Economy

Highlights Easy monetary policy is the linchpin of our 2020 market views and investment strategy, … : As we outlined in our 2020 Key Views report, easy monetary policy should extend the economic expansion and the bull markets in risk assets. ... and last week’s FOMC meeting made it crystal clear that the Fed’s default policy setting for next year is easy: The meeting came and went without much of a fuss, but the FOMC revealed that it will take a major inflation surprise to bring it off the sidelines in 2020. The labor market still has plenty of momentum, and should help keep the real economy humming, … : Through November, 2019’s average net monthly job gains are snugly within the last nine years’ range, and the JOLTS and NFIB surveys point to more hiring and accelerated wage gains. … while trade tensions are apparently less likely to derail it: Details remained vague as we went to press, but Chinese and American trade negotiators have reportedly reached a Phase 1 agreement that will be executed soon. Feature Dear Client, This is our last report of 2019. Our regular publishing schedule will resume on Monday, January 6th. We wish you a happy, healthy and prosperous new year. Chart 1The Fed Stood Down In 2019 Why bother fighting the Fed? Central bankers exert tremendous sway over the economy and markets, and although they’re hardly infallible, they typically get their way over the timeframes that most investors are judged. It’s much easier to make money going with the monetary policy flow than it is to try to resist it, because resistance is only viable when the Fed is plainly behind the curve. Consistent money-making investment strategies revolve around deploying capital when the odds are in one’s favor, and they’re stacked in favor of risk assets when policy is easy, and against them when it’s tight. We missed the latest instance when the Fed was fighting a losing battle at this time last year, when we continued to stick with our below-benchmark-duration recommendation. The money markets called for a 25-basis-point rate cut in 2019 in defiance of the FOMC, which projected 50 basis points ("bps") of hikes (Chart 1). We sided with the Fed, and wound up on the wrong side of the 10-year Treasury rally from 2.70% at the beginning of January to under 1.50% at the end of August. Since the crisis, however, BCA has remained squarely in the easier-for-longer monetary policy camp, which has led us to recommend overweighting stocks throughout the longest US equity bull market on record. The importance of the Fed’s influence was all over the 2020 outlook we laid out last week. The common thread linking our market views and investment strategy is the expectation that monetary policy settings will remain amply accommodative until the election is over. Easy monetary conditions are not confined to the US; major central banks around the world are deliberately pursuing reflationary policy. With the wind of an additional year of generous accommodation filling their sails, we expect that equities and spread product will easily outperform Treasuries and cash in 2020. The Latest From The Fed Chart 2Same Outlook, Fewer Hikes The run-up to last week’s FOMC meeting was devoid of suspense, but members’ dot-plot projections and Chair Powell’s press conference supported our sense that promoting higher inflation expectations is the Fed’s foremost priority. Our base case remains that the Fed will stay on hold at least until its November meeting. Although the Fed remains at pains to remind investors that policy is not on a preset course, the committee clearly expects the growth-without-inflation sweet spot will last through 2020 and beyond. As a group, the 17 FOMC members dialed back their rate-hike expectations from the September meeting, rescinding a net 13 votes for 25-bps hikes in 2020 (Chart 2, top panel) and 7 in 2021 (Chart 2, bottom panel). Several of Powell’s comments at the press conference reinforced the take that the Fed is on hold for the foreseeable future. In his prepared remarks, he repeated the message from the July, September and October meetings that the Fed has not yet accomplished its full-employment mandate. “[W]ages have been rising, particularly for lower-paying jobs. [I]n low- and middle-income communities, … many who have struggled to find work are now finding new opportunities. [Broad-based employment gains] underscore … the importance of sustaining the expansion so that the strong job market reaches more of those left behind.” When the chair says that unemployment can be a full percentage point below NAIRU for an extended period without generating "unwanted upward pressure on inflation," ... He characterized low inflation as a mixed blessing, and was more explicit about the need to get it higher than he was in the past three meetings, when the committee actually cut rates. “While low and stable inflation is certainly a good thing, inflation that runs persistently below our objective can lead to an unhealthy dynamic in which longer-term inflation expectations drift down, pulling actual inflation even lower. In turn, interest rates would be lower as well and closer to their effective lower bound. As a result, the scope for interest rate reductions to support the economy in a future downturn would be diminished, resulting in worse economic outcomes for American families and businesses. … We are strongly committed to achieving our symmetric 2 percent inflation goal.” In the Q&A segment of the press conference, Powell amplified the boilerplate employment language with repeated assertions that the labor market still has some slack. [W]e think we’ve learned that unemployment can remain at quite low levels for an extended period of time without unwanted upward pressure on inflation. In fact, we need some upward pressure [on] inflation to get back to 2 percent. … [E]ven though we’re at three-and-a-half percent unemployment, there’s actually more slack out there. … I’ll say that the labor market is strong. I don’t know that it’s tight because you’re not seeing wage increases[.] … Ultimately[,] … to call it hot, you’d want to see heat. You’d want to see … higher wages. That take contrasts with the Congressional Budget Office’s 4.6% NAIRU estimate, but NAIRU is only a concept. To this point, the economy has been supporting an unemployment rate in the low-3s without overheating, and economists will only have a clear idea of where NAIRU is today well after the fact. The relevant point for investors is that an FOMC that believes the natural rate of unemployment is below its current 50-year low is an FOMC that has sworn off proactive tightening. ... you know the FOMC isn't going to tighten policy pre-emptively. The chair also elaborated on the inflation mandate by saying that “a significant move up in inflation that’s also persistent” is a personal prerequisite for tightening policy. Our US Bond Strategy colleagues interpret “persistent” as meaning that inflation expectations have to get back to the 2.3-2.5% range that is consistent with the Fed’s 2% inflation target. Taken together, the prepared remarks, the Q&A and the fairly significant downward adjustment in the dots – absent any change in the outlook – suggest that the Fed’s reaction function has shifted materially. It will take a significant pickup in inflation, or undeniable signs of froth in the financial markets, for the Fed to tighten policy. The Labor Market Remains On Track November marked the record 110th consecutive month that net nonfarm payrolls have expanded, and the rest of the employment situation report confirmed that the jobs machine continues to motor along eleven years into the expansion (Chart 3). The