Assuming no default risk and no reinvestment risk. 2 Assuming no default risk and no reinvestment risk. 3 Nominal annualised total return, capital plus income. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year.  The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary.  On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Chart 5Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years.   Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt  (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports  3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Negative Interest Rates: Time will tell if negative bond yields are indeed the “new normal”. We need to see negative yields maintained outside of a growth slowdown to prove that thesis. USTs & Bunds: U.S. Treasuries and German Bunds both look overbought, amid extreme price/yield momentum and aggressively long duration positioning. Yet given the persistent headline risk from the U.S.-China trade dispute, and without signs of improving growth in China or Europe, it is too early to position for a reversal of the stretched yield moves. Maintain a neutral overall stance on global duration exposure.1 Feature Positive Headlines On Negative Yields? Investors should always be cautious of “new era” explanations to justify an elevated asset price after a massive rally. That is akin to internet stocks in the late 1990s that were valued on “clicks and eyeballs” in the absence of actual profits. Or the “peak oil” thesis, predicting an impending exhaustion of global petroleum supplies, that was trotted out during past periods when oil prices were already above $100/bbl. The latest such argument can be found in government bonds, where fundamental justifications for the growing inventory of negative yielding bonds being “the new normal” have started to proliferate. The arguments underlying the “Negative Normal Thesis” (which we will coin “NNT”, not to be confused with the MMT of Modern Monetary Theory!) are hardly new. Aging demographics, “savings gluts” and a dwindling supply of global safe assets have been widely cited as causes for low bond yields since early in the 21st century (remember former Fed Chair Alan Greenspan’s famous “bond conundrum”?). Proponents of NNT point to Japan as the textbook example of how rates can stay low forever when savings are high and demand for capital is low. They are now declaring the “Japanification” of Europe … with the U.S. next in line to eventually join the negative rate party. If the argument that negative interest rates are now normal were to hold, however, we would need to see bond yields continue to stay at negative (or at least extremely low) levels even after global economic growth has stabilized. Chart of the WeekIs This Really A “New Era” For Bond Yields? If the argument that negative interest rates are now normal were to hold, however, we would need to see bond yields continue to stay at negative (or at least extremely low) levels even after global economic growth has stabilized. For if negative yields are, in fact, structurally driven by excess savings and not just cyclically driven by weak nominal growth, then improving economic momentum should have little impact on the level of interest rates. That would be a true “Japanification” scenario. For now, as far as we can tell from the data, the big decline in bond yields over the past year can be fully explained by the classic drivers – slowing economic growth and soft inflation (Chart of the Week). Investors are keenly aware of the triggers for these moves by now: a) slowing global trade and capital spending, both victims of the ever-worsening U.S.-China trade dispute; b) the lagged impact of past monetary tightening (Fed rate hikes and, arguably, the end of ECB bond buying at the end of 2018); and c) the persistent strength of the U.S. dollar preventing global “reflation”. You do not have to be an aging saver to view those as good reasons to favor the near-term safety of government bonds. Right now, the steady drumbeat of weakening cyclical global growth indicators is fueling bullish bond sentiment, especially in the parts of the world most exposed to global trade like Europe. Looking ahead, however, we may get the first test of NNT much sooner than expected. The latest update of the OECD’s leading economic indicators (LEI) was released last week. The message is consistent with the modest improvement seen over the past several months (Chart 2), with meaningful gains seen in many economies sensitive to global growth like Mexico, Taiwan, Australia and, most importantly, China.   Our “leading leading” indicator – the diffusion index of the global LEI, which includes many of the individual country OECD LEIs – continues to show that the majority of countries are seeing a rise in their LEI. We have shown that the LEI diffusion index has, in the past, been a fairly reliable leading indicator of the direction of not only the global LEI itself but of global bond yields as well. At present, the relatively optimistic reading from the global LEI diffusion index is at odds with the sharp downward momentum in bond yields (see the middle panel of the Chart of the Week). NNT at work, or a sign of a bubble forming in government bond markets? Time will tell. To be sure, the shaken confidence of investors thanks to the intensifying U.S.-China trade dispute has likely weakened the link between growth and yields – at least temporarily. Investors need to see hard evidence that global growth is bottoming out before seriously reevaluating the current level of bond yields. Signs of improvement in Chinese growth momentum would go a long way to turning around depressed investor confidence. It is still a bit too soon, however, to expect a rebound in Chinese domestic demand given the long lags between leading indicators like the OECD measure (or the China credit impulse) and hard Chinese economic data (Chart 3). More likely, a change in trend for these series would not be visible until well into the 4th quarter of 2019, at the earliest. Chart 2A Ray Of Hope For Global Growth? Chart 3Still A Bit Too Soon To Expect A China Turnaround Signs of better growth in Europe – where negative bond yields are most prevalent, including in corporate bonds – would also help to reverse excessive investor pessimism. A turnaround there, however, also needs better growth in China, given the heavy exposure of European exporters to Chinese demand. So until we see signs of a pickup in Chinese growth momentum, the economic gloomsters, “Ice Agers” and NNT crowd are in charge of the global government bond market. Until we see signs of a pickup in Chinese growth momentum, the economic gloomsters, “Ice Agers” and NNT crowd are in charge of the global government bond market. Bottom Line: Time will tell if negative bond yields are indeed the “new normal”. We need to see negative yields sustained outside of a growth slowdown to prove that thesis. Have The Rallies In U.S. Treasuries & German Bunds Now Gone Too Far? Last week, we upgraded our overall global duration call to neutral on a tactical (0-3 month) basis.2 This was driven by the growing risk that the global central banks – most notably, the Federal Reserve – could be forced to become even more dovish because of the escalation in the U.S.-China trade war. Furthermore, our Global Duration Indicator has pulled back after the steady rise since late 2018, and is now in line with the aggregate level of 10-year bond yields in the major developed markets (Chart 4). This is consistent with a neutral tactical duration view. Chart 4The Signal From Our Duration Indicator Is Consistent With A Neutral Stance There are signs, however, that Treasuries are overbought: Even as Treasury yields are heading closer to the 2016 lows, U.S. inflation expectations derived from the TIPS market are closer to 2% than the lows below 1.5% seen in 2016 (Chart 5). That market pricing seems reasonable, with realized inflation higher, and the labor market tighter, than was the case three years ago. The price momentum for the 10-year Treasury yield is approaching the extremes seen in the “post Fed QE” era (Chart 6), with the 6-month rate of change of the Bloomberg Barclays U.S. Treasury index approaching 10%. The deviation of the 10-year Treasury yield from its 200-day moving average, which is also at the post-QE extreme of -75bps, tells a similar story. Chart 5A Different U.S. Inflation Backdrop Vs. 2016 Chart 6The Fall In UST Yields Looks Stretched Investor positioning has become VERY long, with the J.P. Morgan duration survey of Active Clients surging to the highest level in the two-decade history of the series (Chart 6, third panel). A similar story applies to the German bond market, where the entire yield curve out to 30-years is trading below 0% (raising a cheer from the NNTers): Market-based inflation expectations have collapsed, with the 5-year CPI swap, 5-years forward reaching a low of 1.2% – lower than 2016, despite a tighter overall euro area labor market, accelerating wage growth and core inflation remaining sticky around 1% (Chart 7). The 6-month total return of the German government bond index is reaching a post-European Debt Crisis extreme near 10%, while the 10-year Bund yield is trading around a similar extreme of 50bps below its 200-day moving average (Chart 8). Chart 7European Inflation: Expectations Worse Than Reality Chart 8The Fall in Bund Yields Is Looking Stretched While the near-term backdrop does not justify a tactically bearish view on Treasuries or Bunds, the stretched technical backdrop suggests that yields could snap back quite sharply on any sign of better global growth or an easing of U.S.-China trade tensions. While the near-term backdrop does not justify a tactically bearish view on Treasuries or Bunds, the stretched technical backdrop suggests that yields could snap back quite sharply on any sign of better global growth or an easing of U.S.-China trade tensions. Bottom Line: U.S. Treasuries and German Bunds both look overbought, amid extreme price/yield momentum and aggressively long duration positioning. Yet given the persistent headline risk from the U.S.-China trade dispute, and without durable signs of improving growth in China or Europe, it is too early to position for a reversal of the stretched yield moves. Maintain a neutral overall stance on global duration exposure.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Relative Growth & Inflation: Underlying U.S. and European economic growth momentum remains surprisingly similar, with weakness concentrated in manufacturing industries most exposed to trade uncertainty. Realized inflation readings are also fairly close, although there is less spare capacity in the U.S. where wages are growing at a much faster rate. UST-Bund Spread: The yield gap between 10-year U.S. Treasuries and German Bunds is now fairly valued after the larger decline in U.S. yields seen in 2019. The Fed is more likely to deliver less easing relative to market expectations than the ECB, leaving the UST-Bund spread susceptible to a rebound over the 6-12 months. Hedged Vs Unhedged: We continue to recommend overweighting German Bunds vs U.S. Treasuries in global currency-hedged bond portfolios, given the substantial yield pickup gained by hedging into U.S. dollars out of euros. Feature “We should have Draghi instead of our Fed person.” – U.S. President Donald Trump Chart of the WeekIt’s Tough To Get A Weaker USD, Mr. President In his own inimitable way, President Trump in the above quote has called out the glaring difference between the ECB, which seems very willing to deliver more policy stimulus to a struggling euro area economy, and the Fed, which is reluctantly being pulled towards a rate cut. Yet while the current ECB President will be looking for a new job in a few months after his term expires, the reality is that President Trump will have to live with the current Fed leadership for the foreseeable future. Our Central Bank Monitors do indicate a need for easier monetary policy on both sides of the Atlantic (Chart of the Week). The signal from our ECB Monitor is stronger than that of our Fed Monitor, but U.S. Treasury and German bund yields have both fallen sharply with markets pricing in lower inflation expectations and new policy stimulus. The result is a relatively modest narrowing of U.S.-European expected interest rate differentials that has had little impact in weakening the U.S. dollar (USD) versus the euro. With both the Fed and ECB now in play for rate cuts, this is a good time to review the drivers of the spread between U.S. Treasury (UST) yields and German government bond yields – specifically, the widely-followed 10-year Treasury-Bund spread. A Quick Trans-Atlantic Comparison Of Growth, Inflation & Interest Rates The global bond rally seen this year has driven the 10-year UST yield fall back to the 2% level last seen in 2016. The 10-year Bund yield, on the other hand, has plummeted to a new all-time low of -0.3%. The yield move in the U.S. was larger, thus the UST-Bund spread has narrowed from a 2019 peak of 253bps to the current level of 233bps. Breaking down the nominal 10-year yields into the real yield and inflation expectations components illustrates how the current wide UST-Bund spread is almost purely a “real” phenomenon (Chart 2). 10-year CPI rates are 1.9% and 1.4% in the U.S. and euro area, respectively, accounting for 50bps of the overall 233bps UST-Bund spread. Adjusting the nominal yields by those CPI swap rates leaves a real 10-year Treasury yield of +0.1%, compared to -1.7% in Europe (using the 10-year German yield versus 10-year euro CPI swap). Thus, the market-implied real yield differential is 180bps, accounting for the bulk of the nominal UST-Bund spread. Our proxy for the market’s expectation of the real neutral interest rate – the 5-year Overnight Index Swap (OIS) rate, 5-years forward minus the 5-year CPI swap rate, 5-years forward – is indicating that investors now think the neutral real fed funds rate is 0% and the neutral real ECB rate is around -1% (Chart 3). Chart 2Real Yields Dictating UST-Bund Spread Chart 3Global Yields Discounting Fresh ECB QE? Those market-implied measures typically follow the path of our estimate of the term premium for the 10-year Treasury and Bund. For both markets, however, the term premium is now at a much more negative level than suggested by the past relationship with our real neutral rate proxy. The gap between the 10-year UST term premium (-60bps) and the 10-year German Bund term premium (-124bps) now contributes about 64bps to the nominal UST-Bund spread. When looking at the relative cyclical state of the U.S. and European economies at present, there are surprisingly few differences that show up in the data. Term premia are heavily influenced by investor risk aversion and the demand for safe assets during periods of uncertainty. Given the numerous headline risks that investors are faced with at the moment (U.S.-China trade, slowing global growth, U.S.-Iran military tensions, the start of the 2020 U.S. Presidential election cycle), it is understandable that money has flooded into the safety of developed market government debt. Yet when looking at the relative cyclical state of the U.S. and European economies at present, there are surprisingly few differences that show up in the data (Chart 4). The euro area manufacturing PMI is now at 47.8, below the 50 line that indicates an expanding industrial sector, but may be starting to stabilize. The U.S. ISM manufacturing index, at the same time, now sits at 52.1 and is closing in on the levels seen in Europe. Meanwhile, consumer confidence measures remain elevated both in the U.S. and Europe, even after the recent small dips. Business confidence measures like the NFIB U.S. small business survey and the European Commission’s business climate indicator remain firm relative to the post-crisis history, although both are off their cyclical peaks. That relative dearth of spare capacity in the U.S. compared to Europe is the most fundamental reason for the higher level of U.S. interest rates relative to the euro area. Turning to the state of labor markets on both sides of the Atlantic, the stories are also similar (Chart 5). Unemployment rates are well below the OECD’s estimates of the full employment NAIRU level. Wages are starting to gain some upward momentum in Europe, but U.S. Average Hourly Earnings are growing about one percentage point faster than equivalent measures in the euro area. Chart 4Not A Huge U.S.-Europe Cyclical Growth Gap Chart 5Not A Huge U.S.-Europe Structural Growth Gap The implication here is that there is less slack in the U.S. labor market than in Europe, as exemplified by the fast rate of wage growth in the U.S. Chart 6A Bit More Wage Inflation In The U.S. That relative dearth of spare capacity in the U.S. compared to Europe is the most fundamental reason for the higher level of U.S. interest rates relative to the euro area (Chart 6). U.S. potential GDP growth is only marginally faster than it is in Europe, with virtually the same rate of long-term labor productivity growth (about 0.5% per year, according to the OECD). Yet according to the New York Fed’s most recent estimates of the natural real interest rate (“r-star”), the level of the inflation-adjusted policy rate that would be considered neither stimulative nor restrictive given current estimates of spare capacity, is 0.7% in the U.S. and -0.4% in Europe.1 Looking ahead, both the Fed and ECB are likely to deliver some monetary easing in the coming months, perhaps as soon as the next set of policy meetings in late July. The market expects much more from the Fed, though, with 92bps of cuts discounted over the next twelve months. 16bps of cuts are also expected from the ECB, but that is more likely to be delivered than the market expectation for the Fed. There is even a chance that the ECB could restart their Asset Purchase Program, although likely not after delivering a small rate cut first. In any case, there is likely to be more disappointment from the Fed compared to the ECB over the next 6-12 months, with the result being some upward pressure placed on the UST-Bund spread. Bottom Line: Underlying U.S. and European economic growth momentum remains surprisingly similar, with weakness concentrated in manufacturing industries most exposed to trade uncertainty. Realized inflation readings are also fairly close, although there is less spare capacity in the U.S. where wages are growing at a much faster rate. There is likely to be more disappointment from the Fed compared to the ECB over the next 6-12 months, with the result being some upward pressure placed on the UST-Bund spread. Valuation & Currency Risk In The UST-Bund Spread Our valuation model for the 10-year Treasury-Bund spread indicates that the current spread level of 233bps is very close to fair value of 223bps (Chart 7). Chart 7UST-Bund Spread Fairly Valued The main variables in the model are the spread between the fed funds rate and the ECB 1-week refinancing rate, the ratio of the unemployment rates of the U.S. and euro area, and the differential between the headline inflation rates of the U.S. and euro area. The model also includes the balance sheets of the Fed and ECB as variables, to capture any effects on the Treasury-Bund spread from quantitative easing programs. Historically, the UST-Bund spread has been driven mostly by the gap between Fed and ECB policy rates and, to a lesser extent, the relative state of unemployment. Inflation differentials have become less of a driver of the spread during the years since the 2008 financial crisis (Chart 8), although this is part of the broader issue of wage growth diverging from price inflation in the developed economies. The reaction function of the central banks, and of bond yields, is still rooted in the amount of perceived spare economic capacity – and future inflation potential – implied by unemployment rates. Looking ahead, if the Fed and ECB were both to deliver the full amount of easing over the next year discounted in the USD and EUR OIS curves, then the fair value of the spread would narrow to 208bps. The one-year-ahead forward rates for both the 10-year UST and German Bund imply a spread tightening to 229bps, which means that it would likely require the Fed delivering the full 92bps of easing discounted over the next twelve months – not our base case view – to make betting on additional UST-Bund spread tightening a profitable trade that would beat the forwards. So while the case for betting on additional UST-Bund spread narrowing is a poor one at current levels, the case for favoring Bunds over Treasuries on a currency-hedged basis in U.S. dollar terms is strong. Going long German government bonds vs U.S. Treasuries, while hedging the euro currency exposure into U.S. dollars, actually generates a pickup in yield, despite the fact that the entire German yield curve has negative yields out to 15-year maturities. Chart 9 shows the U.S.-German bond yield spreads for the 2-year, 5-year, 10-year and 30-year maturities. The solid line in all panels represents the yield spread in currency-unhedged terms, while the dotted line in all panels shows the spread after hedging the Bund yields into U.S. dollar equivalents (using 3-month currency forwards). Across all four maturities shown, the wide unhedged U.S.-German spreads turn into negative spreads after currency hedging. This is due to the considerably higher short-term interest rates in the U.S. that are gained when selling euros forward for dollars. Chart 8UST-Bund Spread Driven By Fed/ECB Gap Chart 9UST-Bund Spreads Look VERY Different After Hedging FX Risk Thus, going long German government bonds vs U.S. Treasuries, while hedging the euro currency exposure into U.S. dollars, actually generates a pickup in yield, despite the fact that the entire German yield curve has negative yields out to 15-year maturities. When looking at the relative performance of German bonds relative to not only U.S. Treasuries, but the overall Bloomberg Barclays Global Treasury index, Germany has basically matched the index over the past year in currency-hedged terms (Chart 10, middle panel). On an unhedged basis, the relative performance of German debt is obviously far more volatile given the swings in the euro. Yet even in unhedged terms, the relative performance of Germany versus the U.S. appears to be turning around, despite the recent additional narrowing of the UST-Bund spread (bottom panel). Chart 10Favor Bunds Over USTs In USD-Hedged Bond Portfolios Chart 11UST-Bund Spread Tightening Looks Stretched This highlights the risk of solely looking at the spread between yields denominated in different currencies. FX movements can dominate relative yield changes, as has been the case of late with the EUR/USD exchange rate rising off the 2019 lows on the back of falling UST yields. We continue to prefer viewing cross-country spread trades in currency-hedged terms when we make our recommendations. On that basis, we like hedged Bunds over U.S. Treasuries – especially with the current UST-Bund spread now discounting a lot of relatively bad news in the U.S. versus Europe (Chart 11). Bottom Line: The Fed is more likely to deliver less easing relative to market expectations than the ECB, leaving the UST-Bund spread susceptible to a rebound over the next 6-12 months. We continue to recommend overweighting German Bunds vs U.S. Treasuries in global currency-hedged bond portfolios, given the substantial yield pickup gained by hedging into U.S. dollars out of euros. Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com 1 The New York Fed’s r-star estimates can be found here: https://www.newyorkfed.org/research/policy/rstar Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns