Economy

Special Report

Dear Clients, Please note that this week we are re-publishing a Special Report written by our Emerging Market Strategy team and published on January 7, 2020. The report, authored by Ellen JingYuan He, is an extension of the Special Report published in September 2017 and examines the progress made in China’s “Belt and Road Initiative (BRI)” since its implementation in 2013.  This Special Report concludes that going forward, the Chinese government will likely shift to a stricter regulatory stance in BRI project financing. The shift will lead to a modest pullback in realized BRI investment in 2020. However, given the small size of BRI investments relative to China’s total capital spending, the recovery in Chinese capital goods imports still hinges on the domestic property and infrastructure spending cycle.  I trust you will find this report insightful. In addition, we are closing our long USD/CNH trade, initiated in May 2019 as a currency hedge for our cyclical overweight in Chinese stocks and corporate bonds (denominated in USD terms). As we mentioned in last week’s China Macro and Market Review, upon the signing of the Phase One trade deal on January 15, we expect further modest strengthening in the Chinese currency as China’s economy continues to improve. Therefore, the currency hedge is no longer needed and we recommend that investors favor Chinese stocks and bonds versus the global benchmark in unhedged terms.  Best regards, Jing Sima, China Investment Strategist   Highlights The Chinese government will be applying more scrutiny and tighter oversight over lending for ‘Belt and Road’ Initiative (BRI) projects going forward. As a result, total BRI investment with Chinese financing will fall moderately – by 5% to US$135 billion in 2020 from US$142 billion in 2019. BRI investment is too small relative to mainland capital spending. Hence, the global outlook for capital goods and industrial commodities will be driven by Chinese capex, not BRI. BRI Overview Chart I-1Chinese BRI Investment: Likely To Decline In 2020 China has been promoting and implementing its strategic ‘Belt and Road’ Initiative (BRI) since late 2013. The country has so far signed about 200 BRI cooperation documents with 137 countries and 30 international organizations. The government’s strong push has resulted in a surge in Chinese BRI investment, albeit with a major downturn in 2018 (Chart I-1). BRI projects center on infrastructure development such as transportation (railways, highways, subways and bridges), energy (power plants and pipelines) and telecommunications infrastructure in recipient countries covered by the BRI program. Chart I-2 demonstrates the geographical reach of the BRI as well as transportation linkages/routes being built and funded by it. We discussed the BRI in great detail in a special report published in September 2017. Chart I-2The Belt And Road Program The cumulative size of the signed contracts with BRI-recipient countries over the past six years is about US$700 billion, of which US$460 billion has already been completed. However, the value of newly signed contracts in a year does not equal the actual project investment that occurred in that year, as these contracts generally take several years to be implemented and completed. In this report, “BRI investment” encompasses realized investments for BRI projects, which we derive from the official data of “BRI newly signed contracts.” Based on our calculations, Chinese BRI investment reached about US$142 billion in 2019, equaling about 2% of nominal gross fixed capital formation (GFCF) in China. The latter in 2019 was about US$6 trillion. Yet, BRI is much larger than multilateral funding for the developing world. For example, current annual financing disbursements from the World Bank are only about US$50 billion. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Looking into 2020, due to a number of considerations, the Chinese government’s attitude towards BRI project financing will continue to shift from aggressive to a stricter and more-cautious stance. Consequently, we expect a 10% decline in the total value of annual newly signed contracts in 2020, slightly less than the 13% decline in 2018. In addition, we also expect the average implementation period for BRI projects to be slightly longer this year than last year. Based on these expectations, our projection is that realized Chinese BRI investment in 2020 will likely fall moderately – by 5% to US$135 billion this year from US$142 billion in 2019 (Chart I-1 and Table I-1). Table I-1Projection Of Chinese BRI Project Investment In 2020 BRI Investments: More Scrutiny Ahead The Chinese authorities are constantly recalibrating their BRI implementation strategy. The lessons learned over the past six years as well as shifting domestic macro and global geopolitical landscapes all suggest even more scrutiny ahead. First, the Chinese government has learned hard lessons that easy large lending/financing can result in unanticipated negative consequences. In the past six years, the Chinese government has actively promoted the BRI by providing considerable amounts of financing to BRI projects. The main objectives of the BRI have been: (1) to export China’s excess capacity in heavy industries and construction to other countries; and (2) to build transportation and communication networks to facilitate trade between China and other regions. Although the projects have indeed improved infrastructure and connectivity and boosted both current and potential growth rates in the recipient countries, there have been numerous cases of debt restructuring demand by borrowers as well as growing criticism on China’s BRI as “debt trap diplomacy.” The argument is that China makes loans and uses the debt as leverage to secure land or strategic infrastructure in the recipient countries – in addition to the Middle Kingdom promoting its own geopolitical interests. History will eventually reveal whether BRI constituted “debt trap diplomacy.” As of now, China has either renegotiated or written off debt for some debt-strapped BRI- recipient countries rather than seize their assets. Among all BRI projects spreading over 60 countries in the past six years, there has been only one asset seizure case in Sri Lanka. Crucially, increasingly more BRI-recipient countries are now demanding to renegotiate the terms of their loans and financing, asking China for more favorable concessions, debt forgiveness and write-offs. The reasons run the gamut: from BRI projects not generating enough cash flow to service debt to simple requests among recipient countries for better financing terms. These demands are reducing the value of China’s claims on both BRI projects and recipient countries, and curtailing its willingness to finance more BRI projects. In general, China has learned again that substantially augmenting investments in a single stroke – whether on the mainland or in other countries – produces capital misallocation. The latter results in unviable debtors and bad assets on balance sheets of financiers. Second, many BRI investment projects have suffered delays or cancellations due to changes in the recipient countries’ governments. Reducing both unanticipated negative consequences and unexpected delays/ cancellations requires more scrutiny and tighter oversight on BRI projects by the Chinese government, which is on the way. In April 2019, Chinese President Xi Jinping called for high-quality, sustainability and transparency in implementing BRI projects, as well as a zero-tolerance policy towards corruption. He also stressed that China would only support open cooperation and clean governance when pursuing BRI projects. China’s Ministry of Finance last year released a new document titled, The Debt Sustainability Framework for Participating Countries of the Belt and Road Initiative, in order to identify debt stress among recipient countries and prevent defaults. China, in April, rejected the Kenyan government’s request of US$3.7 billion in new loans for the third phase of its standard gauge railway (SGR) line amid concerns about the country’s finances. In Zimbabwe, the Export-Import Bank of China backed out of providing financing for a giant solar project due to the government’s legacy debts. To be sure, like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. That said, the BRI is a signature initiative of President Xi and still has many positives for China. Specifically, it helps the country export its excess capacity, increase its trade with the rest of the world and expand the country’s geopolitical influence. Therefore, any slowdown in the BRI will be marginal. China will tweak and may reduce the pace of BRI investment moderately, but it will not halt it outright. Like any lender, the risks and costs fall to Chinese banks and financing providers in the event of a default. Therefore, increasing scrutiny of such projects is in the best interests of China as a whole. Bottom Line: There will be increasing scrutiny of BRI projects by the Chinese government. Consequently, it will become incrementally more difficult for BRI countries to obtain financing from China in 2020. Nevertheless, the pace of BRI will slow somewhat but not plunge, given the program’s strategic benefits for China. BRI Financing: Switching From Dollar- To Yuan-Denominated Chinese banks have been the major BRI funding providers. Table I-2 shows Chinese policy banks and large state-owned commercial banks accounted for about 51% and 41% of BRI funding in the past five years, respectively. Table I-2China's BRI Funding Sources During 2014-2018 Debt and equity financing are the two major types of BRI funding, with the former playing the dominant role in the form of bank loans and BRI-specialized bond issuance. While the majority of BRI financing to date – about 83% of the total, according to our estimates – has been denominated in foreign currency (mainly in US dollars), there has been a noticeable rise in loans and bond issuance denominated in yuan. In May 2017, President Xi encouraged domestic financial institutions to promote overseas RMB-denominated financing for BRI projects. In the past two and a half years, about 17% of BRI financing has been in yuan. Before May 2017, such yuan-denominated loans for BRI projects were insignificant. Yuan-denominated BRI loans: The two Chinese policy banks have provided more than RMB 380 billion (equivalent to US$55 billion) in BRI-specialized loans in RMB terms over the past two and half years. Offshore yuan-denominated BRI-related bond issuance by Chinese banks and companies: There has been an increasing amount of BRI-specialized bond issuance in RMB terms offshore over the past several years as well. Onshore yuan-denominated BRI-related bond issuance by governments and organizations/companies of recipient countries: Since 2018, foreign private companies and government agencies have been allowed to issue RMB-denominated BRI bonds onshore in China. There are three reasons why the Chinese authorities will continue to encourage more yuan-denominated financing for BRI projects. Chart I-3China: Few FX Reserves Compared With RMB Money Supply First, balance-of-payment constraints make RMB funding for BRI more desirable. US dollar financing for BRI initiatives inevitably creates demand for the People’s Bank of China’s increasingly precious foreign-exchange resources. The main risk to China’s balance of payments is the 177 trillion of local currency deposits of households and enterprises. The PBoC’s US$3 trillion in foreign exchange reserves accounts for only 12% of Chinese total deposits (Chart I-3). Chinese households and private enterprises prefer to hold a higher proportion of their assets in foreign currencies than they do now. This will continue to generate capital outflows, and risks depleting the nation’s foreign currency reserves. Given potential capital outflows from the domestic private sector, China will be careful in expanding state-sponsored capital outflows, including US dollar-denominated BRI financing. Therefore, increasing RMB-denominated funding will reduce US dollar outflows and diminish pressure on China’s foreign exchange reserves. Second, providing BRI financing in yuan promotes RMB internationalization, which is a major long-term objective of China. When a borrower (whether Chinese or foreign entity) with a BRI project obtains yuan-denominated financing, it is encouraged to also pay its suppliers in yuan. As a result, more global trade is settled in renminbi, promoting its internationalization. This is especially convenient when the borrower buys goods and services from China, as they can easily pay in yuan. In cases where a borrower has to buy services and equipment from other countries and is required to pay in US dollars, the renminbis will go into foreign exchange markets. On margin, this will drive the yuan’s value versus the US dollar lower. Provided China has excess capacity in many raw materials and industrial goods, there is a lot of scope to expand RMB financing for BRI projects, with limited downward pressure on the yuan’s exchange rate. In short, RMB-denominated funding will be used to buy Chinese goods. Chart I-4Low Odds Of Acceleration In Bank Financing In 2020 Finally, in any country, banks originate local-currency denominated loans “out of thin air,” – i.e., bank balance sheet expansion is not constrained by national savings. We have written about this extensively in numerous past reports. Theoretically, there is no hard limit on much in yuan-denominated loans Chinese commercial banks can originate, nor how many yuan-denominated bonds they can buy. What constrains commercial banks from expanding their assets infinitely is banking regulation, liquidity constraints (their excess reserves at the central bank rather than deposits), worries about asset impairment and a lack of loan demand among borrowers. Among these, the most pertinent that could cap the amount of BRI financing originated by Chinese banks is macro-prudential bank regulation that is being implemented by regulators in a piecemeal way to cap leverage among enterprises, households, local governments and banks themselves. Chart I-4 illustrates that banks’ asset growth is on par with nominal GDP, and has recently rolled over. The Chinese authorities target bank assets, bank broad credit and broad money growth at the level of potential nominal GDP growth. This entails low odds of acceleration in bank financing in general and BRI projects in particular. Meanwhile, the need for BRI debt restructuring and provisioning will also lead mainland commercial banks to become slightly more cautious in BRI financing. Bottom Line: Both RMB- and US dollar- denominated financing for BRI projects will marginally diminish in 2020. Macro Implications Chart I-5Deep Contraction In Chinese Property Construction... Implications For Commodities And Capital Goods The size of BRI investments in 2019 – US$142 billion – accounts for only about 2% of China’s nominal GFCF. Hence, BRI investment is too small relative to mainland capital spending. This is why we often do not incorporate BRI when analyzing China’s capital spending cycle. In 2020, we are still negative on China’s property construction activity due to weak real estate demand and increasing difficulty for indebted property developers to secure financing (Chart I-5). There will likely be a moderate growth rebound in Chinese infrastructure investment. However, it will not be able to offset the negative impact on commodities and capital goods from weaker BRI investment and mainland contracting property construction. All in all, the recovery in Chinese capital goods imports will be moderate (Chart I-6). Notably, prices of steel, industrial metals and other raw materials do not signal widespread and robust recovery as of now (Chart I-7). Chart I-6...And In Chinese Capital Goods Imports Chart I-7Commodity Prices Do Not Signal Widespread And Robust Recovery     Impact On Chinese Exports Chinese exports to BRI countries have done much better than its shipments elsewhere (Chart I-8). For example, Chinese exports to ASEAN countries showed a strong 10.4% year-on-year growth in 2019, versus a 1% contraction in overall exports. The ASEAN countries that received significant amounts of BRI investments posted double-digit growth in imports from China. There are two primary reasons behind the stronger growth in Chinese exports to BRI-recipient countries. 1. As most of China’s BRI investment has focused on infrastructure projects, it has significantly increased recipient countries’ imports of capital goods and raw materials. Chart I-9 shows that Chinese exports of digging and excavating machines have gone vertical. Chart I-8Strong Growth In Chinese Exports To BRI Countries Chart I-9Surging Chinese Exports Of Digging And Excavating Machines   2. Considerable BRI investment has propelled recipient countries’ income growth. Chart I-10 reveals a positive correlation between capital spending as a share of GDP and real GDP growth across 33 BRI-receiving developing economies during the BRI implementation period of 2014-2018. Hence, BRI investments have considerable impact on both potential and current growth of recipient countries. Chart I-10Strong Capital Spending Tend To Facilitate Real Economic Growth Chart I-11BRI Helped Boost Chinese Consumer Goods Exports Robust income growth has boosted demand for household goods (Chart I-11). China has a very strong competitive advantage in consumer goods production, especially in low-price segments that are popular in developing economies. Despite a slight drop in overall BRI investment, we still expect solid growth (albeit less than in 2019) in Chinese exports to BRI countries in 2020. Ellen JingYuan He Associate Vice President ellenj@bcaresearch.com   Cyclical Investment Stance Equity Sector Recommendations

Highlights 2019 Performance Breakdown: Our recommended model bond portfolio underperformed the custom benchmark index by -38bps for all of 2019. Winners & Losers: The underperformance of our model bond portfolio in 2019 was concentrated in the government bond side of the portfolio (-103bps), a result of below-benchmark duration positioning and underweights to US Treasuries and Italian government bonds. On the other side was a solid outperformance from spread product allocations (+65bps), mostly driven by an overweight to US high-yield corporate bonds. Q4/2019 Performance: The year ended strongly, however, as the portfolio outperformed by +28bps in Q4, split equally between government bonds and spread product. Scenario Analysis For The Next Six Months: We are targeting a moderately aggressive level of overall portfolio risk, with below-benchmark duration exposure alongside meaningful overweight allocations to global corporate credit. In our base case scenario, global growth will continue to recover supported by accommodative monetary policies, thus opening a window for another year of global corporates outperforming sovereign bonds in 2020. Feature Last week, we published the Global Fixed Income Strategy (GFIS) model bond portfolio strategy for the coming year, in which we translated our 2020 global fixed income Key Views into recommended investment positioning for the next 6-12 months.1 In this week’s report, take a final look back to review the performance of the model portfolio for both the fourth quarter of 2019 and the entire calendar year. We also present our updated scenario analysis, and return projections, for the portfolio over the next six months, incorporating the new recommended allocations introduced last week. As a reminder to existing readers (and to new clients), the model portfolio is a part of our service that complements the usual macro analysis of global fixed income markets. The portfolio is how we communicate our opinion on the relative attractiveness between government bond and spread product sectors. This is done by applying actual percentage weightings to each of our recommendations within a fully invested hypothetical bond portfolio. 2019 Performance: A Short Summary Of A Long Year Chart of the Week2019 Performance: Credit Good, Duration Bad, But A Solid Q4 The 2019 performance of the model portfolio can be summarized by duration dominating credit. Government bond yields rapidly fell in the first three quarters of the year due to weakening global growth and growing political uncertainty, to the detriment of our below-benchmark stance on overall portfolio duration. At the same time, global credit markets performed strongly in 2019, even as risk-free government bond yields plunged, which benefited our overweight stance on global spread product. The 2019 performance of the model portfolio can be summarized by duration dominating credit.  All in all, the overall portfolio return in 2019 was +7.9% (hedged into USD), underperforming our custom benchmark index by -38bps (Chart of the Week).2 That underperformance was more pronounced before the strong rebound in global bond yields witnessed at the beginning of the fourth quarter, at which point the portfolio was underperforming the custom benchmark by -68bps (Table 1). Table 1GFIS Model Bond Portfolio Q4/2019 Overall Return Attribution Looking at the breakdown of underperformance in 2019, our recommended positioning on government bonds (duration and country allocation) dragged the overall performance by -104bps, while our credit tilts (by country and broadly defined credit sectors) provided a partial offset, contributing +65bps. The details of the full year 2019 performance can be found in the Appendix on pages 14-16. In terms of specifics, the biggest sources of underperformance were underweights in US Treasuries (-66bps) and Italian government bonds (-28bps). Those positions, however, were used to “fund” corporate bond overweights in US investment grade (+28bps) and US high-yield (+46bps), as well as euro area corporate debt (+6bps) – allocations that performed well and helped offset the underperformance in US and Italian sovereign debt. More generally across the government bond portion of the portfolio, the drag on returns was concentrated in the 10+ year maturity buckets. This was a consequence of combining our below-benchmark duration stance with a curve-steepening bias that was hurt severely by the bullish flattening of global yield curves in the first three quarters of the year. The drag on returns from curve positioning was particularly acute in Japan and France, where the 10+ year maturity buckets underperformed by -27bps and -13bps, respectively. On a more positive note with regards to country selection, three of our favorite overweights for 2020 – Germany (+10bps), Australia (+7bps) and the UK (+5bps) – all outperformed versus the model portfolio benchmark. Q4/2019 Model Portfolio Performance Breakdown: Winning On Both Sides The GFIS model bond portfolio performed well at the end of 2019, as fixed income markets began to discount stabilizing global growth and reduced central bank easing expectations. The total return for the GFIS model portfolio (hedged into US dollars) in Q4/2019 was only +0.1%, but this managed to outperform the custom benchmark index by a solid +28bps. The GFIS model bond portfolio performed well at the end of 2019, as fixed income markets began to discount stabilizing global growth and reduced central bank easing expectations.  In terms of the specific breakdown between the government bond and spread product allocations in our model portfolio, the former generated +14bps of outperformance versus our custom benchmark index while the latter outperformed by +15bps. The bar charts showing the total and relative returns for each individual government bond market and spread product sector are presented in Charts 2 and 3. Chart 2GFIS Model Bond Portfolio Q4/2019 Government Bond Performance Attribution Chart 3GFIS Model Bond Portfolio Q4/2019 Spread Product Performance Attribution By Sector The most significant movers were: Biggest outperformers Underweight US government bonds with maturity beyond 10+ years (+8bps) Overweight US Ba-rated high-yield corporates (+5bps) Overweight US B-rated high-yield corporates (+5bps) Underweight Italian government bonds with maturity beyond 10+ years (+4bps) Underweight German government bonds with maturity beyond 10+ years (+3bps) Biggest underperformers Underweight US government bonds with maturity of 1-3 years (-2bps) Overweight Japanese government bonds with maturity of 5-7 years (-2bps) Overweight Japanese government bonds with maturity of 7-10 years (-1bp) Overweight UK government bonds with maturity of 5-7 years (-1bp) Underweight German government bonds with maturity of 7-10 years (-1bp) Chart 4 presents the ranked benchmark index returns of the individual countries and spread product sectors in the GFIS model bond portfolio for Q4/2019. The returns are hedged into US dollars (we do not take active currency risk in this portfolio) and are adjusted to reflect duration differences between each country/sector and the overall custom benchmark index for the model portfolio. We have also color-coded the bars in each chart to reflect our recommended investment stance for each market during Q4/2019 (red for underweight, green for overweight, gray for neutral).3 Ideally, we would look to see more green bars on the left side of the chart where market returns are highest, and more red bars on the right side of the chart were returns are lowest. Chart 4Ranking The Winners & Losers From The Model Bond Portfolio In Q4/2019 Global spread product dominates the left half of the chart. EM corporates and EM sovereigns denominated in US dollars turned to be the best performers in Q4, followed by US and European corporate bonds. This was a boon for our model portfolio performance, given our overweight stances on global corporate bonds. This was due to credit spread narrowing, supported by accommodative monetary policy and fading fears of slower global growth. On the other hand, the right side of Chart 4 is predominantly occupied by government bonds. The worst performers in Q4 were German, New Zealand and UK governments bonds – three markets where we have been overweight, although we did take profits on our long-held bullish view on New Zealand in mid-November.4 Bottom Line: Our recommended model bond portfolio outperformed the custom benchmark index during the fourth quarter of the year. The outperformance came both from the government and spread product sides of the portfolio, driven by a smaller exposure to the long-ends of government bond yield curves and our recommended overweight position on US high-yield corporate bonds. Future Drivers Of Portfolio Returns Chart 5Overall Portfolio Allocation: Significantly Overweight Credit Looking ahead, the performance of the model bond portfolio will be driven by three main factors: our below-benchmark duration bias, our overweight stance on corporate debt versus global government bonds, and last week’s upgrade of EM USD-denominated sovereigns and corporates to overweight. In terms of specific weightings in the GFIS model bond portfolio, we now have a more pronounced bias favoring global spread product over government debt, with a relative overweight of fifteen percentage points versus the benchmark index (Chart 5). We also remain modestly below-benchmark on duration, with an overall exposure equal to 0.5 years short of the benchmark (Chart 6). While we do not expect a major surge in bond yields this year, global yield curves discount inflation expectations that are too low and monetary policy easing in 2020 that is unlikely to be delivered (especially in the US). With global growth showing signs of bottoming out, and leading indicators pointing to continued improvement in the next 6-12 months, the risk/reward bias is tilted in favor of global yields moving higher, justifying reduced duration exposure. Looking ahead, the performance of the model bond portfolio will be driven by three main factors: our below-benchmark duration bias, our overweight stance on corporate debt versus global government bonds, and last week’s upgrade of EM USD-denominated sovereigns and corporates to overweight. Chart 6Overall Portfolio Duration: Moderately Below Benchmark Chart 7Portfolio Yield: Significant Positive Carry From Credit Chart 8Portfolio Risk Budget Usage: Moderately Aggressive To better position the model bond portfolio to this backdrop of slowly rising global yields, we adjusted our government bond country allocations last week in favor of lower-beta markets such as Japan, Germany, France, Spain, Australia and the UK, while maintaining underweight positions in higher-beta markets such as the US, Canada and Italy.5 Our decision to upgrade global credit exposure helps boost the yield of our model portfolio to around 3%, or +43bps in excess of the benchmark index yield (Chart 7). Further, these changes represent an increase in the usage of the “risk budget” of our model bond portfolio, which is now running a tracking error (or excess volatility versus that of the benchmark) of 73bps (Chart 8). This is slightly higher than the 58bps prior to last week’s changes, but is still below the maximum allowable tracking error of 100bps that we have imposed on the model portfolio since its inception. More importantly, this is consistent with our view that investors should maintain a “moderately aggressive” level of risk in fixed income portfolios in 2020. Scenario Analysis & Return Forecasts To help provide some insight as to the potential excess returns from our model bond portfolio tilts, we use a framework for estimating total returns for all government bond markets and spread product sectors, based on common risk factors. For credit, returns are estimated as a function of changes in the US dollar, the Fed funds rate, oil prices and market volatility as proxied by the VIX index (Table 2A). For government bonds, non-US yield changes are estimated using historical betas to changes in US Treasury yields (Table 2B). We take yield forecasts for US Treasuries that are translated to shifts in non-US yields using these yield betas.6 Table 2AFactor Regressions Used To Estimate Spread Product Yield Changes Table 2BEstimated Government Bond Yield Betas To US Treasuries In Tables 3A and 3B, we present our three main scenarios for the next six months, defined by changes in the risk factors, and the expected performance of the model bond portfolio in each case. The scenarios, described below, all revolve around our expectation that the most important drivers of future market returns will continue to be the momentum of global growth and the path of US monetary policy. Base Case (Global Growth Recovery): The Fed stays on hold, the US dollar weakens by -2%, oil prices rise by +10%, the VIX hovers around 13, and there is a bear-steepening of the UST curve. This is a scenario where global growth keeps recovering, alongside a US dollar which slightly weakens. The model bond portfolio is expected to beat the benchmark index by +90bps in this case. Global Growth Accelerates: The Fed stays on hold, the US dollar weakens by -5%, oil prices rise by +15%, the VIX declines to 10, and there is a more pronounced bear-steepening of the UST curve. Under this scenario, the pickup in global growth is faster than anticipated, causing the US dollar to weaken substantially as global capital flows move into more growth-sensitive markets outside the US. Both of these forces support EM economies and support oil prices. The model bond portfolio is expected to beat the benchmark index by +125bps in this case. Global Growth Upturn Fails: The Fed cuts rates by -25bps, the US dollar appreciates by +3%, oil prices fall by -20%, the VIX rises to 25; there is a parallel shift down in the UST curve. This is a scenario where global growth merely stabilizes at weak levels but fails to rebound. The Fed finds itself delivering one more rate cut in order to support the US economy. Meantime, the US dollar appreciates as capital flows out of growth-sensitive regions into the safe-haven greenback, particularly as global recession fears result in increased financial market volatility. The model portfolio will underperform the benchmark by -38bps in this scenario. Table 3AScenario Analysis For The GFIS Model Bond Portfolio For The Next Six Months Table 3BUS Treasury Yield Assumptions For The 6-Month Forward Scenario Analysis The scenario inputs for the four main risk factors (the fed funds rate, the price of oil, the US dollar and the VIX index) are shown visually in Chart 9, while the US Treasury yield scenarios are in Chart 10. Chart 9Risk Factor Assumptions For The Scenario Analysis Chart 10US Treasury Yield Assumptions For The Scenario Analysis In terms of our conviction level among the main drivers of the model portfolio returns – duration allocation (across yield curves and countries) and asset allocation (credit versus government bonds) – we are confident that global growth is much more likely to rebound than decelerate further over the course of 2020. This will allow our increased spread product allocation to be the main driver of the portfolio returns. Thus, the overall expected excess return of our model bond portfolio over the benchmark is positive, given that the scenario analysis produces positive excess returns in the Base Case and “Global Growth Accelerates” outcomes. We are confident that global growth is much more likely to rebound than decelerate further over the course of 2020. This will allow our increased spread product allocation to be the main driver of the portfolio returns. Bottom Line: We are targeting a moderately aggressive level of overall portfolio risk, with below-benchmark duration exposure alongside meaningful overweight allocations to global corporate credit. In our base case scenario, global growth will continue to recover supported by accommodative global monetary policy, thus opening a window for another year of global corporates outperforming sovereign bonds in 2020.   Jeremie Peloso Research Analyst jeremiep@bcaresearch.com Robert Robis, CFA Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Our Model Bond Portfolio Strategy For 2020: Selectively Aggressive”, dated January 7, 2020, available at gfis.bcarsearch.com. 2 The GFIS model bond portfolio custom benchmark index is the Bloomberg Barclays Global Aggregate Index, but with allocations to global high-yield corporate debt replacing very high quality spread product (i.e. AA-rated). We believe this to be more indicative of the typical internal benchmark used by global multi-sector fixed income managers. 3 Note that sectors where we made changes to our recommended weightings during Q4/2019 will have multiple colors in the respective bars in Chart 4. 4 Please see BCA Research Global Fixed Income Strategy Weekly Report, “When In Doubt, Trust The Leading Indicators”, dated November 19, 2019, available at gfis.bcaresearch.com. 5 We are defining “beta” here in terms of yield beta, or the sensitivity to changes in an individual country's bond yield to changes the overall level of global bond yields. 6 We are making a change in the betas used in our scenario analysis this week, using trailing 3-year yield betas to US Treasuries in place of the longer-term post-crisis yield betas that were measured over a full 10 years. Appendix Appendix Table 1GFIS Model Bond Portfolio Full Year 2019 Overall Return Attribution Appendix Chart 1GFIS Model Bond Portfolio Full Year 2019 Government Bond Performance Attribution Appendix Chart 2GFIS Model Bond Portfolio Full Year 2019 Spread Product Performance Attribution By Sector   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 Duration: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. TIPS: We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. High-Yield: Investors should add (or increase) exposure to the high-yield energy sector, within an overweight allocation to junk bonds. Junk energy spreads are attractive, and exposure to the sector will mitigate the impact of a potential oil supply shock. Feature Only a month ago, investors were becoming more optimistic about a global growth rebound and the US/China phase 1 trade deal was pushing political risk into the background. Both of those factors caused the 10-year Treasury yield to rise throughout December, hitting an intra-day Christmas Eve peak of 1.95% (Chart 1). But since then, softer global PMI data and the US/Iranian military conflict brought global growth concerns and political risk back to the fore, breaking the uptrend in yields. Chart 1Bond Bear On Pause Global growth and political uncertainty are two of the five macro factors that we identify as important for US bond yields.1 And despite the recent setback, we think both factors will push yields higher in the coming months. Global Growth We have found that the Global Manufacturing PMI, the US ISM Manufacturing PMI and the CRB Raw Industrials index are the three global growth indicators that correlate most strongly with US bond yields. One reason for the recent pullback in yields is the disappointing December data from the Global and US Manufacturing PMIs. The ISM Manufacturing PMI moved deeper into recessionary territory. The Global Manufacturing PMI had been in a clear uptrend since mid-2019, but fell back to 50.1 in December, from 50.3 the month before (Chart 2). The US and Chinese PMIs also declined in December, though they remain well above the 50 boom/bust line (Chart 2, panels 3 & 4). The Eurozone and Japanese PMIs, meanwhile, are still in the doldrums (Chart 2, panels 2 & 5). More worrying than the small tick down in Global PMI is the US ISM Manufacturing PMI moving deeper into recessionary territory, from 48.1 to 47.2. However, we have good reason to think that stronger data are just around the corner (Chart 3). Chart 2Global PMI Ticks Down Chart 3ISM Manufacturing Index Will Rebound First, the difference between the new orders and inventories components of the ISM index often leads the overall index at turning points, 2016 being a prime example (Chart 3, top panel). Much like in 2016, a gap is opening up between new orders-less-inventories and the overall ISM. Second, the non-manufacturing ISM index remains strong despite the weakness in manufacturing (Chart 3, panel 2). With no contagion to the service sector of the economy, we’d expect manufacturing to pick back up. Third, the ISM Manufacturing index has diverged sharply from the Markit Manufacturing PMI, with the Markit index printing well above the ISM (Chart 3, panel 3).2 The ISM index has been more volatile than the Markit index in recent years, and should trend toward the Markit index over time. Fourth, regional Fed manufacturing surveys have generally been stronger than the ISM during the past few months. A simple regression model of the ISM index based on data from regional Fed surveys suggests that the ISM index should be at 49.7 today, instead of 47.2 (Chart 3, bottom panel). Finally, unlike the PMI surveys, the CRB Raw Industrials index has increased quite sharply in recent weeks (Chart 4). We should note that it is not the CRB index itself but rather the ratio between the CRB index and gold that tracks bond yields most closely, and this ratio has actually declined lately due to the strength in gold. Nonetheless, a sustained turnaround in the CRB index would mark a big change from 2019 and would send a strong bond-bearish signal. Chart 4CRB Sends A Bond-Bearish Signal Political Uncertainty The second factor that sent bond yields lower during the past few weeks was the military conflict between the US and Iran. Tensions appear to have de-escalated for now, and we would expect any flight-to-quality flows to unwind during the next few weeks.3 But while we see policy uncertainty easing in the near-term, sending bond yields higher, we reiterate our view that US political uncertainty is the number one risk factor that could derail the 2020 bear market in bonds.4 Specifically, we see two looming US political risks. The first relates to President Trump’s re-election odds. For now, Trump’s approval rating is in line with past incumbent presidents that have won re-election (Chart 5). But if his approval doesn’t keep pace in the coming months, he will try to do something to change his fortunes. That could mean re-igniting the trade war with China, or once again ramping up tensions with Iran. A Bernie Sanders or Elizabeth Warren victory would send a flight-to-quality into bonds. The second risk is that one of the progressive candidates – Bernie Sanders or Elizabeth Warren – secures the Democratic nomination for president. Right now, both trail Joe Biden in the polls and betting markets (Chart 6), but things could change rapidly as the primary results come in during the next few months. The stock market would certainly sell off if an Elizabeth Warren or Bernie Sanders presidency seems likely, sending a flight to quality into bonds.5 Chart 5Trump’s Approval Rating Must Rise Chart 6Democratic Nomination Betting Odds Bottom Line: Despite recent setbacks, global growth looks set to improve and policy uncertainty set to ease during the next couple of months. Both will conspire to push bond yields higher. Investors should maintain below-benchmark portfolio duration. US political risks could flare again around mid-year, sending yields lower. Playing An Oil Supply Shock In US Bond Markets US/Iranian military tensions are easing for now, but could flare again in the future. For that reason, it’s worth considering how US bond markets would respond in the event of a conflict between the US and Iran that removed a significant amount of the world’s oil supply from the market, causing the oil price to spike. The first implication is that US bond yields would fall. Even though it’s tempting to say that the inflationary impact of higher oil prices would push yields up, this effect would not dominate the flight-to-quality into US bonds that would result from the increase in political uncertainty. Case in point, Chart 1 shows that, while the inflation component of yields was stable as tensions flared during the past few weeks, it didn’t come close to offsetting the drop in the 10-year real yield. Beyond the impact on Treasury yields, there are two other segments of the US bond market that would be materially impacted by an oil supply shock: the TIPS breakeven inflation curve and corporate bond spreads. Buy TIPS Breakeven Curve Flatteners Table 1CPI Swap Curve Sensitivity To Oil When considering the impact of an oil supply shock on TIPS breakeven inflation rates, we first look at how the cost of inflation protection is influenced by changes in the oil price. Table 1 shows the sensitivity of weekly changes in different CPI swap rates to a $1 increase in the price of Brent crude oil. We use CPI swap rates instead of TIPS breakeven inflation rates because data are available for a wider maturity spectrum. Our analysis applies equally to the TIPS breakeven inflation curve. Two conclusions are apparent from Table 1. First, the entire CPI swap curve is positively correlated with the oil price, a higher oil price moves CPI swap rates higher and vice-versa. Second, the sensitivity of CPI swap rates to the oil price is greater at the short-end of the curve than at the long-end. This is fairly intuitive given that higher oil prices are inflationary in the short-term but could be deflationary in the long-run if they hamper economic growth. Chart 7Coefficients Stable Over Time Chart 7 shows that our two main conclusions are not dependent on the chosen time horizon. The 2-year CPI swap rate is positively correlated with the oil price for our entire sample period, as is the 10-year rate except for a brief window in 2014. The 2-year rate’s sensitivity is also consistently higher than the 10-year’s. Based on this analysis, we can suggest two good ways to hedge against the risk of an oil supply shock that sends prices higher: Buy inflation protection, either in the CPI swaps market or by going long TIPS versus duration-equivalent nominal Treasuries. Buy CPI swap curve (or TIPS breakeven inflation curve) flatteners.6 But we can introduce one more wrinkle to our analysis. Oil prices can rise because of stronger demand or because a shock suddenly removes supply from the market. It’s possible that the cost of inflation protection behaves differently in each case. Fortunately, the New York Fed has made an attempt to distinguish between those two scenarios. In its weekly Oil Price Dynamics Report, the Fed decomposes Brent oil price changes into demand-driven changes and supply-driven changes.7 It does this by looking at how other financial assets respond to oil price changes each week. Chart 8 shows the cumulative change in the Brent oil price since 2010, along with the New York Fed’s supply and demand factors. According to the Fed, demand has pressured the oil price higher since 2010, but this has been more than offset by greater supply. Chart 8Supply & Demand Oil Price Decomposition Using the New York Fed’s supply and demand series, we look at how CPI swap rates respond to higher oil prices in three different scenarios. First, we identify 252 weeks when demand and supply both contributed to higher oil prices. Second, we identify 95 weeks when higher oil prices were driven solely by demand. Finally, and most pertinently, we identify 92 weeks when higher oil prices were driven only by supply (Table 2). Table 2Weekly Change In CPI Swap Rate When Brent Oil Price Increases Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios are consistent with our results from Table 1. CPI swap rates across the entire curve move higher more than half the time, with greater increases at the short-end of the curve. However, the scenario we are most interested in is the ‘Supply Driven’ scenario. Presumably, a military conflict with Iran that took oil supply off the market would lead to less supply and also a decrease in global demand. Results for this scenario are more mixed. The 1-year CPI swap rate still rises 60% of the time, but rates further out the curve are somewhat more likely to fall. With this in mind, CPI swap curve or TIPS breakeven curve flatteners look like the best way to hedge against an oil supply shock, better than an outright long position in inflation protection. This is good news, since we have previously argued that owning TIPS breakeven curve flatteners is a good idea even without an oil supply shock.8 Corporate bond excess returns respond positively to changes in the oil price. We recommend that investors enter TIPS breakeven curve flatteners, both because short-term inflation expectations will respond more quickly than long-term expectations to stronger realized inflation data and to hedge against the risk of an oil supply shock. Buy Energy Junk Bonds Table 3Corporate Bond Sensitivity To Oil Corporate bonds are the second segment of the US fixed income market that could be materially impacted by an oil supply shock, particularly bonds in the energy sector. To assess the potential value of corporate bonds as a hedge, we repeat the above analysis but use weekly corporate bond excess returns versus duration-matched Treasuries instead of CPI swap rates. Table 3 shows that investment grade and high-yield corporate bond returns both respond positively to changes in the oil price. Further, we see that energy bonds are more sensitive to the oil price, outperforming the overall index when the oil price rises, and vice-versa. Chart 9 shows that, while oil price sensitivities vary considerably over time, they are almost always positive. Also, energy sector sensitivity has been consistently above that of the benchmark index since 2014. Chart 9Betas Mostly Positive Going one step further, we once again use the New York Fed’s supply and demand decomposition to identify weeks when supply and/or demand was responsible for higher oil prices. Because we have more historical data for corporate bonds than for CPI swaps, this time we identify 340 weeks when both supply and demand drove the oil price higher, 123 weeks when only demand drove it higher and 142 weeks when only supply was responsible for the higher oil price (Table 4). Table 4Weekly Corporate Bond Excess Returns (BPs) When Brent Oil Price Increases Results for the ‘Demand & Supply Driven’ and ‘Demand Driven’ scenarios show that higher oil prices boost excess returns to both investment grade and high-yield corporate bonds more than half the time. Energy bonds also tend to outperform their respective benchmark indexes in the ‘Demand & Supply Driven’ scenario, but perform roughly in-line with the benchmark in the ‘Demand Driven’ scenario. But once again, it is the ‘Supply Driven’ scenario that we are most interested in. Here, we see that an oil supply disruption that leads to higher oil prices also leads to lower corporate bond excess returns. This is true for both the investment grade and high-yield indexes and for energy bonds in both rating categories. However, we also note that high-yield energy debt significantly outperforms the overall junk index during these “risk off” periods. In contrast, investment grade energy debt is not a clear outperformer. Chart 10HY Energy Spreads Are Very Attractive These results line up with our intuition. When oil prices are driven higher by demand it could simply be a sign of strong economic growth and not any specific trend related to the energy sector. As such, we’d expect all corporate bonds to perform well in those scenarios, but wouldn’t necessarily expect energy debt to outperform. However, supply disruptions in the Middle East directly benefit US shale oil players, whose debt is principally found in the high-yield energy sector. The investment grade energy sector is less exposed to the US shale space, and its documented outperformance in the ‘Supply Driven’ scenario is weaker as a result. We already recommend an overweight allocation to high-yield bonds and a neutral allocation to investment grade corporates. Within that overweight allocation to high-yield bonds, we recommend shifting some exposure toward the energy sector for two reasons. First, high-yield energy was severely beaten-down last year and is ripe for a rebound if global economic growth recovers, as we expect (Chart 10). Second, our analysis suggests that an allocation to energy will help mitigate losses in the event of a renewed flaring of US/Iranian tensions that removes oil supply from the market. Bottom Line: We recommend that investors initiate TIPS breakeven curve flatteners (or CPI swap curve flatteners) and add exposure to the high-yield energy sector. Both positions look attractive on their own terms, but will also help hedge the risk of an oil supply disruption if US/Iranian tensions flare back up in the months ahead.   Ryan Swift US Bond Strategist rswift@bcaresearch.com Footnotes 1 The others are: the output gap, the US dollar and sentiment. For more details please see US Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com 2 The Markit index is used in the construction of the Global PMI shown in Chart 2, 3 For more details on the politics behind the US/Iran conflict please see Geopolitical Strategy Special Alert, “A Reprieve Amid The Bull Market In Iran Tensions”, dated January 8, 2020, available at gps.bcaresearch.com 4 Please see US Bond Strategy Special Report, “2020 Key Views: US Fixed Income”, dated December 10, 2019, available at usbs.bcaresearch.com 5 Please see Global Investment Strategy Weekly Report, “Elizabeth Warren And The Markets”, dated September 13, 2019, available at gis.bcaresearch.com 6 In the TIPS market, an example of a breakeven curve flattener would be to buy 2-year TIPS and short the 2-year nominal Treasury note, while also buying the 10-year nominal Treasury note and shorting the 10-year TIPS. 7 https://www.newyorkfed.org/research/policy/oil_price_dynamics_report 8 Please see US Bond Strategy Weekly Report, “Position For Modest Curve Steepening”, dated October 29, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Portfolio Strategy Gold bullion is on the move again, and falling real yields, a soft economic backdrop, a depreciating US dollar and resurgent geopolitical uncertainty, all argue for reintroducing a modest portfolio hedge by overweighting the global gold mining index. Washed out technicals, depressed valuations, the turn in our EPS growth model, rising industry capex and bottoming EM-related financial market data, all signal that it no longer pays to be bearish materials stocks. Augment exposure to neutral. Recent Changes Boost global gold miners to overweight via the long GDX/short ACWI exchange traded funds, today. Book gains and lift the S&P materials sector to neutral, today.  Table 1Sector Performance Returns (%) Feature “There is nothing so disturbing to one's well-being and judgment as to see a friend get rich.” - Charles P. Kindleberger “The bubble involves the purchase of an asset, usually real estate or a security, not because of the rate of return on the investment but in anticipation that the asset or security can be sold to someone else at an even higher price; the term the ‘greater fool’ has been used to suggest the last buyer was always counting on finding someone else to whom the stock or the condo apartment or the baseball cards could be sold.”  - Charles P. Kindleberger Equities broke out to fresh all-time highs in the second week of the year, shrugging off the flare up in geopolitical risk. It seems that nothing can derail this juggernaut and the following narrative is now prevalent: Bad news is actually good for equities because the Fed will step in and do more QE and cut interest rates anew. Good news is great because the Fed will not hike interest rates as the economy is chugging along. No news is good news as money has to flow somewhere and equities are the default answer. Kindleberger’s quotes above are instructive.      To put the recent advance in perspective, the SPX is up 425 points uninterruptedly since early October – when the Fed commenced ramping up its Treasury purchases – and it is, at a minimum, headed for a much needed breather. Contrary to popular belief, a handful of tech stocks explain this recent meteoric rise rather than a broad-based advance (Chart 1). Currently, the top five stocks in the S&P 500 (AAPL, MSFT, GOOGL, AMZN & FB) comprise over 18% of its market cap, even higher than the late-1999/early-2000 concentration (top panel, Chart 1). On January 9, 2020, AAPL’s $30bn one day market cap increase was larger than the bottom 300 stocks’ market cap in the S&P 500 and is another anecdote that drives this return concentration point home.   Chart 1Teflon Tech Stocks   As a reminder, we are neutral the broad tech sector and overweight the largest subgroup, the S&P software index, thus participating in this euphoric rise in stocks that has been defying earnings fundamentals. Granted, such phenomena are prevalent late cycle. While this can go on for a bit longer, it is clearly unsustainable and represents a big risk especially given the proliferation of passive funds. Tack on rising geopolitical risks and the odds of a sharp drawdown increase significantly. Before we proceed to our SPX EPS analysis, however, it is worth noting some disappointing economic data. The decade low in the ISM manufacturing, the deceleration in non-farm payroll growth, the grinding higher in the 4-week average of unemployment insurance claims, the contraction in C&I loans, the sustained pessimism in CEO confidence and the down hook in average hourly earnings all warn that macro headwinds abound despite the looming signing of the “phase one” US/China trade deal (Chart 2). All of the rise in the SPX last year was due to multiple expansion. Now, in order for the SPX to continue rallying, profits will have to do the heavy lifting. However, our analysis shows that the market is fully priced and earnings will have to hit escape velocity in order for equities to grow into their pricey valuations (Chart 3). Chart 2Underwhelming Chart 3Lofty Valuations Currently, our SPX EPS growth model has no pulse. This four-factor macro model is regression based (out of sample since January 2014) and continues to forecast a contraction into mid-year (Chart 4). Chart 4No EPS Pulse Table 2 summarizes three EPS scenarios analysis, along with a forward P/E multiple and SPX forecast. Table 2Three Scenarios This week we are re-instituting a small portfolio hedge, which lifts a niche deep cyclical sector to neutral from previously underweight. Step 1: We plugged into the model our base, worse and best case estimates of these four variables into mid-year, and we got as output the model’s estimate of EPS growth for end-2020 with a range of -1% to 10% (one important assumption is that the historical correlation of the movement of these variables holds steady). Step 2: Then, we applied these growth rates to the IBES 2019 EPS forecast of $162/share and arrived at our end-2020 three scenarios EPS level estimates with a range of $160/share to $178/share. Step 3: We then assigned probabilities to those three outcomes resulting in an EPS forecast of $169/share. Step 4: In order to get an SPX expected value we needed to assign a forward P/E multiple to our EPS estimate. Thus, we introduced our base, worse and best case forward P/Es (with an equal probability of occurrence) and multiplied them with our $169/share weighted EPS forecast in order to arrive at the SPX 3,049 expected value for end-2020 (please refer to the Appendix below for additional details of our analysis and click here if you would like to request the excel file and insert your own estimates and probabilities). Chart 5 depicts the results of our analysis. Chart 5Projections Currently, sell-side analysts expect 10% profit growth in calendar 2020, a tall order in our view, and the SPX appears 8% overvalued according to our analysis. However, a potential break in historical correlations where the ISM recovers, the bond market sells off fearing an inflationary spurt pushing interest rates higher yet P/E multiples continue to expand indiscriminately, could sustain the melt-up phase in stocks in general and mega cap tech stocks in particular. While the macro data cannot fall indefinitely and a natural trough will occur sometime in the first half of the year, we doubt that a V-shaped recovery is imminent. Our base case is a stabilization of macro data equating to roughly 5% EPS growth for this year as noted above, with risks clearly titled to the downside. Under such a backdrop, perceptive equities will have to, at least, mildly deflate to this EPS reality. This week we are re-instituting a small portfolio hedge, which lifts a niche deep cyclical sector to neutral from previously underweight. In Gold We Trust While the SPX has been on an impressive run, it has failed to outshine gold bullion that has been on a tear lately. The bottom panel of Chart 6 shows that gold could be sniffing out a couple of Fed interest rate cuts, warning that the economic backdrop remains frail. This gold move is compelling us to reintroduce a modest portfolio hedge and today we recommend augmenting exposure to global gold miners to overweight. Chart 6What Is Gold Sniffing Out? Global gold miners have a lot going for them. Rising global policy uncertainty plays to their strength as investors seek the refuge of safe haven assets especially when geopolitical risks flare up (top panel, Chart 7). If our FX strategists hit the bull’s eye and the greenback loses steam this year,1 then gold related equities should outperform given the inverse correlation most commodities, including bullion, enjoy with the US dollar (bottom panel, Chart 7). Chart 7Solid Backdrop Importantly, real US bond yields have taken a beating recently underpinning gold prices and gold mining equities. This is significant, as bullion yields nothing and gold miners next to nothing so from an opportunity cost perspective it pays to hold a zero yielding asset when competing yields fall and vice versa (second panel, Chart 7). Worrisomely, this fall in real US yields is de facto pushing global real yields lower, which might indicate that investors worry that the global economy has more downside. In fact, economists’ estimates for GDP growth (as compiled by Bloomberg, third panel, Chart 7) continue to decelerate globally, and they forecast below-trend real output growth in the US for 2020. Global manufacturing also reflects this soft economic backdrop. While the global manufacturing PMI is trying to trough – it ticked down last month and is just a hair above the boom/bust line – both its momentum and diffusion are weak, heralding a catch up phase in global gold miners (PMI momentum shown inverted, Chart 8). Chart 8Global Economy Not Out Of The Woods Yet Boost global gold miners to an above benchmark allocation via the long GDX/short ACWI exchange traded funds. From a gold positioning perspective, on all three fronts we monitor (gold ETF holdings, gold net speculative positions and bullish consensus on gold) we see green lights (Chart 9). Even global gold miners’ extremely overbought positions have now been worked out according to our Technical Indicator (TI). Following the parabolic bull run from May to September last year, our TI is now drifting to the neutral zone. Relative valuations have also corrected offering investors a compelling entry point (Chart 10). Chart 9Enticing Sentiment Chart 10Compelling Entry Levels In sum, gold bullion is on the move again and falling real yields, a soft economic backdrop, a depreciating US dollar and resurgent geopolitical uncertainty, all argue for reintroducing a modest portfolio hedge by overweighting the global gold mining index. Bottom Line: Boost global gold miners to an above benchmark allocation via the long GDX/short ACWI exchange traded funds. Lift Materials To Neutral While materials stocks have broken down recently, our fresh gold miners overweight lifts the broad materials sector from previously underweight to currently neutral (Chart 11). Not only have relative share prices given way, but also breadth is weak as measured both by the percentage of groups with a positive year-over-year momentum and by the number of groups trading above their 40-week moving average (Chart 12). Moreover, relative valuations are downbeat (second panel, Chart 12), with relative P/S and P/B cratering. Chart 11Breakdown On the profit front, earnings breadth fell below neutral recently and net earnings revisions have collapsed. Wall Street analysts are even forecasting a dire relative revenue backdrop for the coming twelve months (Chart 13). Chart 12Washout Chart 13Extreme Pessimism Reigns While the sell-side has all but given up on this niche deep cyclical sector, we are going against the grain and posit that it no longer pays to be bearish materials stocks. First, our materials sector profit growth model has troughed and signals that a turnaround in EPS growth is underway and should gain steam this year (second panel, Chart 14). Keep in mind that this niche deep cyclical sector has borne the brunt of the Sino/American trade war and the recent de-escalation can serve as a catalyst for an earnings-led recovery (trade policy uncertainty shown inverted, Chart 11). Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation. Second, this industry is not at a standstill. Contrary to the overall economy, materials executives are investing in new projects as financial market reported materials sector capex clearly shows (third & bottom panels, Chart 14). These investments should bear fruit in coming quarters and translate into higher top line growth, something that is not at all discounted in bombed out relative sales growth expectations (bottom panel, Chart 13). Finally, there is tentative evidence that the EMs in general and China in particular are at least stabilizing. Not only are their manufacturing PMIs above the boom/bust line (not shown), but also financial market data suggest that the selling in materials stocks is nearing exhaustion. JP Morgan’s EM currency index is ticking higher, the CRB metals index is showing some signs of life and EM equities have been outperforming their global peers (Chart 15). Chart 14EPS Model Trough, Rising Capex…   Chart 15…And Firming Financial Market Data Signal It No Longer Pays To Be Bearish Netting it all out, washed out technicals, depressed valuations, the turn in our EPS growth model, rising industry capex and bottoming EM-related financial market data all signal that it no longer pays to be bearish materials stocks. Bottom Line: Book relative gains of 5% since inception and lift the S&P materials sector to a benchmark allocation.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com       Appendix Appendix 1 Appendix 2 footnotes 1     Please see BCA Foreign Exchange Strategy Weekly Report, “On Oil, Growth And The Dollar” dated January 10, 2020, available at fes.bcaresearch.com.   Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps (Stop 10%)

Special Report

Highlights The balance of power in US labor negotiations has shifted infrequently in the industrial age: Management completely dominated labor before the New Deal, which gave rise to a 45-year labor golden age that lasted until the Reagan revolution and globalization put employers firmly back in control. Employees rarely make gains without sympathetic elected officials and judges: The New Deal was a watershed in labor relations history because it granted workers legal protections that leveled the playing field with employers. Successful strikes beget strikes: Momentum matters in labor negotiations. One union’s win may embolden other unions to strike, blazing a path for further gains by demonstrating that the price of labor peace has risen. The pendulum may be swinging back in labor’s favor: Unions still face formidable headwinds in Washington, DC and state capitals, but a run of successful strikes may signal that rumors of the labor movement's demise have been exaggerated. Feature Where will inflation come from, and when will it arrive? An investor who answers these questions will have advance notice of the end of the expansion and the bull markets in equities and credit. Per our base-case scenario, the expansion won’t end until monetary policy settings become restrictive, and the Fed won’t pursue restrictive policy unless inflation pressures force its hand. Inured by a decade of specious warnings that “money printing” would let the inflation genie out of the bottle, investors are skeptical that inflation will ever re-emerge. The inflation backdrop has become much more supportive in the last few years, however, upon the closing of the output gap, and the stimulus-driven jolt in aggregate demand. Output gaps in other major economies will have to narrow further (Chart 1) for global goods inflation to gain traction, and mild inflation elsewhere in the G7 (Chart 2) suggests that goods prices are not about to surge. Chart 1There's Still Enough Spare Capacity ... Chart 2... To Restrain Global Goods Inflation Services are not so easily imported, though, and services inflation is a more fully domestic phenomenon. Rising wages could be the spur for services inflation, and the labor market is tight on several counts: the unemployment rate is at a 50-year low; the broader definition of unemployment, also encompassing discouraged workers and the underemployed, reached a new all-time (25-year) low in December; the JOLTS job openings and quits rates at or near their all-time (19-year) highs; and the NFIB survey and a profusion of anecdotal reports suggest that employers are having a hard time finding quality candidates. With labor demand exceeding supply, wages for nonsupervisory workers have duly risen (Chart 3). Gains in other compensation series have been muted, however, and investors have come to yawn and roll their eyes at any mention of the Phillips Curve. Chart 3Wage Growth Is Solid, But It's Lost A Good Bit Of Momentum Perhaps it’s not the Phillips Curve that’s broken, but workers’ spirits. A supine organized labor movement could explain why the Phillips Curve itself is so flat. As the old saying goes, if you don’t ask, you know what you’re going to get, and beleaguered unions and their memberships, cowed by two decades of woe coinciding with China’s entry into the WTO (Chart 4), have been afraid to ask. Strikes are the most potent weapon in labor’s arsenal; if it can’t credibly wield them, it is sure to be steamrolled. Chart 4Globalization Has Been Unkind To Labor Two years of high-profile strike victories by public- and private-sector employees may suggest that the sands have begun to shift, however, and inspired our examination of labor’s muscle. This first installment of a multi-part Special Report focuses on the history of US labor relations, with an eye toward identifying themes that shape relative bargaining power. We will subsequently examine the factors influencing the propensity for labor and management militancy, with a focus on where wages are headed in the near future. The Colosseum Era (1800-1933) We view US industrial labor history as having three distinct phases. We label the first, which lasted until the New Dealers took over Washington, the Colosseum era (Figure 1), because labor and management were about as evenly matched as the Christians and the lions in ancient Rome. Uprisings in textile mills, steel factories, and mines were swiftly squelched, often violently. Management was able to draw on public resources like the police and state National Guard units to put down strikes, or was able to unleash its own security or ad hoc militia forces on strikers or union organizers without state interference. The public, staunchly opposed to anarchists and Communists, generally sided with employers. Figure 1Significant Events In The Colosseum Era Unions won some small-bore victories during the period, but they nearly all proved fleeting as companies regularly took back concessions and public officials and courts failed to enforce the loose patchwork of laws aimed at ameliorating industrial workers’ plight. Labor inevitably suffered the brunt of the casualties when conflicts turned violent. Workers were hardly choir boys, and seem to have initiated violence as often as employers’ proxies, but they were inevitably outgunned, especially when police, guardsmen or soldiers were marshaled against them. Societal norms have changed dramatically since the Colosseum era, but the lore of past “battles” encourages an us-versus-them union mentality that occasionally colors negotiations. The UAW Era (1933-1981) Established presumptions about the employer-employee relationship were upended when FDR entered the White House. Viewing labor organization as a way to ease national suffering, New Dealers passed the Wagner Act to grant private-sector workers unionization and collective bargaining rights, and created the National Labor Relations Board to ensure that employers respected them. The Wagner Act greatly aided labor organization, enabling unions to build up the heft to engage with employers on an equal footing. Unionized workers still fought an uphill battle in the wake of the Depression, but tactics like the sit-down strike (Box) produced some early labor victories that paved the way for more. The UAW signed a similar accord with Chrysler immediately after the Flint sit-down strike, and the CIO (the UAW’s parent union) swiftly reached an agreement with US Steel that significantly improved steelworkers’ pay and hours. Labor unions’ path wasn’t always smooth – Ford fiercely resisted unionization until 1941, and ten protesters were killed, and dozens injured, by Chicago police at a peaceful Memorial Day demonstration in support of strikers against the regional steelmakers that did not follow US Steel’s conciliatory lead – but it generally trended upward after the New Deal (Figure 2). From the 1950 signing of the Treaty of Detroit, a remarkably generous five-year agreement between the UAW and the Big Three automakers, the UAW ran roughshod over the US auto industry for three-plus decades. The New Deal’s encouragement of unionization had given labor a fighting chance, and was the foundation on which all of its subsequent gains were built. Figure 2Significant Events In The UAW Era Box David Topples Goliath: The Flint Sit-Down Strike The broad mass of factory workers had not been organized to any meaningful degree before the New Deal, and the United Auto Workers (UAW) was not formed until 1935. Despite federal protections, the fledgling UAW had to conduct its operations covertly, lest its members face employer reprisals. At the end of 1936, when it took on GM, only one in seven GM employees was a dues-paying member. The strike began the night of December 30th when workers in two of GM’s Flint auto body plants sat down at their posts, ignoring orders to return to work. The sit-down action was more effective than a conventional strike because it prevented GM from simply replacing the workers with strikebreakers. It also made GM think twice about attempting to remove them by force, lest valuable equipment be damaged. GM was unsure how to dislodge the workers after a court injunction it obtained on January 2nd went nowhere once the UAW publicized that the presiding judge held today’s equivalent of $4 million in GM shares. It turned off the heat in one of the plants on January 11th, before police armed with tear gas and riot guns stormed it. The police were rebuffed by strikers who threw bottles, rocks, and car parts from the plant’s upper windows while spraying torrents of water from its fire hoses. No one died in the melee, but the strike was already front-page news across the country, and the attack helped the strikers win public sympathy. Michigan’s governor responded by calling out the National Guard to prevent a rematch, shielding the strikers from any further violence. The strike was finally settled on February 11th when GM accepted the UAW as the workers’ exclusive bargaining agent and agreed not to hinder its attempts to organize its work force. The Reagan-Thatcher Era (1981 - ??) The disastrous strike by the air traffic controllers’ union (PATCO) is the watershed event that heralded the end of unions’ golden age. Strikes by federal employees were illegal, so PATCO broke the law when it went on strike in April 1981, spurning the generous contract terms its leaders had negotiated with the Reagan administration. PATCO had periodically held the flow of air traffic hostage throughout the seventies to extract concessions from its employer, earning the lasting enmity of airlines, government officials and the public. Other unions were aghast at PATCO’s openly contemptuous attitude, and declined to support it with sympathy strikes, while conservatives blasted the new administration behind closed doors for the profligacy of its initial PATCO offer. President Reagan therefore had an unfettered opportunity to make an example out of the controllers, and he seized it, firing those who failed to return to work within 48 hours and banning them from ever returning to government employment. A fed-up public supported the president’s hard line, and employers and unions got the message that a new sheriff was in town. His deputies were not inclined to enforce labor-friendly statues, or investigate labor grievances, with much vigor, and they would not necessarily look the other way when public sector unions illegally struck. Unions also found themselves on the wrong side of the growing disaffection with bureaucracy that was bound up with the push for deregulation. The globalization wave further eroded labor’s power. Unskilled workers in the developed world would be hammered by the flat world that allowed people, capital and information to hopscotch around the globe. Eight years of a Democratic presidency brought no relief, as the “Third Way” Clinton administration embraced the free-market tide (Chart 5), and the unionized share of employees has receded all the way back to mid-thirties levels (Chart 6). Chart 5Inequality Took Off ... Chart 6... As Unions Lost Their Way A Fourth Phase? A handful of data points do not make a trend, especially in a series that stands out for its persistence, but the bargaining power pendulum could be shifting. Public school teachers won improbable statewide victories with illegal strikes in three highly conservative states in the first half of 2018 (Table 1); a canny hotel workers union steered its members to big gains in their contract negotiations with Marriott in the second half of 2018; and the UAW bested General Motors and the rest of the Big Three automakers last fall. Unions may have more bargaining power than markets and employers realize, and they could be on the cusp of becoming more aggressive in flexing it. The next installment(s) in this series will examine the factors determining whether or not unions will become more assertive and the likelihood that more assertive bargaining would meet with success. Table 1Teachers' Unions Conquer The Red States Takeaways There is not sufficient space to explore those factors in this installment, but we conclude by highlighting two key themes that emerge from our historical review. US industrial history makes it clear that employees are unlikely to gain ground if government sides with employers. Employees no longer have to fear that the state will look the other way while strikers are beaten, or fail to prosecute those responsible for loss of life, but they face especially long odds when the government is inclined to favor employers. Its thumb weighs heavily on the scale when it drags its feet on enforcement; cuts funding to agencies policing workplace standards; and appoints agency or department heads that are conditioned to see things solely from employers’ perspective, shaped by long careers in management. Successful strikes beget strikes, and the converse is also true. Withholding their labor is employees’ most powerful weapon, and when employers can’t replace them cheaply and easily, strikes often succeed. Striking is frightening for an individual, however, because it cuts off his or her income (or sharply reduces it, if the striker’s union has a strike fund) until the strike is over. If the strike fails, the employee may find him/herself blacklisted, impairing his/her long-term income prospects on top of his/her short-term losses. Prudent workers should therefore strike sparingly, with the due consideration that a prudent poker player exercises before going all-in. When other unions facing comparable conditions pull off successful strikes, it makes it much easier for another union to take the leap, in addition to making success more likely, provided conditions truly are comparable. “Before they occur, successful strikes appear impossible. Afterward, they seem almost inevitable .”1 The retrospective inevitability stiffens the spine of potential strikers who observe successful outcomes, and raises the bar for action among potential strikers who observe failures. “Just as defeats in struggle lead to demoralization and resignation, victories tend to beget more victories .”2 Public opinion matters just as surely as momentum, and it proved decisive in the Flint sit-down strike and in the air traffic controllers’ showdown with President Reagan. According to Gallup’s annual poll, Americans now regard unions as favorably as they did before Thatcher and Reagan came to power (Chart 7). We will dive more deeply into the topic in our next installment, as we probe labor market conditions for insight into the direction of inflation, and its implications for Fed policy, the business cycle and markets. Chart 7Could Unions Make A Comeback?   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Blanc, Eric. Red State Revolt: The Teachers’ Strike Wave and Working-Class Politics, Verso: New York (2019), p. 204. 2 Ibid, p. 209.