annual job gains have not been as large as they often were in the 1991-2001 expansion, but they have been remarkably steady since 2011, averaging an even 200,000 net additions per month without once dipping below 170,000 for a full year (Chart 4). The unemployment rate fell back to the 3.5% 50-year low first reached in September, and the broader unemployment rate, capturing discouraged workers and involuntary part-time workers, is just a tick above the dot-com boom’s 6.8% low (Chart 5). Chart 3The Job Gains Haven't Been As Big As They Were In The '90s, ... Chart 4... But They've Been Remarkably Steady Chart 5All Unemployment Measures Are Extremely Low Neither the JOLTS nor the NFIB survey offers any indication that employment gains are about to dry up. JOLTS job openings have exceeded the number of unemployed workers since early 2018, and job openings as a share of overall employment remain way above the last cycle’s peak (Chart 6). The NFIB survey’s share of small businesses with unfilled job openings is similarly extended (Chart 7, top panel), and the diffusion index of firms planning to expand payrolls in the next three months is around its dot-com highs (Chart 7, middle panel). Hiring momentum appears as if it will remain solid over the visible horizon. Chart 6Survey Says ... With labor demand exceeding readily available supply, wage gains ought to accelerate. The prime-age employment-to-population ratio remained at an 11-year high last month, shy of only its dot-com boom highs (Chart 8). The Phillips Curve using the prime-age employment-to-population ratio is not kinked, and exhibits a strong correlation with compensation gains (Chart 9). Chart 7... More Jobs Are On The Way Chart 8Prime-Age Employment Is Back To Its Pre-Crisis Peak   Average hourly earnings for production and nonsupervisory employees, which comprise about 80% of the labor force, have already been growing at a 3.7-3.8% clip, and the Conference Board’s consumer confidence survey (Chart 10, middle panel) and the quits rate (Chart 10, bottom panel) suggest that they can keep climbing. So, too, does the Fed’s pivot; it usually tightens policy to slow the economy when real wage gains reach today’s levels, but now it appears bent on abetting further gains (Chart 10, top panel). Chart 9There Will Be Upward Pressure On Wages, ... Bottom Line: The labor market is strong, and poised to stay that way for the immediate future, especially given that the Fed seems to be egging it on in an attempt to boost inflation expectations and spread the expansion’s gains more evenly. Chart 10... And The Fed Doesn't Mind At All Investment Implications A robust labor market should keep household income growing nicely, and fortified balance sheets will enable households to spend much of their income gains, supporting consumption. Government spending is certain to support the economy ahead of a hotly contested election. We have worried about volatile fixed investment’s potential to stymie growth, largely because of concerns that the uncertainty surrounding trade tensions could cause corporations to pull back on capex until they get a better sense of the rules of the road. The apparent breakthrough in the US-China trade negotiations may resolve some of that uncertainty. With the Fed seemingly settling in for an extended period of holding the target fed funds rate at 1.75%, the risk to our view may be that we’re being insufficiently bullish on the markets. Another year of generous accommodation, here and abroad, is likely to keep life insurers, pension funds and endowments avidly searching for yield. It will be hard to default while that search is afoot, and it will also be hard for spreads to widen in an appreciable way. The combination should allow spread product to continue to generate excess returns over Treasuries and cash, though we echo our US Bond Strategy colleagues’ preference for high-yield over investment-grade corporates. Easy policy also supports equity outperformance. Global ex-US acceleration will benefit international indexes more than US indexes, but US equities will still generate attractive absolute returns. S&P 500 earnings will pick up a little as the rest of the world begins to stir, though truly juicy equity returns will require multiple expansion. We are not yet ready to call for a couple of points of re-rating, but note that it would be consistent with the monetary policy backdrop, the historical sprint-to-the-finish equity bull market pattern, and investors’ need for investment destinations in a persistently low-yield world.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com

Special Report

Feature The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Every decade a dominant theme captures investors’ imaginations and morphs into a bubble. Massive speculation typically propels the relevant asset class into the stratosphere as investors extrapolate the good times far into the future and go on a buying frenzy. Chart 1 shows previous manic markets starting with the Nifty Fifty, gold bullion, the Nikkei 225, the NASDAQ 100, crude oil and most recently the FAANGs. Chart 1Manias: An Historical Roadmap What will be the dominant themes of the next decade? How should investors capitalize on some of these big trends? The purpose of this Special Report is to identify and provoke a healthy debate on the prevailing investment themes for the 2020s and to speculate on what the key US sector beneficiaries and likely losers may be. Theme #1: De-Globalization Picks Up Steam The first investment theme for the upcoming decade is the “apex of globalization” or “de-globalization”. We have written about this theme extensively at BCA Research and it is the mega-theme of our sister Geopolitical Strategy (GPS) service. Odds are high that countries will continue looking inward as the US adopts a more aggressive trade policy, China’s trend growth slows, and US-China strategic tensions intensify. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Chart 2 shows that we are at the conclusion of a period of tranquility. Pax Americana underpinned globalization as much as Pax Britannica before it. The US is in a relative decline after decades of geopolitical stability allowed countries like China to rise to “great power” status and rivals like Russia to recover from the chaos of the 1990s. Chart 2De-globalization Has Commenced De-globalization has become the consensus since the election of Donald Trump. But Trump is not the prophet of de-globalization; he is its acolyte. Globalization is ending because of structural factors, not cyclical ones. And its decline was pre-written into its “source code.” Three factors stand at the center of this assessment, outlined in our 2014 Special Report, “The Apex Of Globalization – All Downhill From Here”: multipolarity, populism and protectionism. Events have since confirmed this view. The three pillars of globalization are the free movement of goods, capital, and people across national borders. We expect to see marginally less of each in the future. Investment Implication #1: Profit Margin Peak The most profound and provocative investment implication from de-globalization is that SPX profit margins have peaked and will likely come under intense pressure, especially for US conglomerates that – on a relative basis to international peers – most enthusiastically embraced globalization. Reconstructed S&P 500 profits and sales data date back to the late-1920s. Historically, corporate profit margins and globalization (depicted as global trade as a percentage of GDP) have been positively correlated (Chart 3). Chart 3Profit Margin Trouble As countries are more outward looking, trade flourishes and openness to trade allows the free flow of capital to take advantage of profit-maximizing projects. Following the Great Recession and similar to the Great Depression, trade has suffered and trade barriers have risen. The Sino-American trade war has accelerated the inward movement of countries, including Korea and Japan, and has had negative knock-on effects on trade as evidenced by the now two-year old global growth deceleration. China’s response to President Trump’s election was to redouble its pursuit of economic self-sufficiency, which meant a crackdown on corporate debt and a fiscal boost to household consumption. Trump’s tariffs then damaged sentiment and trade between the two countries. Any deal reached prior to the 2020 US election will remain in doubt among global investors. The longer the trade war remains unresolved, the deeper the cracks will be in the foundations of the global trading system. Such a backdrop is negative for profit margins, as inward looking countries prevent capital from being allocated most efficiently. Moreover, the uprooting of supply chains due to the trade war hurts margins and the redeployment of equipment in different jurisdictions will do the same at a time when final demand is suffering a setback. In addition, rising profit margins are synonymous with wealth accruing to the top 1% of US families and vice versa. This relationship dates back to the late-1920s, as far back as our dataset goes. Using Piketty and Saez data, which exclude capital gains, it is clear that profit margin expansion exacerbates income inequality (top panel, Chart 4). Chart 4Heightened Risk Of Wealth Re-distribution Expanding margins lead to higher profits. Because families at the top of the income distribution are more often than not business owners, income disparities are the widest when margins are in overshoot territory. Eventually this income chasm comes to a head and generates political discontent. Populism has emerged on both the right and left wings of the US political spectrum – and since the rise of Trump, even Republicans complain about inequality and the excesses of “corporate welfare” and laissez-faire capitalism. Because inequality is extreme – relative to America’s developed peers – and political forces are mobilizing against it, the probability of wealth re-distribution is rising in the coming decades (middle panel, Chart 4). Labor’s share of national income has nowhere to go but higher in coming years and that is negative for profit margins, ceteris paribus (bottom panel, Chart 4). Drilling beneath the surface, the three secular US equity sector/factor implications of the apex of globalization paradigm shift are: prefer small caps over large caps prefer value over growth overweight the pure-play BCA Defense Index Investment Implication #2: Small Is Beautiful While a small cap bias is contrary to the cyclical US Equity Strategy view of preferring large caps to small caps, the issue is timing: the small cap preference is a secular view with a time horizon that spans the next decade. The small versus large cap share price ratio’s ebbs and flows persist over long cycles. Small caps outshined large caps uninterruptedly from 1999 to 2010. Since then large caps have had the upper hand (Chart 5). Were the apex of globalization theme to gain traction in the 2020s, small caps should reclaim the lead from large caps, especially in the wake of the next US recession. Similar to the death of the global banking model, companies with global footprints will suffer the most, especially compared with domestically focused outfits. One way to explore this theme is via domestic versus global sector preference. But a more investable way to position for this sea change, is to buy small caps (or microcaps) at the expense of large caps (or mega caps). Small caps are traditionally domestically geared compared with large caps that have significantly more foreign sales exposure. Chart 5It’s A Small World After All The closest ETF ticker symbols resembling this trade is long IWM:US/short SPY:US. Investment Implication #3: Buy Value At The Expense Of Growth Similar to the size bias, the style bias also moves in secular ways. Value outperformed growth from the dot com bust until the GFC. Since then growth has crushed value, even temporarily breaking below the year 2000 relative trough. This breakneck pace of appreciation for growth stocks is clearly unsustainable and offers long-term oriented investors a compelling entry point near two standard deviations below the historical mean (Chart 6). Chart 6Value Has The Upper Hand Versus Growth Financials populate value indexes, a similarity with small cap outfits. Traditionally, financials are a domestically focused sector with export exposure registering at half of the S&P’s average 40% level of internationally sourced revenues. On the flip side, tech stocks sit atop the growth table and they garner 60% of their revenue from abroad. This value over growth style preference will pay handsome dividends if the de-globalization theme becomes more main stream as countries become more hawkish on trade and the Sino-American war continues to erect barriers to trade that took decades to lift. The caveat? If President Trump strikes a short-term deal with China ahead of the 2020 election, the de-globalization theme will suffer a setback. But our geopolitical strategists expect a ceasefire at best, not a durable deal, and also expect the trade war to resume in some way, shape or form in 2021-22, regardless of the outcome of the US election. The closest ETF ticker symbols resembling this trade is long IVE:US/short IVW:US.  Investment Implication #4: Defense Fortress One final long-term playable investment idea from the apex of globalization is a structural bull market in defense stocks (Chart 7). Our October 2016 “Brothers In Arms” Special Report drew parallels with the late nineteenth century period of European rearmament, and the American and Soviet arms race of the 1960s. These movements were greatly beneficial to the aerospace and defense industry. Currently, the move by several countries to adopt more independent foreign policies, i.e. to move away from collaboration and cooperation toward isolationism and self-sufficiency, entails an accompanying arms race. Chart 7Stick With Pure-play Defense Stocks Table 1 China’s challenge to the regional political status quo motivates a boost to defense spending globally. In fact SIPRI data on global military spending by 2030 (Table 1) increases our conviction that this trade will succeed on a five-to-ten year horizon. Beyond the global arms race, two additional forces are at work underpinning pure-play defense contractors. A global space race with China, India and the US wanting to have manned missions to the moon, and the rise of global cybersecurity breaches. Defense companies are levered to both of these secular forces and should be prime sales and profit beneficiaries to rising space budgets and increasing cybersecurity combat budgets. The ticker symbols for the stocks in the pure-play BCA defense index are: LMT, RTN, NOC, GD, HII, AJRD, BWXT, CW, MRCY. Theme #2: Tech Sector Regulation, US Enacts Privacy Laws The second long-term geopolitical theme that we are exploring is the regulatory or “stroke of pen” risk that is rising on FAANG stocks – Facebook, Apple, Amazon, Netflix, and Google. These companies were this decade’s undisputed stock market winners. The US anti-trust regulatory framework was designed to curb broad anti-competitive actions of trusts. As Lina Khan discusses in her seminal article, these actions “include not only cost but also product quality, variety, and innovation.” However, through subsequent regulatory evolution, the Chicago School has focused the US anti-trust process on consumer welfare and prices. If President Reagan and the courts could change how anti-trust laws were administered in the 1980s, so too can future administrations and courts. Today the US Congress, on both sides of the aisle, is looking into regulatory tightening, while the judicial system will take longer to change its approach. Moreover, the impetus for tougher anti-trust policy is here. It comes from a long period of slow growth, income inequality, and economic volatility – such as in the 1870s-80s. This was certainly the case for Standard Oil in 1911, which became a nation-wide boogeyman despite most of its transgressions occurring in the farm belt states. Today, income inequality is a prominent political theme and source of consumer discontent. A narrative is emerging – which will be super-charged during the next recession – that growth has been unequally distributed between the old economy and the twenty-first century technology leaders. With regard to privacy, the news is equally grim for large tech outfits. The EU General Data Protection Regulation (GDPR), which came into force on May 2018, imposes compliance burdens on any company handling user data. In the US, California has signed its own version of the law – the Consumer Privacy Act – which will go into effect in January 2020. These laws give consumers the right to know what information companies are collecting about them and what companies that data is being shared with. They also allow consumers to ask technology companies to delete their data or not to sell it. While tech companies are likely to fight the new California law, and the US court system is a source of uncertainty, we believe the writing is on the wall. The EU is by some measures the largest consumer market on the planet. California is certainly the largest US market of the states. It is unlikely that the momentum behind consumer protection will change, especially with the EU and California taking the lead. The odds of a federal privacy law, following in the footsteps of the Consumer Privacy Act, are also rising. Investment Implication #5: Shun Interactive Media & Services Stocks These risks introduce a severe overhang for FAANG stocks. We are especially worried for the S&P interactive media & services index that includes GOOGL and FB. Tack on the threat of federal regulation and this represents another major headwind for profits and net profit margins that are extremely elevated for these near monopolies. Given that advertising revenue is crucial to the business model of social media companies (GOOGL and FB included), a significant uptick in privacy regulation will likely hurt their bottom line. With regard to profit margins, tech stocks in general command a profit margin twice as high as the SPX. Specifically, FB and GOOGL enjoy margins that are 500 basis points higher than the broad tech sector (Chart 8)! This is unsustainable and will likely serve as easy prey for policymakers. Our view does not necessarily call for breaking up these monopolies. The US will have to weigh the economic consequences of anti-trust policy in a context of multipolarity in which China’s national tech champions are emerging to compete with American companies for global market share. Nevertheless increased regulation is inevitable and some forced sales of crown jewel assets may take place. Moreover, the threat of a breakup will lurk in the background, creating uncertainty until key legislative and judicial battles have already been fought. That will take years. Finally, we doubt the tech sector will be left alone to “self-regulate” its incumbents and negotiate a price on consumers’ privacy. More likely, a new privacy law will loom overhead, serving as a negative catalyst for profit growth. Uncertainty will weigh on the S&P interactive media & services relative performance. Chart 8Regulation Will Squeeze Tech Margins The ticker symbols to short/underweight the S&P interactive media & services index are an equally weighted basket of GOOGL and FB (they command a 98% market cap weight in the index). Theme #3: SaaS, Artificial Intelligence, Augmented Reality And Autonomous Driving Are Not Fads The third big theme that will even outlive the upcoming decade is the proliferation of software as a service (SaaS). The move to cloud computing and SaaS, the wider adoption of artificial intelligence, machine learning, autonomous driving and augmented reality are not fads, but enjoy a secular growth profile. In the grander scheme of things today’s world is surrounded by software. Millions of lines of code go even into gasoline powered automobiles, let alone electric vehicles. Autonomous driving is synonymous with software, the Internet of Things (IoT) needs software, the space race depends on software, modern manufacturing and software are closely intertwined, phone calls for quite some time have been a software solution, and the list goes on and on. This tidal effect is hard to reverse and is already embedded in workflows across industries. Opportunities to penetrate health care and financial services more deeply remain unexplored and it is difficult to envision another competing industry unseating “king software”. These secular trends are not only productivity enhancing, but will also most likely prove recession-proof. When growth is scarce investors flock to any source of growth they can come by and we are foreseeing that when the next recession arrives, investors will likely seek shelter in pure play SaaS firms. Investment Implication #6: Software Is Eating The World Buying software stocks for the long haul seems like a bulletproof investment idea. But the recent stellar performance of software stocks that has moved valuations to overshoot territory. Our recommended strategy is to buy or add software stock exposure on any weakness with a 10-year investment time horizon. All of these secular trends have pushed capital outlays on software into a structural uptrend. Software related capex is not only garnering a larger slice of the tech spending budgets but also of the overall capex pie. If it were not for software capex, the contraction in non-residential investment in recent quarters would have been more severe (Chart 9). Private sector software capex is near all-time highs as a share of total outlays. Government investment in software is also reaccelerating at the fastest pace since the tech bubble. When productivity gains are anemic, both the business and government sectors resort to software upgrades in order to boost productivity. Cyber security is another more recent source of software related demand as governments around the globe are taking such risks extremely seriously (bottom panel, Chart 9). Given this upbeat demand backdrop and ongoing equity retirement, software stocks are primed to grow into their pricey valuations. Chart 9Software Is Eating The World Finally, this long-term trade will also serve as a hedge to the short/underweight position we recommend in the S&P interactive media & services index. The closest ETF ticker symbol resembling the S&P software index is IGV:US. Theme #4: Millennials Already Are The Largest Cohort And Will Dominate Spending The fourth long-term theme we anticipate will gain traction in the 2020s is the demographic rise of the Millennial generation. Much has been made of preparing for the arrival of the Millennial generation, accompanied by well-worn stereotypes of general "failure to launch" as they reach adulthood. However, "arrival" is a misnomer as this age cohort is already the largest and "failure" is simply untrue. According to the U.S. Census Bureau, Millennials are the US’s largest living generation. Millennials (or Echo Boomers) defined as people aged 18 to 37 (born 1982 to 2000), now number more than 80mn and represent more than one quarter of the US’s population. Baby Boomers (born 1946 to 1964) number about 75mn. Stealthily becoming the largest age group in the US over the last few years, Millennials per-year-birth-rate peaked at 4.3mn in 1990. Surprisingly, the pace matched that of the post-war Baby Boom peak-per-year-birth-rate in 1957 - the per-year average over the period was higher for the Baby Boomers (Chart 10). Chart 10Millennials Are The Largest Cohort This gap is now set to grow rapidly as the death rate of Baby Boomers accelerates. What is more, the largest one-year age cohort is only 25 years old, thus, Millennials will be the dominant generation for many years. It is unclear how these “kids” will impact the market as they become the most important consumers, borrowers and investors, but make no mistake: this is a seismic shift in economic power and it is here to stay. The Echo Boom is a big, generational demographic wave. A difficult and painful delay has not tempered its looming importance. Finally, this wave of echo-boomers is educated, relatively unburdened by debt (please see BOX in the June 11, 2018 Special Report on demystifying the student debt load as it pertains to Millennials), and as they inevitably “grow up”, form new households and have kids. They will borrow, spend, earn, but not necessarily save and invest to the same extent as the Boomers. And this will be an important long-term theme going forward. Near term we might already be seeing signs of their arrival and firms have begun to pivot accordingly. Investment Implication #7: Buy The BCA Millennials Equity Basket Millennials will boost consumption spending in a number of different ways. The relatively unburdened Millennial cohort will be entering prime home acquisition age soon and this should underpin the long-term prospects of the US housing market and derivative industries. Further, Millennials consume differently from their parents; social media, online shopping and smart phones are not the consumption categories of the Baby Boomers. With this in mind, we have created a basket of ten stocks that we think will be driven over the long term by the demographic rise of the Millennial. We note that these stocks are heavily weighted to the technology and consumer discretionary sectors, which is logical as Millennial consumption habits tend to be discretionary focused and technology-based. Beginning with consumer discretionary, we are highlighting AMZN, NFLX and SPOT as core holdings in our Millennials basket. AMZN’s heft dwarfs consumer discretionary indexes but it could fall in several categories; the acquisition of Whole Foods makes it a Millennials-focused consumer staples retailer and its cloud computing web services segment is a tech leader. NFLX and SPOT represent the means by which Millennials consume media, by streaming movies and music over the internet. The idea of owning physical media is rapidly becoming an anachronism. The home ownership themes noted in the report above lead us to add HD and LEN to the basket. Millennials are “doers” and are set to be the dominant DIYers in the next few years, making HD a logical choice. LEN, as the nation’s largest home builder, should benefit from the Millennials coming of age into home buyers. We are also adding TSLA to our basket as a lone clean tech-oriented equity. TSLA capitalizes on the increasing shift to clean energy of Millennials (the key reason why no traditional energy companies have a spot in our basket). The technology stocks in our Millennials basket are AAPL, UBER (which replaces FB as of today) and MSFT, together representing more than 9% of the total value of the S&P 500. AAPL’s inclusion in the list is predictable as the leading domestic purveyor of devices on which Millennials consume media content. FB is a predictable holding, with more than half of all Americans being monthly active users, dominated by the Millennial cohort. It has served our basket well since inception, but today we are compelled to remove it and replace it with UBER. UBER is a Millennial favorite and the epitome of the sharing economy. In reality UBER is a logistics company and while it is losing money it is eerily reminiscent of AMZN in its early days. Maybe UBER will dominate all means of transportation and its ease of use will propel it to a mega cap in the coming decade. Our inclusion of MSFT is based on its leadership in cloud computing, a rapidly growing industry. We expect the connectivity and mobile computing demands of Millennials will accelerate. The last stock we are adding to our basket is also the only financial services equity. Though avid consumers, Millennials have shown an aversion to cash, preferring card payment systems, including both debit and credit-based. Accordingly, we are adding the leader in both of these, V, to our Millennials basket (Chart 11). Chart 11Buy BCA’s Millennial Equity Basket Investors seeking long term exposure to stocks lifted by the supremacy of the Millennial generation should own our Millennial basket (AAPL, AMZN, UBER, HD, LEN, MSFT, NFLX, SPOT, TSLA, V). We would not hesitate to add other sharing economy stocks, including Airbnb, to this basket should they become investable in the near future. Theme #5: ESG Becomes Mainstream Investors are increasingly looking at allocating assets based on environmental, social, and governance (ESG) considerations, and this mini-theme has the potential to become a big trend in the 2020s. There are a number of factors that underpin ESG investing. First, Millennials are climate conscious and given that they already are the largest cohort in the US they will not only dominate spending, but also influence election results. Moreover, via social media Millennials can sway public opinion and participate in the ESG conversation. Second, ECB President Christine Lagarde recent speech to the Economic and Monetary Affairs Committee of the European Parliament is a must read.1 If the ECB were to explicitly focus on climate change policy as part of its monetary policy operations then this is a game changer. Green investment financing including “green bonds” could become mainstream. Keep in mind the as reported in the FT “the European Parliament has declared a climate emergency; the new European Commission (EC) has taken office on a promise of an imminent “green new deal”, and Commission president Ursula von der Leyen has vowed to accelerate emissions cuts.” Last Wednesday, the EC released “The European Green Deal” with a pretty aggressive time table. The EC president said “The green deal is Europe’s man on the moon moment” and presented 50 policies slated to get rolled by 2022 to meet revamped climate goals. The implication is that once ESG takes center stage at a number of these institutions it will be easier to become mainstream and propagate the world over. Third, large institutional investors are starting to adopt an ESG mindset, especially pension plans. These investors with trillions of dollars at their disposal can not only disfavor fossil fuel investment, but also undertake investments in “green projects” via private and public equity markets. Banks are also moving in the “greening of finance” direction and given that they are the pipelines of the global plumbing system, swift adoption will go a long way in taking ESG mainstream. Finally, the electric vehicle (EV) proliferation is another key driver on how the ESG theme will play out in the 2020s. As a reminder, in the US 50% of all energy consumption is gasoline related linked to automobiles. While battery technology still has limitations, EV is no longer a fad as the German and Japanese automakers are starting to make inroads on TSLA. These car manufacturers do not want to be left out, especially if this shift toward EV becomes mainstream in the 2020s. The Chinese are not far behind on the EV manufacturing front, however government policy can really become a game changer. If a number of countries and/or California mandate a large share of all new vehicles sold be EV, then the investment implications will be massive. Investment Implication #8: Avoid Fossil Fuels, Gambling, Alcohol And Tobacco… While there are a few ESG related ETFs, we would rather explore this theme’s investment implications of sectors to avoid in the coming decade. We are believers that ESG criteria will continue to gain in importance in institutional investment management decisions. Accordingly, we would tend to avoid ‘sin stocks’, including gambling, tobacco and alcohol; demand for their services is unlikely to decline but investment weightings should mean that share prices will underperform. Further, we think a clean energy shift will mean energy stocks will likely continue to be long-term underperformers (Chart 12). Chart 12Areas To Avoid As ESG Becomes Mainstream Final Thoughts On The US Dollar In this report, we tried to focus on the upcoming decade’s big themes that we deem will play out, and centered recommendations on US equities/sectors. We do not want to neglect some macroeconomic variables that tend to mean revert over time. Specifically, the US dollar, interest rates and most importantly US indebtedness, will also be key drivers of investment theses in the 2020s. Currently, debt is rising faster than nominal GDP growth with the government and non-financial business debt-to-GDP profiles on an unsustainable path (second panel, Chart 13). Granted, the saving grace has been generationally low interest rates as the debt service ratios have fallen (top panel, Chart 13). However, if the four decade bull market in Treasury bonds is over, or may end definitively with the next US recession sometime in the early 2020s, then rising interest rates are the only mechanism to concentrate CEOs’ and politicians’ minds. On the dollar front, Chart 14 highlights the ebbs and flows of the trade-weighted US dollar since it floated in the early-1970s. The DXY index has moved in six-to-ten year bull and bear markets. The most recent trough was during the depths of the Great Recession, while the (tentative?) peak was in late-2016. If history repeats, eventually the dollar will mean revert lower in the 2020s, especially given the fiscal profligacy of the current administration that may continue into 2024, assuming President Trump gets re-elected next November. Chart 13Unsustainable Debt Profiles Chart 14Greenback’s Historical Ebbs And Flows The US dollar remains the reserve currency of the world today, but that exorbitant privilege is clearly fraying on the edges as the balance-of-payments dynamics are heading in the wrong direction. Over the next five years, the US Congressional Budget Office (CBO) estimates that the US budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit then stabilizes (usually happens when global growth improves), this will pin the twin deficits at 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. The US saw its twin deficits swell to almost 13% of GDP following the financial crisis, but the difference then was that in the wake of the commodity boom the dollar was cheap (and commodity currencies overvalued). The subsequent shale revolution also greatly cushioned the US trade deficit. Shale productivity remains robust and US output will continue to rise, but the low-hanging fruit has already been plucked.   Another dollar-negative force is its expensiveness. By rising 35% since its trough, the USD has sapped the competitiveness of the US manufacturing sector, which is accentuating the American trade deficit outside of the commodity sector. If the ESG trend ends up hurting oil prices, the US current account will follow the widening deficit in manufactured products. Moreover, the US is lagging Europe on the green revolution. Either the US will have to import green technologies, or the US government will have to provide more subsidies to the private sector. Either way, both of these dynamics will hurt the US current account deficit further. Historically, the currency market is the main vehicle to correct such imbalances. Chart 15Twin Deficits Will Weigh On The US Dollar The apex of globalization will also hurt the greenback. In a world where all the markets are integrated, borrowers in EM nations often use the reserve currency to issue liabilities at a lower cost. This boosts the demand by EM central banks for US dollar reserves to protect domestic banking systems funded in USD. Moreover, some countries like China implement pegs (both official and unofficial) to the US dollar in order to maintain their competitiveness and export their production surpluses to the US. To do so they buy US assets. If the global economy becomes more fragmented and the Sino-US relationship continues to deteriorate structurally as we expect, then these sources of demand for the dollar will recede. Overlay the widening US current account deficit, and you have the perfect recipe for a depreciating trade-weighted US dollar. Finally, the US is likely to experience more inflation than the rest of the world following the next recession. The US economy has a smaller capital stock as a share of GDP than Europe or Japan, and American demographics are much more robust. This means that the neutral rate of interest is higher in the US than in other advanced economies. As a result, the Fed will have an easier time generating inflation by cutting real rates than both the ECB and the BoJ. Higher inflation will ultimately erode the purchasing power of the dollar and prove to be a structurally negative force for the USD.   Anastasios Avgeriou US Equity Strategist anastasios@bcaresearch.com Matt Gertken Geopolitical Strategist mattg@bcaresearch.com Marko Papic Chief Strategist, Clocktower Group marko@clocktowergroup.com Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Mathieu Savary The Bank Credit Analyst mathieu@bcaresearch.com   References Please click on the links below to view reports: Peak Margins - October 7, 2019 The Polybius Solution - July 5, 2019 War! What Is It Good For? Global Defense Stocks! - October 31, 2018 The Dollar: Will The U.S. Invoke A "Nuclear" Option? - August 30, 2018 Is The Stock Rally Long In The FAANG? - August 1, 2018 Millennials Are Not Coming Of Age; They Are Already Here - June 11, 2018 Brothers In Arms - October 31, 2016 The End Of The Anglo-Saxon Economy?  - April 13, 2016 Apex of Globalization  - November 12, 2014 Footnotes 1           https://www.imf.org/en/News/Articles/2019/09/04/sp090419-Opening-Statement-by-Christine-Lagarde-to-ECON-Committee-of-European-Parliament

Special Report

Highlights Go short the DXY index with a target of 90 and a stop loss of 100. The top-performing G10 currencies in 2020 will be the NOK and SEK. Remain short USD/JPY as portfolio insurance. USD/JPY and the DXY are usually positively correlated. A weak dollar will lend support to gold prices. Gold will also benefit from abundant liquidity and persistently low/negative real rates. EUR/USD should touch 1.18, while GBP/USD will retest 1.40. There are abundant trade opportunities at the crosses. Our favorites are long AUD/NZD and short CAD/NOK. Feature The DXY index has been trading on the weaker side in recent months and is breaking below the upward-sloped channel in place since the middle of last year. In a nutshell, the performance of the dollar DXY index has been unimpressive for this year (Chart 1). The decisive break down represents an important fundamental shift, since the next level of support lies all the way towards the 90-92 zone. Given additional confirmation from a few of our indicators in recent weeks, we are selling the DXY at current levels, with a tight stop at 100. Chart 1A Report Card On Currency Performance Green Shoots On Global Growth Frequent readers of our bulletin are well aware of the observation that the dollar is a countercyclical currency. As such, when global growth is rebounding, more cyclical economies benefit most from this growth dividend. This tends to weaken the dollar. Recent data confirms that this trend remains firmly intact. We expect continued improvement in both the ISM and global manufacturing PMI, but for now, the message is that the epicenter of the growth recovery is from outside the US. Chart 2Major Dollar Tailwinds Have Peaked We expect continued improvement in both the ISM and global manufacturing PMI, but for now, the message is that the epicenter of the growth recovery is from outside the US (Chart 2). This has typically been synonymous with a lower dollar. In the euro area, the expectations components of the ZEW and Sentix surveys continue to outpace current conditions, which tends to lead European PMIs by about six months. It is becoming more and more evident that we will be out of a manufacturing recession in the euro area early next year (Chart 3). Chinese imports surprised to the upside for the month of November, in line with the message from easing in financial conditions (Chart 4). Should stimulus continue to be frontloaded into next year, this should continue to support global growth. The perk-up in copper prices is a good confirmatory signal. Chart 3A V-Shaped Recovery In European Manufacturing Chart 4Chinese Growth Will Benefit From Stimulus Japanese GDP saw a big upward revision for the third quarter, and a few leading indicators suggest nascent green shoots despite the October consumption tax hike. A new fiscal package was announced recently and should go a long way in boosting domestic demand (Chart 5). Chart 5Japanese Growth Chart 6USD/SEK Has Peaked The currencies of small, open economies such as the SEK and the NZD have started to stage meaningful reversals. These currencies are usually good at sensing shifts in the investment landscape, and our suspicion is that they were primary funding vehicles for long USD trades (Chart 6). The slowdown in the global economy has been driven by the manufacturing sector, so it is fair to assume that this is the part of the economy that is ripe for mean reversion. Not to mention, cyclical swings in most economies tend to be driven by manufacturing and exports rather than services. More specifically, the currencies that have borne the brunt of the manufacturing slowdown should also experience the quickest reversals. This is already being manifested in a very steep rise in their bond yields vis-à-vis those in the US (Chart 7A and 7B). For example, yields in Norway, Sweden, Switzerland and Japan have risen significantly versus those in the US since the bottom. Should the nascent pickup in global growth morph into a synchronized recovery, this will go a long way in further eroding the US’s yield advantage. Chart 7AInterest Differentials And Exchange Rates Chart 7BInterest Differentials And Exchange Rates The key risk to a bearish dollar view is a US-led global growth rebound, allowing the Federal Reserve to adopt a much more hawkish stance relative to other central banks. This would be an environment in which US inflation would also surprise to the upside. This is not our baseline view, especially following the dovish revisions of the Summary of Economic projections made by the Fed this week. Bottom Line: Given further confirmation from a swath of indicators, we are going short the DXY index at current levels with an initial target of 90 and a stop loss at 100.  Go Long SEK Our highest-conviction views on currencies are being long the NOK and SEK.  Our highest-conviction views on currencies are being long the NOK and SEK. This view has been in place for a few months via other crosses, but we are taking the leap today in putting these positions on versus the dollar. Less aggressive investors can still stick to NOK and SEK trades as the crosses. Chart 8Soft Data Is Much Worse Of all the G10 currencies we follow, the Swedish krona is probably the most perplexing. The Riksbank is one of the few central banks to have raised rates this year, but the krona remains the weakest G10 currency. Admittedly, the performance of the Swedish manufacturing sector has been dismal, especially so in October (Chart 8). That said, the euro area, which has also experienced a deep manufacturing recession, has seen a better currency performance this year despite a more dovish European Central Bank. The big question for Sweden is whether the manufacturing sector is just in a volatile bottoming process, or about to contract much further. Domestically, retail sales were strong for the month of October and inflation is surprising to the upside. Exchange rates tend to be extremely fluid in discounting a wide swath of economic data, and in the case of Sweden, in discounting the outcome for global growth. This suggests that the quick reversals in the EUR/SEK and USD/SEK – from levels close to or above their 2008 highs – means that it will take anything but a deep recession to justify a weaker krona.  Bottom Line: In terms of SEK trading strategy, short USD/SEK and short NZD/SEK are good bets, since the SEK has a higher beta to global growth than the US dollar and the kiwi (Sweden exports 45% of its GDP versus 27% for New Zealand). However, an additional trade suggestion is to go short EUR/SEK for Europe-centric investors. Go Long NOK As Well Chart 9Opportunity Or Regime Shift? Since the middle of the last decade, another perplexing disconnect has been the divergence between the price of oil and the performance of petrocurrencies. From the 2016 bottom, oil prices have more than doubled, but the petrocurrency basket has massively underperformed versus the US dollar (Chart 9).  We agree with our commodity strategists that the outlook for oil prices is to the upside. Oil demand tends to follow the ebbs and flows of the business cycle, with demand having slowed sharply on the back of a manufacturing recession. Transport constitutes the largest share of global petroleum demand. A manufacturing pickup will therefore boost oil demand. Rising oil prices are bullish for petrocurrencies but being long versus the US dollar is no longer an appropriate strategy. This is because the landscape for oil production is rapidly shifting, with the US shale revolution grabbing market share from both OPEC and non-OPEC members. In 2010, only about 6% of global crude output came from the US. Fast forward to today and the US produces almost 15% of global crude, having grabbed market share from many other countries. In short, as the now-largest oil producer in the world, the US dollar is itself becoming a petrocurrency (Chart 10). Chart 10US Has Grabbed Oil Production Market Share Chart 11Buy Oil Producers Versus Oil Consumers The strategy going forward will be twofold. First, buying a petrocurrency basket versus the dollar will require perfect timing in the dollar down leg. The second strategy is to be long a basket of oil producers versus oil consumers. Chart 11 shows that a currency basket of oil producers versus consumers has had both a strong positive correlation with the oil price and has outperformed a traditional petrocurrency basket. Our recommendation is that NOK long positions should be played both via selling the CAD and USD (Chart 12). The discount between Western Canadian Select crude oil and Brent has also widened, which has historically heralded a lower CAD/NOK exchange rate (Chart 13). We are also long the NOK/SEK, given our belief that interest rate differentials and momentum will favor this cross over the next three months.   Chart 12CAD/NOK And DXY Chart 13NOK Will Outperform CAD Bottom Line: Remain short CAD/NOK for a trade, but more aggressive investors should begin accumulating long NOK positions versus the US dollar outright. The Yen As Portfolio Insurance Chart 14Short USD/JPY: A Contrarian Bet The yen tends to underperform at the crosses as global growth rebounds but still outperform versus the dollar, at least, until the Bank of Japan is forced to act (Chart 14). This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much,” position. Economic data from Japan over the past few weeks suggests the economy is weakening, but not fully succumbing to pressures of weak external growth and the consumption tax hike. The labor market remains relatively tight, and Tokyo office vacancies are hitting post-crisis lows, suggesting the demand for labor remains tight. The final print of third-quarter GDP growth rose to 1.8%. Wages are inflecting higher as well. The new fiscal spending package is likely to lend support to these trends.  What these developments suggest is that the BoJ is likely to stand pat in the interim, a course of action that will eventually reignite deflationary pressures in Japan (Chart 15). A return towards falling prices will eventually force the BoJ’s hand, but might see a knee-jerk rise in the yen before. Total annual asset purchases by the BoJ are currently a far cry from the central bank’s soft target of ¥80 trillion, and unlikely to change anytime soon (Chart 16). Chart 15What More Could The BoJ Do? Chart 16Stealth Tapering By The BoJ   It is important to remember why deflation is so pervasive in Japan, making the BoJ’s target of 2% a bit of a pipedream if it stands pat. The overarching theme for prices in Japan is a rapidly falling (and rapidly ageing) population, leading to deficient demand (Chart 17). Meanwhile, domestically, an aging population (that tends to be the growing voting base), prefers falling prices. What is needed is to convince the younger population to save less and consume more, but that is difficult when high debt levels lead to insecurity about the social safety net. On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathema for Japanese net interest margins and share prices (Chart 18). Any policy shift that is increasingly negative for banks could easily tip them over. This suggests the shock needed for the BoJ to act may be greater than history.  Chart 172% Inflation = Mission Impossible? Chart 18Negative Rates Are Anathema To Banks We believe global growth is bottoming, but the traditional yen/equity correlation can also shift. Inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been lifting the relative return on capital. The propensity of investors to hedge these purchases will be less if the dollar is in a broad-based decline. Bottom Line: An external shock could tip the Japanese economy back into deflation. The risk is that if the dollar falls, the yen remains flat to lower in the interim. Given cheap valuations and a lack of ammunition by the BoJ, our view is that it is a low cost for portfolio insurance. EUR/USD As The Anti-Dollar Our near-term target for EUR/USD is 1.18. This level will retest the downward sloping trendline in place since the Great Financial Crisis (Chart 19). Chart 20 plots the relative growth performance of the euro area versus the US, superimposed with the exchange rate. The result is very evident: The collapse in the euro since the financial crisis has been driven by falling growth differentials between the Eurozone and the US. There is little the central bank can do about deteriorating demographic trends, but it can at the margin stem falling productivity. One of its levers is to lower the cost of capital in the entire Eurozone, such that it makes sense even for the less productive peripheral countries to borrow and invest. Chart 19EUR/USD Chart 20Structural Slowdown In European Growth Importantly, yields across the periphery are rapidly converging towards those in Germany, solving a critical dilemma that has long plagued the Eurozone in general and the euro in particular. In simple terms, ECB policy has historically always been too easy for some member countries while too stimulative for others. This has traditionally led to internal friction for the currency. However, with 10-year government bond yields in France, Spain and even Portugal now close to the neutral rate of interest for the entire Eurozone, this dilemma is slowly fading. Labor market reforms in Mediterranean Europe have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract by almost 10%. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades. Italy remains saddled with a rigid and less productive workforce, but overall adjustments have still come a long way to closing a key fissure plaguing the common currency area. Earnings estimates for euro zone equities versus the US are rising. This tends to firmly lead the euro by about nine to 12 months, suggesting we are due for a pop in the coming quarters. Chart 21Relative R-Star* In The Eurozone Could Rebound The bottom line is that the various forces that may have been keeping the neutral rate of interest artificially low in the euro area are ebbing. The proverbial saying is that a chain is only as strong as its weakest link. This means that if the forces pressuring equilibrium rates in the periphery are slowly dissipating, this should lift the neutral rate of interest in the entire euro zone. Over a cyclical horizon, this should be bullish for the euro (Chart 21). Bottom Line: European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Earnings estimates for euro zone equities versus the US are rising. This tends to firmly lead the euro by about nine to 12 months, suggesting we are due for a pop in the coming quarters (Chart 22). Chart 22The Euro Might Soon Pop Concluding Thoughts Being long Treasurys and the dollar has been a consensus trade for many years now (Chart 23). According to CFTC data, this has been expressed mostly through the aussie and kiwi, although our bias is that the Swedish krona and Norwegian krone have been the real victims. Chart 23Unfavorable Dollar Technicals Chart 24The US Dollar Is Overvalued Various models have shown valuation to be a very poor tool for managing currencies, but an excellent one at extremes (Chart 24). The results show the US dollar as overvalued, especially versus the Swedish krona, Japanese yen and Norwegian krone. Commodity currencies are closer to fair value, and within the safe-haven complex the Japanese yen is more attractive than the Swiss franc. The euro is less undervalued than implied by the overvaluation in the DXY index. Finally, we are keeping our long GBP/JPY position for now, but with a new target of 155, and tightening the stop to 145 (near our initial target). Inflows into the UK should improve given more clarity from the political overhang, which can lead to an overshoot in the cross. Reviving global growth will also benefit inflows into sterling assets. On a tactical basis however, EUR/GBP is ripe for mean revision given oversold conditions.   Chester Ntonifor Foreign Exchange Strategist chestern@bcaresearch.com Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades