Business Cycles

Highlights The consensus view seems to be that equities have to cool off in 2020, even if the danger has passed: Recession fears have dissipated as the yield curve has returned to its normal upward-sloping orientation and US-China trade tensions have abated, but equity return expectations are modest following last year’s bonanza. We agree that a bear market is unlikely, but expect a better year than the consensus, … : Bull markets tend to sprint to the finish line, and if the next recession won’t start before the middle of 2021, 2020 should be another strong year for the S&P 500. … even if earnings growth is uninspiring: Multiples almost always expand when the Fed eases from an already accommodative position, and they expand a lot provided the Fed isn’t easing in response to a market bust or financial crisis. We expect that an inflation revival will take the consensus by surprise, but not this year: We think rising inflation will induce the Fed to bring the curtain down on the expansion and the equity bull market, but not until 2021 at the earliest. Feature We spent the last full week before the holidays meeting with clients and prospects on the west coast. As they look ahead to 2020, investors don’t see any major storm clouds on the horizon, but they sense that stocks have run about as far as they can. We agree with the view that neither a recession nor a bear market awaits, but we expect equities will comfortably outdistance bonds and cash. Forced to take a stand on whether the S&P 500 will beat or fall short of the typical consensus expectation for mid-to-high-single-digit gains,1 we would happily bet the over. As we detailed in our last two publications in December, our optimistic take stems from the deliberately reflationary policy being pursued by the Fed and other major central banks. Restoring inflation expectations to its desired range is job number one for the Fed, and its open commitment to doing so ensures that risk assets will have the monetary policy wind at their back for an extended period. The European Central Bank and the Bank of Japan want to rekindle inflation as well, and can be counted upon to maintain easy policy settings. The rest of the world’s central banks will continue to take their cue from their more influential peers, as no one wants the export headwind of a strong currency in a low-growth environment. Earnings growth has been the primary driver of the 11-year-old equity bull market, not multiple expansion. In our base-case scenario, easy monetary policy will encourage multiple expansion, while a less threatening trade climate, and a modest revival in Chinese aggregate demand, will boost economic activity, especially outside of the US. The modest global acceleration provoked by a pickup in Chinese imports will support earnings growth, so that both equity drivers, earnings and multiples, will be moving in the right direction. We anticipate that at least half of the current bull market’s remaining upside will come from multiple expansion, however. Dismaying as it might be for investors with a value bent, our bull thesis is built on the view that today’s fully-to-somewhat-richly-valued stocks will become overvalued before this market cycle is complete. A Stealth Earnings Boom Skeptics of the efficacy of extraordinarily accommodative monetary policy have decried the current bull market as “manipulated,” fed by monetary steroid injections that have inflated asset prices at the cost of undermining the real economy’s future prospects. The data flatly contradict the skeptics’ claims: since the end of February 2009, consensus forward four-quarter S&P 500 earnings expectations have grown at an annualized rate of 9.6% (Chart 1, middle panel), while the forward multiple has expanded at a 4.6% pace (Chart 1, bottom panel). Growth in forward earnings estimates has accounted for two-thirds of the 14.6% annualized appreciation in the S&P 500 (Chart 1, top panel); multiple expansion has only contributed a third. Chart 1A Great Decade For Earnings A Great Decade For Earnings A Great Decade For Earnings Chart 2DM Growth Has Been Weak DM Growth Has Been Weak DM Growth Has Been Weak Positioning for a valuation overshoot does not inspire as much confidence as positioning for robust earnings growth. US economic growth has been lackluster since the crisis (Chart 2, top panel), and it’s been downright anemic in Europe (Chart 2, middle panel) and Japan (Chart 2, bottom panel). Few investors foresaw potent earnings growth against that macro backdrop, as aggregate corporate revenue growth ought to converge with nominal GDP growth over time. Only margin expansion could deliver S&P 500 earnings growth above and beyond a meager 4% revenue growth base. As early as 2011, US corporate profit margins looked quite stretched (Chart 3), making further expansion seem improbable. After adjusting for the secular decline in effective corporate income tax rates, corporations’ growing share of national income, the expansion of the high-margin financial sector and the secular decline in debt service costs,2 however, history suggested that profit margins still had room to grow. It would be 2018 before they would peak, thanks in part to the 40% cut in the top marginal corporate income tax rate, and the plunge in debt service costs (Chart 4). Compensation is corporations’ single largest expense, though, and the inexorable decline in labor's share of profits was the key driver (Chart 5). Since China’s entry into the WTO, real wages have failed to keep up with productivity gains (Chart 6), dramatizing the shift of profit share from labor to capital. Chart 3Never Say Die Margin Growth, Nourished On... Never Say Die Margin Growth, Nourished On... Never Say Die Margin Growth, Nourished On... Chart 4... Rock-Bottom Rates ... ... Rock-Bottom Rates ... ... Rock-Bottom Rates ... Chart 5... And Labor's Woes ... And Labor's Woes ... And Labor's Woes Chart 6Globalization Has Helped Corporate Profits Globalization Has Helped Corporate Profits Globalization Has Helped Corporate Profits Profit margins contracted across the first three quarters of 2019, with per-share revenue growth topping per-share earnings growth by an average of three percentage points. We expect that real unit labor costs will rise as the pendulum swings back in labor’s direction in line with an extremely tight job market and a slowdown in outsourcing as globalization loses momentum. Revived activity in the rest of the world can offset some margin pressure from a rising wage bill, however, especially if it helps push the dollar lower. And rising wages aren’t all bad for profits, as rising household income leads to rising consumption, and rising consumption boosts corporate revenue growth. In our base-case 2020 scenario, S&P 500 earnings will grow despite accelerating wage growth. Multiples And The Monetary Policy Cycle Although the S&P 500’s forward multiple is already elevated (Chart 7), the historical relationship between monetary policy and equity multiples argues that re-rating is more likely than de-rating going forward. We divide the fed funds rate cycle (Chart 8) into four phases based on the direction of the fed funds rate (higher or lower) and the state of monetary policy (easy or tight). We are currently in Phase IV, when the Fed has most recently eased policy while policy settings were already accommodative. If margins have finally peaked, multiple expansion will have to assume a bigger role in supporting the bull market. Chart 7Elevated But Not Worrisome Elevated But Not Worrisome Elevated But Not Worrisome Chart 8The Fed Funds Rate Cycle The Conventional Wisdom The Conventional Wisdom Since consensus earnings estimates began to be compiled in 1979, forward multiples have shrunk when the Fed hikes rates and expanded when it cuts them (Table 1). The empirical results align with intuition and arithmetic: investors should become stingier when the rate used to discount future earnings rises, and more generous when that rate falls. While we believe that the mid-cycle rate cuts are finished and that the fed funds rate will fall no further over the rest of this bull market, continued multiple expansion does not require continued rate cuts. Phase IV usually ends with an extended stretch when the Fed holds the funds rate at its trough level, but forward multiples do not peak until the final stages of the phase. Making the intuition-and-arithmetic statement more exact, investors become more generous when rates fall, and remain that way until a rate hike is a sure bet. Table 1A Consistent Inverse Relationship The Conventional Wisdom The Conventional Wisdom Away from the last two Phase IVs, when the Fed cut rates in response to the duress issuing from the end of the dot-com mania and the financial crisis, re-rating gains have been significantly larger. Table 2 details the changes in multiples in each Phase IV episode over the last 40 years. Away from the grinding de-rating following the dot-com bust, and the slow re-rating accompanying the tepid post-crisis recovery, multiples have expanded at better than a 17% annualized rate. Voluntary cuts like last summer’s, made when policy is already easy, independent of the imperative to nurse a post-crisis economy back to health, have been awfully good for investors. Table 2Voluntary Cuts Turbocharge Multiples The Conventional Wisdom The Conventional Wisdom There have been only two instances when the starting multiple has been as high as it was at the start of the latest run of rate cuts. As noted above, conditions in the spring of 2001, when the NASDAQ was a year into its eventual two-and-a-half-year slide, and a recession had just begun, bear little resemblance to conditions today. The fall of 1998, when the Fed delivered a rapid-fire 75 basis points of easing to protect the economy from the potential ramifications of Long Term Capital Management’s failure, looks a lot more like last summer. It is not our base case that the latest round of insurance cuts will push forward multiples to dot-com levels, but they do have scope to expand. The Inflation Timetable It remains our high-conviction view that inflation expectations will not return to the Fed’s target levels quickly. Their path has seemed to provide a nearly perfect real-life case study supporting the adaptive expectations framework, which posits that the recent past exerts a powerful influence on near-term expectations about the future. Inflation is way down the list of investors’ concerns because it has been dormant ever since the crisis, just as it was in the mid-‘60s once memories of high postwar inflation had faded. It conversely remained an acute fear for more than a decade after the Volcker Fed turned the tide in the early ‘80s (Chart 9). Multiples have really surged when the Fed has provided discretionary accommodation outside of periods of distress. The slow but meaningful rise in the trimmed mean PCE (Chart 10, top panel) and CPI series3 (Chart 10, bottom panel) should pull core PCE and core CPI higher over time. In the near term, however, the absence of upward momentum in several leading inflation indicators will likely stretch “over time” beyond the first half of the year, if not the whole year. As tight as the labor market is, unit labor costs have not been able to break out of the range that’s contained them for the last five years (Chart 11, top panel); the New York Fed’s Underlying Inflation Gauge has pulled a disappearing act after a seemingly decisive breakout in mid-2018 (Chart 11, middle panel); and the share of small businesses planning price increases has come off the late 2018 boil (Chart 11, bottom panel). Chart 9Recency Bias In Action Recency Bias In Action Recency Bias In Action Chart 10Inflation's Not Dead, ... Inflation's Not Dead, ... Inflation's Not Dead, ...   Chart 11... But It's Still Hibernating ... But It's Still Hibernating ... But It's Still Hibernating Investment Implications We spent the holidays reading up on the history of strikes in the United States and believe a shift in the balance of negotiating power from management to labor may be stirring, as a two-part Special Report will soon explore. Such a shift would render wages much more sensitive to a lack of labor market slack. Upward wage pressure could then filter into consumer prices either via a cost-push or demand-pull framework, as corporations either seek to defend margins from higher input costs or try to implement opportunistic price hikes. Cost-push or demand-pull, many investors seem to be dismissing the potential for an inflation revival, especially the ones we met in northern California, where the deeply held consensus view asserts that looming job destruction from artificial intelligence makes broad wage growth all but impossible. Inflation is not an immediate concern, but we expect it will ultimately spell the end of the bull market and the expansion. Allocating a generous share of long-maturity Treasury exposures to TIPS is an excellent way to protect a portfolio against its eventual re-emergence. We advise investors to maintain at least an equal weight allocation to equities to profit from our view that ongoing multiple expansion will surprise to the upside. Risk-friendly positioning remains appropriate, as long as intensifying US-Iran tensions or other geopolitical conflicts don’t negate the positive impact of reflationary monetary policy.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 The ten buy- and sell-side strategists surveyed in Barron’s 2020 Outlook, published December 16th, called for an average gain of 4%. 2 Please see the October 2012 BCA Special Report, “Are US Corporate Profit Margins Really All That High?” available at www.bcaresearch.com. 3 Trimmed-mean inflation series operate like figure skating judging in the Olympics – the top and bottom readings are thrown out, and the mean is calculated from the remaining scores.

Highlights An analysis on Thailand is available below. In all scenarios of global market performance, EM will underperform DM in the first half of 2020. Absolute return investors should be mindful of downside risks in EM financial markets. The principal drivers for EM corporate profits are domestic demand in both China and EM ex-China. US and European demand are not particularly relevant. We do not expect a recovery in domestic demand in China and the rest of EM in the early months of 2020. EM corporate profit growth is unlikely to turn positive in H1 2020. Volatility Is A Coiled Spring Chart I-1EM Stocks And Profits: An Unsustainable Divergence EM Stocks And Profits: An Unsustainable Divergence EM Stocks And Profits: An Unsustainable Divergence EM share prices and currencies have been range-bound in 2019, despite the strong rally in DM share prices. On one hand, growing hopes of a US-China trade deal, global monetary easing and expectations of a global growth recovery have put a floor under EM (Chart I-1, top panel). On the other hand, a lack of actual growth recovery in EM/China, a deepening contraction in EM corporate profits and lingering structural malaises in many EM economies have capped upside potential (Chart I-1, bottom panel). Consistent with this sideways market action, implied volatility measures for EM equities and currencies have dropped to record lows (Chart I-2, top and middle panels). Similarly, implied volatility measures for commodities currencies – which tend to be strongly correlated with EM risk assets – have plummeted close to their historic lows (Chart I-2, bottom panel). Remarkably, DM currency markets’ implied volatility has also collapsed to the all-time lows recorded in 2007 and 2014 (Chart I-3, top panel). Chart I-2EM Vol Is A Coiled Spring EM Vol Is A Coiled Spring EM Vol Is A Coiled Spring Chart I-3DM Currency Vol Is At Record Low DM Currency Vol Is At Record Low DM Currency Vol Is At Record Low   Nevertheless, past performance does not guarantee future performance. The fact that global financial market volatility has been very low over the past 12 months does not imply that it will remain subdued going forward. On the contrary, when DM currency volatility was this low in 2007 and 2014, it was followed by a bear market in EM risk assets (Chart I-3, bottom panel). Both EM and DM market volatility resemble a coiled spring. As such, it is quite likely these coiled springs will snap sometime in the first half of 2020. If this is indeed the case, it will be accompanied by a selloff in EM risk assets. We devote this report to discussing the reasons why such dynamics are likely to play out. An urge on the part of investors to deploy capital in EM has supported EM financial markets despite shrinking corporate profits. Hence, investment portfolios should be positioned for a resurgence in financial market volatility in general and currency volatility in particular in H1 2020. As we argued in our November 14 report, the US dollar is still enjoying tailwinds, especially versus EM and commodities currencies. All in all, asset allocators should continue to underweight EM stocks, credit markets and currencies relative to their DM counterparts. In all scenarios of global market performance, EM will underperform DM in the first half of 2020. Absolute return investors should be mindful of downside risks in EM financial markets. As always, the list of our recommended country allocations across EM equities, currencies, credit markets and domestic bonds is presented in the tables at the end of our report – please refer to pages 18-19. An Urge To Deploy Capital Amid Poor EM Fundamentals Investors’ unrelenting urge to deploy capital in EM financial markets put a floor under EM equities and currencies in 2019. Yet poor fundamentals have prevented EM equities and currencies from rallying. Such a battle between two opposing forces has produced a stalemate in EM financial markets. The same is true for commodities and many global market segments sensitive to global growth. Chart I-4Global Industrials: A Rally Without Profit Amelioration Global Industrials: A Rally Without Profit Amelioration Global Industrials: A Rally Without Profit Amelioration This stalemate is unlikely to last forever. Next year will likely be a year of either an EM breakout or breakdown. EM corporate earnings hold the key, and China’s domestic demand is of paramount importance to the EM profit cycle. We discuss our outlook for both the China and EM business cycles below. Following are the reasons why we believe market expectations of a rebound in global growth are too optimistic, and that EM risk assets are at risk: First, there is a widening gap between share prices and corporate profits. Not only are EM per-share earnings shrinking at a double-digit rate, as shown in Chart I-1 on page 1, but also EM EPS net revisions have not yet turned positive. This widening gap between share prices and net EPS revisions is also striking for global industrials (Chart I-4). If corporate profits stage an imminent recovery, stocks will continue to advance. Alternatively, investor expectations will not be met, and a selloff will ensue. As the top panel of Chart I-5 illustrates, the annual growth rate of EM EPS will at best begin bottoming – from double-digit contraction territory – only in the second quarter of 2020. Odds are that investor patience might run out before that occurs and EM markets will sell off in such a scenario. Second, improvement in US and European growth is not in and of itself a sufficient reason to be positive on EM/China growth. In fact, neither US nor euro area consumer spending have been weak (Chart I-5, middle and bottom panels). Yet, EM growth and corporate profits have plunged. Hence, EM growth is by and large not contingent on consumer spending in the US and Europe. As we have repeatedly argued, EM profit growth and risk assets are driven by China/EM domestic demand, rather than by US or European growth cycles. Third, EM financial markets are not cheap. Our composite valuation indicators based on 20% trimmed-mean and equal-weighted multiples indicate that stocks are trading close to their fair value (Chart I-6). These indicators are composed based on the trailing and forward P/E ratios, price-cash earnings, price-to-book value and price-to-dividend ratios for 50 EM equity subsectors. Chart I-5EM Profits Are Driven By China Not US Or Europe EM Profits Are Driven By China Not US Or Europe EM Profits Are Driven By China Not US Or Europe Chart I-6EM Equities Are Fairly Valued EM Equities Are Fairly Valued EM Equities Are Fairly Valued   When valuations are neutral, stock prices can rise or drop depending on the outlook for corporate profits. Provided we believe EM corporate profits will continue to contract for now, risks to share prices are skewed to the downside. Finally, several markets are still conveying a cautious message regarding EM assets. Specifically: There are cracks forming in EM credit markets. EM sovereign credit spreads are widening. Remarkably, emerging Asian high-yield corporate bond yields – shown inverted in Chart I-7 – are beginning to rise. Rising borrowing costs for high-yield borrowers in emerging Asia have historically heralded lower share prices in the region (Chart I-7). Chains often break in their weak links. Similarly, selloffs commence in the weakest segments and then spread from there. Hence, the budding weakness in emerging Asian junk corporate bonds and EM sovereign credit could be signals of a forthcoming selloff in EM/China plays. Remarkably, emerging Asian and Chinese small-cap stocks have failed to stage a rally in the past three months – despite global risk appetite having been strong (Chart I-8). This also signifies the lack of a meaningful recovery in emerging Asia in general and China in particular. Chart I-7A Canary In A Coal Mine? A Canary In A Coal Mine? A Canary In A Coal Mine? Chart I-8No Rally In Chinese And Emerging Asian Small Caps No Rally In Chinese And Emerging Asian Small Caps No Rally In Chinese And Emerging Asian Small Caps Chart I-9Semiconductor Prices Are Still Subdued Semiconductor Prices Are Still Subdued Semiconductor Prices Are Still Subdued Last but not least, cyclical currencies and commodities markets are not signaling a global business cycle recovery. Neither industrial metals nor oil prices have been able to rally meaningfully. EM currencies have also failed to appreciate versus the dollar. In addition, semiconductor prices – both DRAM and NAND – remain weak (Chart I-9). Bottom Line: An urge on the part of investors to deploy capital in EM has supported EM financial markets despite a poor growth background, in general, and shrinking corporate profits, in particular. China: Structural Malaises To Delay A Cyclical Recovery Recent macro data, particularly PMIs, have once again raised hopes of a business cycle recovery in China. While it is reasonable to infer that the industrial cycle in China has recently stabilized, sequential improvements will be hard to achieve in the coming months for the following reasons: The credit and fiscal spending impulse has historically led the manufacturing cycle in China on average by about nine months. However, this time gap has varied – from three months in the first quarter of 2009 to about 20 months in 2017 (Chart I-10). Chart I-10China Credit/Fiscal Impulse And Business Cycle: Varying Time Lags China Credit/Fiscal Impulse And Business Cycle: Varying Time Lags China Credit/Fiscal Impulse And Business Cycle: Varying Time Lags There are several reasons why the time lag could be longer than nine months in the current cycle: (1) The US-China confrontation is dampening sentiment among both enterprises and households in China. Marginal propensity to spend among households and enterprises is low and has not improved (Chart I-11). A Phase One deal is unlikely to reverse this. The fact remains that the US and China have failed to reach an even small and limited accord in the past year of negotiations. With this in mind, even if there is a Phase One deal, businesses both in China and around the world are unlikely to alter their investment plans substantially. (2) Regulatory pressures on banks and on the shadow banking sector to deleverage remain acute. Although the People’s Bank of China has reduced interest rates and is providing ample liquidity, the regulatory tightening measures from 2016-2018 have not been reversed. Consistently, commercial banks’ assets and broad bank credit growth are rolling over anew (Chart I-12). Chart I-11China: Lack Of Appetite To Spend For Enterprises And Households China: Lack Of Appetite To Spend For Enterprises And Households China: Lack Of Appetite To Spend For Enterprises And Households Chart I-12Banking System Is Now More Restrained Compared With Previous Stimulus Episodes Banking System Is Now More Restrained Compared With Previous Stimulus Episodes Banking System Is Now More Restrained Compared With Previous Stimulus Episodes   (3) There has been no stimulus targeting the real estate market. Without a recovery in the property market – both strong price appreciation and construction activity – it will be difficult to achieve a business cycle recovery. The basis is that real estate – not exports to the US – has been the key pillar driving China’s growth over the past 10 years. Even if there is a Phase One deal, businesses both in China and around the world are unlikely to alter their investment plans substantially. In the onshore bond market, government bond yields do not confirm the sustainability of the improvement in the national manufacturing PMI (Chart I-13). China’s local currency government bond yields have generally been a good coincident indicator for the industrial cycle, and they are not flashing green. Chart I-13Chinese Local Bond Yields Doubt The Sustainability Of A Stronger PMI Chinese Local Bond Yields Doubt The Sustainability Of A Stronger PMI Chinese Local Bond Yields Doubt The Sustainability Of A Stronger PMI November Asian and Chinese trade data have been somewhat mixed. Korea’s total exports and exports to China still show double-digit contraction (Chart I-14, top panel). Similarly, Japanese foreign machine tool orders – both total and from China – remain in deep contraction (Chart I-14, middle panel). In contrast, Taiwanese exports to China and to the world ex-China have improved (Chart I-14, bottom panel). The recuperation in Taiwanese exports to China could be attributed to stockpiling of semiconductors by mainland companies. Odds are that China has decided to stockpile semiconductors from Taiwan, given the lingering uncertainty over the China-US relationship, especially regarding China’s access to semiconductors. Real estate – not exports to the US – has been the key pillar driving China’s growth over the past 10 years. Infrastructure spending remains lackluster, despite a surge in special bond issuance by local governments over the past 12 months (Chart I-15, top panel). Chart I-14Asian Trade Was Still Very Weak In November Asian Trade Was Still Very Weak In November Asian Trade Was Still Very Weak In November Chart I-15China: Domestic Demand Is Lackluster China: Domestic Demand Is Lackluster China: Domestic Demand Is Lackluster   Chart I-16EM Ex-China: No Recovery In Domestic Demand EM Ex-China: No Recovery In Domestic Demand EM Ex-China: No Recovery In Domestic Demand The reason is that special bond issuance accounts for a small share of infrastructure investment. Bank loans, corporate bond issuance by LFGVs and land sales are still the main source of funding for capital expenditures on infrastructure. Finally, on the consumer side, auto sales are contracting for a second straight year, while smartphone sales are flat-to-down for a third year in a row (Chart I-16, middle and bottom panels). EM Ex-China: Mind The Deflationary Forces In EM ex-China, Korea and Taiwan, not only are their exports weak, but their domestic demand trajectory is also downbeat (Chart I-16). Despite rate cuts by EM central banks, their interest rates remain elevated in real terms (adjusted for inflation). The basis is that inflation has dropped as much as policy rate cuts. In fact, in many economies, inflation is flirting with all-time lows (Chart I-17). Furthermore, lending rates by banks have not been adjusted sufficiently low in line with the declines in policy rates. Consequently, local borrowing costs in EM remain elevated. Not surprisingly, broad money growth is close to a record low (Chart I-18). Chart I-17EM Ex-China: Inflation Is At A Record Low EM Ex-China: Inflation Is At A Record Low EM Ex-China: Inflation Is At A Record Low Chart I-18EM Ex-China: More Aggressive Monetary Easing Is Necessary EM Ex-China: More Aggressive Monetary Easing Is Necessary EM Ex-China: More Aggressive Monetary Easing Is Necessary   Table I-1EM Corporate Profits Across Sectors 2020 Key Views: A Resolution Of The EM Stalemate 2020 Key Views: A Resolution Of The EM Stalemate Without recognizing non-performing loans and recapitalizing banks, a sustainable credit cycle - and hence domestic demand recovery - is implausible in many EM countries. This will impede the corporate profit recovery, especially for banks that account for 28% of MSCI EM corporate profits (Table I-1). As we argued in our November 14 report, such deflationary tendencies in many EM economies warrant a weaker currency. Bottom Line: The principal drivers for EM corporate profits are domestic demand in China and EM ex-China, rather than the ones in the US or Europe. We do not expect a recovery in domestic demand in both China and the rest of EM in the early months of 2020. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Thailand: Bet On More Monetary Easing Chart II-1Thailand Is Flirting With Deflation Thailand Is Flirting With Deflation Thailand Is Flirting With Deflation Deflationary pressures are mounting in Thailand. This will lead the central bank to cut interest rates much further. We therefore recommend to continue overweighting Thai domestic bonds within an EM local bond portfolio, currency unhedged.  Thailand’s economy is flirting with deflation and needs lower interest rates, a cheaper currency and a fiscal boost: Core inflation has fallen to a mere 0.5%. Likewise, headline inflation has plunged to 0.2%, which is far below the central bank’s lower-bound target of 1% (Chart II-1). Further, nominal GDP growth has dropped below the prime lending rate (Chart II-2). Adjusted for core inflation, real lending rates are too high for the economy to handle. If lending rates are not brought down, credit demand will decline further and non-performing loans will mushroom (Chart II-3). Chart II-2Thailand: Nominal GDP Growth Is Below Prime Lending Rate Thailand: Nominal GDP Growth Is Below Prime Lending Rate Thailand: Nominal GDP Growth Is Below Prime Lending Rate Chart II-3Thailand: Decelerating Domestic Credit Thailand: Decelerating Domestic Credit Thailand: Decelerating Domestic Credit   High borrowing costs are especially detrimental for the non-financial private sector – households in particular. Consumer debt currently stands at 125% of disposable income. The central bank is set to deliver more rate cuts and will probably begin intervening in the foreign exchange market to weaken the baht. Thailand’s economic growth has decelerated and more downside is likely. Business sentiment is deteriorating, companies’ book orders are falling and manufacturing production is contracting (Chart II-4, top panel). Overall, corporate earnings are shrinking 8% from a year ago in local currency terms (Chart II-4, bottom panel). Declining corporate profitability is beginning to hurt capex and employment. In turn, slower employment and wage growth have hit consumer confidence. Private consumption volume has decelerated decisively (Chart II-5, top panel) and passenger vehicle sales are falling (Chart II-5, bottom panel). Chart II-4Thailand: Business Sentiment Is Falling Thailand: Business Sentiment Is Falling Thailand: Business Sentiment Is Falling Chart II-5Thailand: Consumer Spending Has Been Hit Thailand: Consumer Spending Has Been Hit Thailand: Consumer Spending Has Been Hit Chart II-6Thailand's Real Estate Market Is Weak Thailand's Real Estate Market Is Weak Thailand's Real Estate Market Is Weak The real estate market is also slowing down. Chart II-6 shows various types of residential property prices. Specifically, house price appreciation has either decelerated or turned into deflation. Accordingly, construction activity has been weak. Overall, the Thai economy needs significant monetary and fiscal easing. Yet the 2020 fiscal budget entails only a 6% increase in expenditures in nominal terms, which is insufficient to halt the economy’s downtrend momentum. With the budget already set, aggressive monetary easing - in the form of generous rate cuts and foreign exchange interventions to induce some currency depreciation – is the only tool available to the authorities at the moment. Bottom Line: The Thai economy is facing strong deflationary forces and requires lower interest rates and a cheaper currency. The central bank is set to deliver more rate cuts and will probably begin intervening in the foreign exchange market to weaken the baht. Investment Recommendations Local interest rates will drop further and the Bank of Thailand (BoT) will keep cutting interest rates next year in the face of mounting deflationary trends in the economy. For dedicated EM fixed-income portfolios, we recommend keeping overweight positions in Thai local currency bonds and sovereign credit within their respective EM portfolios. While the Thai baht could depreciate because of monetary easing, the currency will still perform better than many other EM currencies. Thailand carries a very robust current account surplus of 6% of GDP. This will provide a cushion for the baht. Furthermore, foreign ownership of local currency bonds is low at 18%. This limits potential foreign outflows from local bonds in case the currency depreciates. In addition, Thailand’s foreign debt obligations - which are calculated as the sum of short-term claims, interest payments and amortization over the next 12 months - are small, accounting for 14% of exports. This limits hedging needs by Thai debtors with foreign currency liabilities and, hence, the currency’s potential downside. We recommend EM equity investors to keep an overweight position in Thai equities. First, Thai bourse is defensive in nature – with utilities, consumer staples and healthcare accounting for 27% of the MSCI Thailand market cap – and will begin outperforming as EM share prices come under renewed stress (Chart II-7, top panel). Second, net EPS revision in Thailand vs. EM has plummeted to a 16-year low (Chart II-7, bottom panel). This entails that a lot of bad news has already been priced in relative terms. Finally, narrow money (M1) growth seems to be bottoming. This is occurring because the central bank has begun accumulating foreign exchange reserves. While it might take some time before monetary easing leads to an economic recovery, Thai share prices will benefit from it early on (Chart II-8). Chart II-7Thailand vs. EM: Relative Stock Prices And Earnings Revisions Thailand vs. EM: Relative Stock Prices And Earnings Revisions Thailand vs. EM: Relative Stock Prices And Earnings Revisions Chart II-8Thailand: Narrow Money And Share Prices Thailand: Narrow Money And Share Prices Thailand: Narrow Money And Share Prices   Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com   Footnotes     Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

Highlights Our take on the key macro drivers of financial markets is quite similar to last year’s, … : Monetary policy is still accommodative; lenders are ready, willing and able; and the expansion remains intact. ... because the Fed and other central banks have reset the monetary policy clock, … : At this time last year, we projected that the Fed would be on the cusp of tightening monetary policy enough to induce a recession by the middle of 2020. Three rate cuts later, we now expect that policy won’t become restrictive until 2021. … pushing the inflection points investors care about further out into the future: The next recession won’t begin before monetary policy settings are tight, and stocks won’t peak until about six months before the recession starts. We are keeping close tabs on the trade negotiations and potential election outcomes, but we expect that 2020 will be another rewarding year for riskier assets: The equity bull market is likely to last for all of next year, and spread product will keep cranking out excess returns over Treasuries and cash for a while longer, too. Overweight equities and spread product. Feature Mr. and Ms. X made their annual visit to BCA last month, giving us an opportunity to gather our thoughts for 2020, while reviewing how our calls turned out in 2019. Both BCA and US Investment Strategy got the asset allocation conclusion right – overweight equities and spread product, while underweighting Treasuries – but the Fed did the opposite of what we expected heading into 2019, putting us on the wrong side of the Treasury duration call for most of the year. We still think investors are overly complacent about the potential for future inflation, but we concede that the future remains further off than we initially expected. Monetary policy settings got more accommodative nearly everywhere in the world in 2019, ... Our Outlook 2020 theme, as detailed in the year-end edition of The Bank Credit Analyst, is Heading into the End Game,1 and it is clear that the expansion is in its latter stages. We do not think that the end of the expansion, the equity bull market, or credit’s extended stretch of positive excess returns is at hand, however. The full-employment/low-inflation sweet spot is still in place, and the Fed has no plans to get in the expansion’s way, even if inflation begins to gain some traction. Its biggest policy priority is trying to get inflation expectations back to the 2.3 – 2.5% range consistent with its inflation target. Chart 1Globalization Hits A Wall Globalization Hits A Wall Globalization Hits A Wall Central banks around the world followed the Fed’s lead this year, cutting their policy rates in an attempt to shield their economies from potentially worsening trade tensions. Though no central banker would say it out loud, joining the rate-cutting parade also helped to defend against currency appreciation, as no one wants a strong currency when growth is in such short supply. The upshot is that global central banks are deliberately promoting reflation. That’s a supportive policy backdrop for risk assets, and while it may well lead to a bigger hangover down the road, it will ramp up the party now. Exogenous challenges remain. Trade tensions are a thorn in businesses’, consumers’ and investors’ sides. Even if US-China tensions die down, a belligerent US administration appears bent on using tariffs and other trade barriers as a cudgel to force concessions from other nations. The trade tailwind that boosted economic growth and investment returns across the last two decades has been stilled (Chart 1). Saber rattling by the US, or mischief from the usual rogue-state and non-state suspects, could also keep markets on edge. The looming election could give investors heartburn, and clients around the world remain anxious about the prospects of a Warren administration. Exogenous risks abound, but it is not our base case that a critical mass will coalesce to disrupt our view that generous-to-indulgent monetary policy settings will delay the day of reckoning, and keep the bull market going all the way through the coming year. As The Cycles Turn From our perspective, the practice of investment strategy is properly founded on the study of cycles. The key cycles – the business cycle, the credit cycle, and the monetary policy cycle – determine how receptive the macroeconomic backdrop is for taking investment risk. Investments made when the backdrop supports risk taking have a much better likelihood of generating excess returns over Treasuries and cash than investments made against an unfriendly macro backdrop. We therefore start every investment decision with an assessment of the key cycles. Determining whether the economy is expanding or contracting may seem like an academic debate with little practical application when the official business cycle arbiters don’t even determine the beginning and ending dates of recessions until well after the fact.2 Equity bear markets reliably coincide with recessions, however, and over the last 50 years, they have begun an average of six months before their onset (Chart 2). An investor who recognizes that a recession is at hand has a good chance of outperforming his/her competitors as long as s/he aggressively adjusts portfolio allocations in line with that recognition. Chart 2Bear Markets Rarely Occur Outside Of Recessions, ... Bear Markets Rarely Occur Outside Of Recessions, ... Bear Markets Rarely Occur Outside Of Recessions, ... Our key view, then, is that the start of the next recession is at least 18 to 24 months away. Tight monetary policy is a necessary, albeit not sufficient, condition for a recession (Chart 3), and we consider the Fed’s current monetary policy settings to be easy, especially after this year’s three rate cuts. A recession can’t begin until the Fed reverses those three cuts and, per our estimate of the equilibrium rate, tacks on at least three additional hikes. Tightening along those lines is decidedly not on the Fed’s 2020 agenda. Chart 3... And Recessions Only Occur When Monetary Conditions Are Tight ... And Recessions Only Occur When Monetary Conditions Are Tight ... And Recessions Only Occur When Monetary Conditions Are Tight Our recession judgment compels us to be overweight equities. Even if the next recession begins exactly halfway through 2021, history suggests that 2020 returns will be robust. Over the last 50 years, the S&P 500 has peaked an average of six months before the start of a recession, and returns heading into the peak have been quite strong, especially in the last four expansions (Table 1). Those results are consistent with bull markets’ tendency to sprint to the finish line (Chart 4). Table 1Stocks Don't Quit Until A Recession Is Near 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Chart 4Bull Markets End In Stampedes 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet The Fed Funds Rate Cycle We estimate that the equilibrium fed funds rate is currently around 3¼%, and project it will approach 3½% by the end of next year. If we are correct that the Fed’s main policy aim is to prod inflation expectations higher, it follows that it will remain on hold at 1.75% well into 2020. A desire to avoid even the appearance of meddling in the election may well keep the FOMC sidelined until its November and December meetings. The implication is that monetary policy will have no chance to cross into restrictive territory before the first half of 2021. The bottom line for investors is that the day when the economy and markets will have to confront tight monetary conditions has been indefinitely postponed. The Fed has effectively deferred the inflections in the business cycle and the equity market to some point beyond 2020. A longer stretch of accommodation would also continue to fuel the equity bull market, as Phases I and IV of the fed funds rate cycle, in which the fed funds rate is below our estimate of equilibrium (Chart 5), have been equities’ historical sweet spot. Over the last 60 years, the S&P 500 has accrued all of its real returns when policy was easy (Table 2), while Treasuries have shined when it’s tight (Table 3). Chart 5The Fed Funds Rate Cycle 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Table 2Equities Love Easy Policy, … 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet Table 3… When They Leave Treasuries Far Behind 2020 Key Views: No Inflection Yet 2020 Key Views: No Inflection Yet The Credit Cycle Our 30,000-foot view of the credit cycle is based on the banking mantra that bad loans are made in good times. When an expansion has been going on for a while, loan officers focus more on maintaining market share than lending standards, while managers of credit funds attract more assets, pushing them to find a home for their new inflows. Banks and bond managers are thereby pro-cyclical at the margin, keeping the good times going by lending to increasingly marginal borrowers and/or relaxing the terms on which they will lend. (They’re conversely stingy when real-time conditions are bad.) Lenders’ lagging/coincident focus keeps lending standards and borrower performance closely aligned in real time (Chart 6). Chart 6Standards Are Coincident In Real Time, ... Standards Are Coincident In Real Time, ... Standards Are Coincident In Real Time, ... Standards are a contrarian indicator over longer periods, though, because shoddily underwritten loans eventually show their true colors. We find a solid fit between corporate bond default rates and lending standards in the preceding 20 quarters (Chart 7). Lending standards tightened slightly in 2015, but were still quite easy in an absolute sense. A majority of banks tightened standards in 2016 amidst the oil rout, which could point to marginally better 2020-21 performance, but post-2010 standards have hardly been stringent. Chart 7... And Leading Over Five-Year Periods ... And Leading Over Five-Year Periods ... And Leading Over Five-Year Periods The stock of outstanding loans and bonds is therefore vulnerable. The relaxation of corporate bond covenants so soon after the financial crisis has not escaped the notice of bearish investors and reporters. It is not enough for an investor to identify a vulnerability, however; s/he also has to identify the catalyst that is going to cause a rupture. The challenge is that ultra-accommodative monetary policy delays the formation of negative catalysts. To the utter torment of an observer with an attraction to the Austrian School of Economics’ survival-of-the-fittest ethic, it is not at all easy to default in a ZIRP/NIRP world. The stock of $12 trillion of bonds with negative nominal yields (down from August’s $17 trillion peak) has ginned up a fervent search for yield among large institutional investor constituencies that have to meet a fixed distribution schedule, like life insurers and pension funds. These income-starved investors help explain why nearly any borrower, no matter how sketchy, can draw a crowd of would-be lenders simply by offering an incremental 50 or 75 basis points of yield. Borrowers default when no one is willing to roll over their maturing obligations; they get even more leveraged when lenders are climbing over each other to lend to them. It is also hard to default when central banks are deliberately pursuing reflation. Inflation makes debt service easier, and central banks are all-in for reflation as a means to bolster inflation expectations, defend against further trade tensions, and to ensure currency strength doesn’t undermine exports. The credit cycle is well advanced, and the Austrians may be at least partially vindicated when the ensuing selloff is worse than it would otherwise have been for having been delayed, but it looks to us like it has more room to run. The rapture remains out of reach for Austrian School devotees, who slot between Tantalus and New York Knicks fans on the cosmic persecution scale. Bonds We remain bearish on Treasuries and reiterate our below-benchmark duration recommendation, though we recognize that the 10-year Treasury yield is unlikely to rise beyond the 2.25-2.5% range in the next year. There’s only one more rate cut to price out of the OIS curve, and neither inflation expectations nor the term premium will return to normal levels quickly. The intermediate- and long-term outlook for the Federal budget is grim, given the size of the deficit while unemployment is at a 50-year low (Chart 8), but Dick Cheney will maintain the upper hand over deficit hawks for 2020 and several years beyond. We do think investors are complacent about inflation’s eventual return, though, and continue to advocate for TIPS over nominal Treasuries. It is tough to default in a ZIRP/NIRP world, when several institutional investor constituencies have a voracious appetite for yield. Chart 8The Budget Outlook Is Grim The Budget Outlook Is Grim The Budget Outlook Is Grim Chart 9IG Spreads Are Wafer Thin IG Spreads Are Wafer Thin IG Spreads Are Wafer Thin Our benign near-term view of the credit cycle makes us comfortable continuing to overweight spread product, subject to our US Bond Strategy colleagues’ preferences. They are only neutral on investment-grade corporates, given their scant duration-adjusted spread over Treasuries (Chart 9). They recommend overweighting high-yield corporate bonds instead, given that high-yield spreads still offer ample positive carry. They also recommend agency mortgage-backed securities as a high-quality alternative to investment-grade corporates, noting that their low duration (three years versus nearly eight for corporates) offers better protection against rising rates. Equities With monetary policy still accommodative, and the expansion still intact, the cyclical backdrop is equity-friendly. If we’re correct that policy won’t turn restrictive until early to mid-2021 at the earliest, the bull market should be able to continue through all of 2020. We do not foresee a return to double-digit earnings growth, but the upward turn in leading indicators across a wide swath of countries outside of the US suggests that a revival in the rest of the world could help S&P 500 constituents grow earnings by mid-single digits, via a pickup in non-US demand and some softening in the dollar. Net share retirements could even nudge earnings growth into the high single digits. If earnings multiples hold up (they’ve expanded at a 5.5% annual rate in Phase IV of the fed funds rate cycle, and don’t typically contract until Phase II), S&P 500 total returns could reach the high single digits, easily putting them ahead of prospective Treasury returns. Multiple expansion isn’t required to support an overweight equities recommendation, but we would not be at all surprised if it occurred. Bull markets often get silly as they sprint to the finish line, and it would be unusual if some froth didn’t bubble up before this bull market, the longest of the postwar era, calls it quits. The Dollar We expect the dollar to weaken against other major currencies in 2020. As the rest of the world finds its footing and begins to accelerate, the growth differential between the US and other major economies will narrow. The dollar will attract less safe-haven flows as the rest of the world’s major economies escape stall speed. Though we expect the countercyclical dollar will rally again when the next recession hits, weakening in 2020 is consistent with our constructive global growth view. Putting It All Together We are sanguine about the US economy, which continued to trundle along at a trend pace in 2019 despite a series of headwinds. It withstood 4Q18’s sharp equity selloff and bond-spread blowout that tightened financial conditions and made corporate and investor confidence wobble. It withstood the 35-day federal government shutdown that lasted nearly all of January. It kept marching forward despite the trade war with China, and it overcame, at least for now, the angst over the inverted yield curve. If the economy continued to expand at roughly its trend pace despite those obstacles, it may not really have needed 25-basis-point rate cuts in July, September and October. The thread connecting our macro views and investment recommendations is the idea that monetary policy settings are highly accommodative and are likely to stay that way until the 2020 election. We expect that risk assets will outperform against an accommodating monetary backdrop. The naysayers are as likely to be confounded by central banks in 2020 as they have been throughout the entire ZIRP/NIRP era. The scolds scouring the data to try to find signs of excesses, and the Chicken Littles who have been frightened by clickbait headlines and strategists deliberately pursuing pessimistic outlier strategies, get one thing right. The market selloffs when the equity and credit bull markets end will be worse than they would have been if the Fed and other central banks were not deliberately attempting to reflate their economies. But their timing is likely to be as bad now as it has been all throughout 2019 (and for the entire post-crisis period for card-carrying, sandwich-board-wearing Austrians). You can’t fight the Fed, much less the ECB, the Bank of Japan, the Bank of England, the Swiss National Bank, the Reserve Banks of Australia and New Zealand, and a broad swath of all of the rest of the world’s central banks.   Doug Peta, CFA Chief US Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the December 2019 Bank Credit Analyst, “Outlook 2020: Heading Into The End Game,” available at www.bcaresearch.com. 2 The NBER’s Business Cycle Dating Committee announced in December 2008 that the last recession began in December 2007. It announced in September 2010 that it had ended in June 2009.

An analysis on Brazil is available below. Feature Chart I-1Poor Performance By EM Stocks, Currencies And Commodities bca.ems_wr_2019_11_28_s1_c1 bca.ems_wr_2019_11_28_s1_c1 I had the pleasure of meeting again with a long-term BCA client Ms. Mea last week during my trip to Europe. Ms. Mea and I meet on a semi-annual basis, where she has the opportunity to query my analysis and view. In our latest meeting, she was more perplexed than usual by the global macro developments and financial market dynamics. Ms. Mea: All the seemingly positive news on the trade front is pushing up global share prices. In fact, a substantial portion -if not all -of the global equity price gains have occurred on days when there has been positive news surrounding the US-China trade negotiations. Given EM financial markets were the most damaged by the trade war, one would have thought that EM markets would outperform in a rally stemming from progress in negotiations. Yet this has not occurred. EM currencies have failed to advance (a number of currencies are in fact breaking down), EM sovereign credit spreads are widening and the relative performance of EM vs. DM share prices has relapsed (Chart I-1). What is causing this disconnect? Answer: The disconnect is due to a somewhat false narrative that the global trade and manufacturing recession as well as the EM/China slowdown were primarily caused by the US-China trade confrontation. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The latter can only partially be attributed to the US-China trade tariffs and tensions. Chart I-2 illustrates that mainland exports are not contracting while imports excluding processing trade1 are down 5% from a year ago. This implies that China’s growth slump has not been due to a contraction in its exports but rather due to weakness in its domestic demand. The principal reason behind the global manufacturing and trade recession has been a deceleration in Chinese domestic demand. The basis as to why mainland exports have held up so well is because Chinese exporters have been re-routing their shipments to the US via other countries such as Vietnam and Taiwan. Critically, the key force driving EM currencies and risk assets has been Chinese imports (Chart I-3). Mainland imports continue to shrink, with no recovery in sight. This is the reason why EM risk assets and currencies have performed so poorly, even amid the global risk-on environment. Chart I-2Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chinese Imports Are Worse Than Exports Chart I-3China Imports Drive EM Currencies bca.ems_wr_2019_11_28_s1_c3 bca.ems_wr_2019_11_28_s1_c3   Ms. Mea: Are you implying that a ceasefire in the trade war will not help Chinese growth rebound, and in turn support EM economies? The “Phase One” agreement and possible reductions in US tariffs on imports from China may help the Middle Kingdom’s exports, but not its imports. Crucially, the Chinese authorities will likely be reluctant to augment their credit and fiscal stimulus if there is a “Phase One” deal with the US. Absent greater stimulus, China’s domestic demand is unlikely to stage a swift recovery. In the case of a “Phase One” agreement, a mild improvement in business confidence in China and worldwide is likely, but a major upswing is doubtful. The basis is that business people around the world have witnessed the struggles faced by the US and China in their negotiations. They will likely doubt the ability of both nations to reach a structural resolution – and rightly so. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. Importantly, global investors are miscalculating China’s negotiating strategy and tactics. We put much greater odds than many other investors on the possibility that China will continue to drag out the negotiations without signing the “Phase One” agreement. This could easily derail the global equity rally. Investors should realize that the Chinese economy does not depend on exports to the US nearly as much as is commonly believed. China’s shipments to the US have been around 3.3% of GDP, even before the trade war began. The value-added to the economy/income generated from China’s exports to the US is less than 3% of its GDP. In contrast, capital spending accounts for the largest share (42%) of China’s GDP. In turn, investment outlays are driven by the credit cycle and fiscal spending, rather than by exports. Chart I-4China: Stimulus And Business Cycle bca.ems_wr_2019_11_28_s1_c4 bca.ems_wr_2019_11_28_s1_c4 Ms. Mea: Turning to stimulus in China, the authorities have been easing for about a year. By now, the cumulative effect of this stimulus should have begun to revive the mainland’s domestic demand. Why do you still think China’s business cycle has not reached a bottom? Answer: Indeed, our credit and fiscal spending impulse has been rising since January. Based on its historical relationship with business cycle variables – it leads those variables by roughly nine months – China’s growth should have troughed in August or September (Chart I-4). However, the time lags between the credit and fiscal spending impulse and economic cycle are not constant as can be seen in Chart I-4. On average, the lag has been nine months but has also varied from zero (at the trough in early 2009) to 18 months (at the peak in 2016-‘17). Relationships in economics – as opposed to those in hard sciences – are not constant and stable. Rather, correlations and time lags between variables vary substantially over time. In addition, the magnitude of stimulus is not the only variable that should be taken into account. The potential multiplier effect is also significant. One way to proxy the multiplier effect is via the marginal propensity to spend by households and companies. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Our proxies for Chinese marginal propensity to spend by companies and households have been falling (Chart I-5). This entails that households and businesses in China remain downbeat, which caps their expenditures, in turn offsetting the positive impact of stimulus. In our opinion, the prime cause behind households’ and businesses’ reluctance to spend is the weak property market. Without rapidly rising property prices and construction volumes, boosting sentiment and growth will prove challenging. We discussed the current conditions and outlook of China’s property market in last week’s report. Construction is the single largest sector of the mainland economy, and it is in recession: floor area started and under construction are all shrinking (Chart I-6). Chart I-5China: A Weak Multiplier Effect China: A Weak Multiplier Effect China: A Weak Multiplier Effect Chart I-6China Construction Is In Recession China Construction Is In Recession China Construction Is In Recession   It is difficult to envision an improvement in manufacturing and a rebound in demand for commodities/materials and industrial goods without a recovery in construction. Notably, Chart I-6 displays the most comprehensive data on construction, as it encompasses all residential and non-residential construction by property developers and all other entities. Ms. Mea: Why are some global business cycle indicators turning up if, as you argue, the global manufacturing slowdown originated from Chinese domestic demand and the latter has not yet turned around? Answer: At any point of the business cycle, it is possible to find data that point both up and down. Our ongoing comprehensive review of global business cycle data leads us to conclude that the improvement is evident only in a few circumstances, and is not broad-based. In particular: In China and the rest of EM, there is no domestic demand recovery at the moment. China and EM ex-China capital goods imports are shrinking (Chart I-7). Chinese consumer spending is also sluggish (Chart I-8). The rise in China’s manufacturing Caixin PMI over the past several months is an aberration. Chart I-7EM/China Capex Is Very Weak EM/China Capex Is Very Weak EM/China Capex Is Very Weak Chart I-8No Recovery For Chinese Consumers No Recovery For Chinese Consumers No Recovery For Chinese Consumers     In EM ex-China, Korea and Taiwan, narrow and broad money growth are underwhelming (Chart I-9). These developments signify that EM policy rate cuts have not yet boosted money/credit and domestic demand. We elaborated on this in more detail in our recent report. The basis for such poor transmission is banking-system health in many developing countries. Banks remain saddled with non-performing loans (NPLs). The need to boost provisions and fears of more NPLs continues to make banks reluctant to lend. Besides, real (inflation-adjusted) lending rates are high, discouraging credit demand. In the US and euro area, consumption – outside of autos – as well as money and credit growth have never slowed in this cycle. The slowdown has largely been due to exports and the auto sector. The latter may be bottoming in the euro area (Chart I-10). This might be behind the improvement in some business surveys in Europe. Chart I-9EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low EM Ex-China: Money Growth Is At Record Low Chart I-10Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over? Euro Area’s Auto Sales: Is The Worst Over?   European business survey data are mixed, but the weakest segment - manufacturing – remains lackluster. In particular, Germany’s IFO index for business expectations and current conditions in manufacturing have not improved (Chart I-11, top panel). Similarly, the Swiss KOF economic barometer remains downbeat (Chart I-11, top panel). The only improvement is in Belgian business confidence, and a mild pickup in the euro area manufacturing PMI (Chart I-11, bottom panel). Chart I-11European Manufacturing And Business Confidence European Manufacturing And Business Confidence European Manufacturing And Business Confidence   In the US, shipping and carload data are rather grim. They are not corroborating the marginal improvement in the US manufacturing PMI. Overall, at this point there are no signs that domestic demand is recovering in China and the rest of EM, which have been the epicenter of the slowdown. The improvement is limited to some data in the US and Europe. Consistently, US and European share prices have been surging, while EM equities have dramatically underperformed. Ms. Mea: What about lower interest rates driving multiples expansion in both DM and EM equities? Answer: Concerning multiples expansion, our general framework is as follows: So long as corporate profits do not contract, lower interest rates will likely lead to equity multiples expansion. However, when corporate earnings shrink, the latter overwhelms the positive effect of a lower discount rate on multiples, and share prices drop along with lower interest rates. DM corporate profits are flirting with contraction, but are not yet contracting meaningfully. Hence, it is sensible that US and European stocks have experienced multiples expansion. In contrast, EM corporate earnings are shrinking at a rate of 10% from a year ago as illustrated in Chart I-12. The basis for an EM profit recession is the downturn in Chinese domestic demand and consequently imports. EM per-share earnings correlate much better with Chinese imports (Chart I-13, top panel) than US ones (Chart I-13, bottom panel). Chart I-12EM Profits And Share Prices EM Profits And Share Prices EM Profits And Share Prices Chart I-13EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US EM EPS Is Driven By China Not The US   In fact, we have documented numerous times in our reports that EM currencies and share prices correlate well with China’s business cycle/global trade/commodities prices, more so than with US bond yields. This does not mean that EM share prices are insensitive to interest rates. They are indeed sensitive to their own borrowing costs, but not to US Treasury yields. Chart I-14 demonstrates that EM share prices move in tandem with inverted EM sovereign US dollar bond yields and EM local currency bond yields. Similarly, emerging Asian share prices correlate with inverted high-yield Asian US dollar corporate bond yields (Chart I-14, bottom panel). Chart I-14EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields EM Share Prices And EM Bond Yields Chart I-15Chinese Bond Yields Herald Relapse In EM Stocks And Currencies bca.ems_wr_2019_11_28_s1_c15 bca.ems_wr_2019_11_28_s1_c15 In short, EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Looking forward, exchange rates hold the key. A relapse in EM currencies will push up both the US dollar and local currency bond yields in many EMs. That will in turn warrant a setback in EM share prices. Ms. Mea: What about the correlation between EM performance and Chinese local rates? Answer: This is an essential relationship. Chart I-15 demonstrates that EM share prices and currencies have a strong positive correlation with local interest rates in China. The rationale is that all of them are driven by China’s business cycle. Relapsing interest rates in China are presently sending a bearish signal for EM risk assets and currencies. Ms. Mea: What does all this mean for investment strategy? A few weeks ago, you wrote that if the MSCI EM equity US dollar index breaks above 1075, you would reverse your recommended strategy. How does this square with your fundamental analysis that is still downbeat? Answer: My fundamental analysis on EM/China has not changed: I do not believe in the sustainability of this EM rebound in general, and EM outperformance versus DM in particular. The key risk to my strategy on EM stems from the US and Europe. It is possible that US and European share prices continue to rally. EM share prices typically sell off when EM borrowing costs rise – regardless if it is driven by mounting US Treasury yields or widening credit spreads. Notably, the high-beta segments of the US equity market and the overall Euro Stoxx 600 index are flirting with major breakouts (Chart I-16A and I-16B). If these breakouts transpire, the up-leg in US and European share prices will be long-lasting. This will also drag EM share prices higher in absolute terms. This is why I have placed a buy stop on the EM equity index. Chart I-16AUS High-Beta Stocks High-Beta Stocks High-Beta Stocks Chart I-16BEuropean Equities: At A Critical Juncture European Equities: At A Critical Juncture European Equities: At A Critical Juncture   That said, I have a strong conviction that EM will continue to underperform DM, even in such a scenario. Hence, I continue to recommend underweighting EM versus DM in both global equity and credit portfolios. As we have recently written in detail, the global macro backdrop and financial market dynamics in such a scenario will resemble 2012-2014, when EM currencies depreciated, commodities prices fell and EM share prices massively underperformed DM ones (Chart I-17). Further, I am not arguing that the current global trade and manufacturing downtrends will persist indefinitely. The odds are that the global business cycle, including China’s, will bottom sometime next year. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January. The point is that EM share prices have decoupled from fundamentals – namely corporate earnings growth – since January (please refer to Chart I-12 on page 8). This is an unprecedented historical gap, making EM stocks, currencies and credit markets vulnerable to continued disappointments in EM corporate profitability. Ms. Mea: What market signals give you confidence in poor EM performance going forward? Answer: Even though the S&P 500 has broken to new highs, multiple segments of EM financial markets have posted extremely disappointing performance. These include: Small-cap stocks in EM overall and emerging Asia as well as the EM equal-weighted equity index have struggled to rally (Chart I-18). Chart I-17EM Underperformed During 2012-14 Bull Market bca.ems_wr_2019_11_28_s1_c17 bca.ems_wr_2019_11_28_s1_c17 Chart I-18Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen Various EM Equity Indexes: Failure To Rally Is A Bad Omen   Various Chinese equity indexes – onshore and offshore, small and large – have failed to advance and continue to underperform the global equity index. EM ex-China currencies and industrial commodities prices have remained subdued (please refer to Chart I-1 on page 1). Ms. Mea: Would you mind reminding me of your country allocation across various EM asset classes such as equities, credit, currencies and fixed-income? Answer: Within an EM equity portfolio, our overweights are Mexico, Russia, central Europe, Korea and Thailand. Our equity underweights are Indonesia, the Philippines, Turkey, South Africa and Colombia. We continue recommending to short an EM currency basket including ZAR, CLP, COP, IDR, MYR, PHP and KRW. Today, we add the BRL to our short list (please refer to the section below on Brazil). As to the country allocation within EM local currency bonds and sovereign credit portfolios, investors can refer to our asset allocation tables below that are published at the end of each week’s report and are available on our web site. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Brazil: Deflationary Pressures Warrant A Weaker BRL The Brazilian real is breaking below its previous support. We recommend shorting the BRL against the US dollar. The primary macro risk in Brazil is not inflation but rather mounting deflationary pressures. Inflation has fallen to very low levels, to the bottom of the central bank’s target range (Chart II-1). Deflation or low inflation is dangerous when there are high debt levels. The Brazilian government is heavily indebted. With nominal GDP growth still below government borrowing costs and a primary budget balance at -1.3% of GDP, the public debt trajectory remains unsustainable as we discussed in previous reports (Chart II-2). Chart II-1Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Brazil: Undershooting Inflation Target Chart II-2Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable Public Debt Dynamics Are Still Not Sustainable   The cyclical profile of the economy is very weak as shown in Chart II-3. Tight fiscal policy and a drawdown of foreign exchange reserves have caused money growth to slow. That in turn entails a poor outlook for the economy, which will reinforce the deflationary trend. Accordingly, Brazil needs to reflate its economy to boost nominal GDP, which is the only scenario where the nation escapes a public debt trap. Yet, fiscal policy is straightjacketed by the spending cap rule, which stipulates that government spending can only grow at the previous year’s IPCA inflation rate. Federal government spending is set to grow only at the low nominal rate of 3.4% in 2020. Hence, monetary policy is the sole tool available for policymakers to reflate. Both bond yields and bank lending rates remain elevated in real terms. This hampers any recovery in the business cycle. Notably, the marginal propensity to spend by companies and consumers is declining, foreshadowing weaker economic activity ahead (Chart II-4). Chart II-3Brazil: The Economy Is Weak Brazil: The Economy Is Weak Brazil: The Economy Is Weak Chart II-4Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining Brazil: Propensity To Spend Is Declining   The central bank is determined to reduce interest rates further. As such, they cannot control the exchange rate. Indeed, the Impossible Trinity thesis states that in an economy with an open capital account (like in Brazil), the authorities cannot control both interest and exchange rates simultaneously. Minister of Economy Paulo Guedes stated in recent days that tight fiscal and easy monetary policies are consistent with a lower currency value. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. In fact, currency depreciation is another option to boost nominal growth that the nation desperately needs. Brazilian policymakers are open to the idea of a weaker exchange rate and will not defend the real. Their currency market interventions are intended to smooth volatility in the exchange rate but not preclude depreciation. Commodities prices remain an important driver of the Brazilian real (Chart II-5). These have failed to rebound amid the risk-on regime in global financial markets. This suggests that the path of least resistance for commodities prices is down, which is bad news for the real. Brazil’s current account deficit is widening and has reached 3% of GDP (Chart II-6). Notably, not only are export prices deflating but export volumes are also shrinking (Chart II-6, bottom panel). Chart II-5BRL And Commodities Prices BRL And Commodities Prices BRL And Commodities Prices Chart II-6Widening Current Account Deficit Widening Current Account Deficit Widening Current Account Deficit   Chart II-7The BRL Is Not Cheap The BRL Is Not Cheap The BRL Is Not Cheap Meanwhile, the nation’s foreign debt obligations – the sum of short-term claims, interest payments and amortization over the next 12 months – are at $190 billion, all-time highs. As the real depreciates, foreign currency debtors (companies and banks) will rush to acquire dollars or hedge their dollar liabilities. This will reinforce the weakening trend in the currency. Finally, the Brazilian real is not cheap - it is close to fair value (Chart II-7). Hence, valuation will not prevent currency depreciation. Bottom Line: We are initiating a short BRL / long US dollar trade. Investors should remain neutral on Brazil within EM equity, local bonds and sovereign credit portfolios. Investors with long-term horizon should consider the following strategy: long the Bovespa, short the real. This is a bet that Brazil will succeed in reflating the economy at the detriment of the currency. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Andrija Vesic Research Analyst andrijav@bcaresearch.com     Footnotes 1    Processing trade includes imports of goods that undergo further processing before being re-exported.   Equities Recommendations Currencies, Credit And Fixed-Income Recommendations

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

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

Feature Chart 1A Feeling Of Deja Vu? A Feeling Of Deja Vu? A Feeling Of Deja Vu? Chair Powell described the recent rate cut as a “mid-cycle adjustment,” rather than a transition to full-on policy easing. This mid-cycle reference was most likely intended to leave the door open for (i) additional “insurance cuts”, likely as soon as September,1 and (ii) the tightening cycle that began at the end of 2015 to eventually resume. Needless to say the market – and President Trump –did not appreciate the hawkish tone of the latter. Importantly, it shows that the current cycle is very similar to the one in the mid-90s (Chart 1). Back then, following the post-Mexican peso devaluation (Tequila Crisis) in December 1994, the bond market started pricing three Fed cuts while the stock market was rebounding in Q1/1995 from the previous quarter’s drawdown (Chart 1, panel 2). Further, the Fed rate cuts in the mid-90s came in response to persistently low and weakening U.S. inflation (Chart 1, panel 3) amidst slowing growth in the rest of the world (Chart 1, panel 4). Bear with us, there is more to it. Former President Clinton was up for reelection the year following the first rate cut in July 1995, at a time that would later be painted as one of “irrational exuberance” in financial markets by then-Chairman Alan Greenspan. In other words, the Fed acted to sustain that economic expansion, respond to the deflationary pressures and mitigate international developments. Sound familiar?  Table 1Run-Up To The First Rate Cut: Now Vs. 1995 Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse As a result, we decided to follow-up on the Special Report published in May when we examined which sectors performed best during Fed loosening cycles leading to recessions.2 In this issue, we delve a little deeper and – in light of all the similarities mentioned above – only look at the sectors’ relative performance following “mid-cycle adjustments” in the post-war era or, broadly speaking, the six loosening cycles that did not morph into a recession. We first isolate the 1995 episode, as the similarities in the stock market’s behavior between now and then are uncanny (Table 1). The S&P returned 18.6% and 17.3% in the six months leading to the 1995 and 2019 initial rate cuts, respectively. In relative terms, seven of the 10 sectors actually performed in a similar fashion over these two periods.3 Further, we broaden out our analysis by including six such non-recessionary loosening episodes, as highlighted in Chart 2. We omit the short-lived tightening in monetary policy both in 1976 and 1986 and instead look at the broader loosening trend. Chart 2Post-War Era Mid-Cycle Adjustments Post-War Era Mid-Cycle Adjustments Post-War Era Mid-Cycle Adjustments Table 2 displays the results of our analysis of the sectors’ relative average performance during “mid-cycle adjustments.” Table 2Sector Relative Performance And Non-Recessionary Fed Rate Cuts Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse The average performance of the broad market registers negative returns ahead of the first rate cut followed by strong 6-, 12- and 24-month positive returns given the more supportive monetary backdrop and the absence of a dreaded recession. What follows in Charts A, B, C and D, is the sectors’ relative performance in the four different timeframes. Image Image Image Image The rate-sensitive sectors – S&P utilities, telecoms, consumer discretionary and financials – underperform early before they outperform once the Fed has started to ease with the exception of the S&P utilities which initially delivers low but positive returns and continue to underperform up to two years after the beginning of the “mid-cycle adjustments.” Chart 3Defying Gravity Defying Gravity Defying Gravity Similarly, we find that most of the deep cyclicals underperform in the run-up to the first rate cut and usually outperform subsequently. The S&P energy is an exception as it outperformed heading into the cutting cycle and then underperformed 6 to 12 months after the first rate cut. Admittedly, we cannot yet rule out the possibility Jay Powell and the Fed might very well be wrong and that the July cut will turn out to be more than just a “mid-cycle adjustment.”  After all, various slopes of the yield curve have already inverted (Chart 2, bottom panel) and the probability that the U.S. might enter into a recession 12 months from now reached 31.5% at the end of July, according to the New York Fed probit model based on the 3-month/10-year Treasury slope (Chart 3). Besides, that was before the yield curve underwent a roughly parallel shift lower of about 30 bps in a few days earlier this month, following the FOMC meeting and news about the escalation in Sino-U.S. trade tensions. Chart 3 shows our probit forecast taking into account the recent further yield curve inversion. What we know is that the current loosening episode is likely to run at least for the rest of the year. Market participants still expect at least three additional rate cuts from the Fed over the next 12 months (Chart 1, panel 2) and, as a reminder, the “mid-cycle adjustments” in the past all provided more than one interest rate cut. While we use this Special Report as a roadmap to sector performance before and after a “mid-cycle adjustment,” our view remains that a recession looms in the coming 18 months and, as such, we continue to decrease cyclical sector exposure and to add defensive exposure.4 (For purposes of completeness, we included reference charts in Appendix A showing individual sector relative performance since 1960 with the non-recessionary Fed rate cut episodes highlighted.) Finally, for those interested in how the yield curve reacts to such “mid-cycle adjustments,” our U.S. Bond Strategists5 performed a similar exercise and found that the 10-year Treasury yield has a tendency to rise following non-recessionary rate cuts and decline following rate cuts that led to a U.S. recession. They also document an interesting yield curve pattern: the curve tends to steepen quite sharply in the aftermath of a non-recessionary rate cut, before starting to flatten after a few months. Appendix A  Chart 4A U.S. S&P Consumer Staples U.S. S&P Consumer Staples Chart 4B U.S. S&P Health Care U.S. S&P Health Care Chart 4C U.S. S&P Utilities U.S. S&P Utilities Chart 4D U.S. S&P Telecom. Services U.S. S&P Telecom. Services Chart 4E U.S. S&P Energy U.S. S&P Energy Chart 4F U.S. S&P Technology U.S. S&P Technology Chart 4G U.S. S&P Industrials U.S. S&P Industrials Chart 4H U.S. S&P Materials U.S. S&P Materials Chart 4I U.S. S&P Consumer Discreationary U.S. S&P Consumer Discreationary Chart 4J U.S. S&P Financials U.S. S&P Financials   Jeremie Peloso, Research Analyst JeremieP@bcaresearch.com Arseniy Urazov, Research Associate ArseniyU@bcaresearch.com Footnotes 1 As we go to press, the probability of a 25 bps rate cut for the September FOMC meeting is 74.2% and of 25.8% for a 50 bps rate cut, based on CME FedWatch Tool. 2 Please see U.S. Equity Strategy Special Report, “Sector Performance And Fed Loosening Cycles: A Historical Roadmap”, dated May 6, 2019, available at uses.bcaresearch.com 3 Please see U.S. Equity Strategy Weekly Report, “A Recession Thought Experiment”, dated June 10, 2019, available at uses.bcaresearch.com 4 Please see U.S. Equity Strategy Weekly Report, “The Fed Apotheosis”, dated July 29, 2019, available at uses.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Track Records”, dated June 18, 2019, available at usbs.bcaresearch.com

Dear Client, Next week I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Amr answers some key questions that clients have been asking about Japan recently: Does the Bank of Japan have any monetary policy ammunition left? How hard will October’s tax hike hit consumption? Has Japan’s corporate governance improved meaningfully? Is there a case for a rerating of Japanese equities? I trust you will find his report very informative. Best regards, Peter Berezin, Chief Global Strategist Highlights Risk assets are likely to struggle over the next few weeks as investors digest both the decision by President Trump to further raise tariffs on Chinese imports, and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. Despite the bluster from the Trump Administration, a trade deal between the U.S. and China is still more likely than not. The failure to reach a deal would weaken the U.S. economy, hurting Trump’s reelection prospects. Reassuringly, there is scant evidence that the global manufacturing downturn has infected the service sector to any significant degree. This is true not just for the U.S., but for manufacturing-intensive economies such as Germany as well. The share of manufacturing in both GDP and employment has fallen steadily around the world. Manufacturing output has also become less volatile over time, and less correlated with service sector growth. As global manufacturing activity starts to recover later this year, earnings growth will pick up. Stay overweight global equities relative to bonds on a 12-month horizon, while preparing to increase exposure to EM and European stocks. Feature First The Fed, And Then Trump Risk assets got hit by a one-two punch this week. First, the Federal Reserve dashed investors’ hopes for an extended easing cycle. While the Fed did cut rates by 25 basis points and pledged to end its balance sheet runoff in August (two months earlier than previously indicated), Jay Powell’s characterization of the Fed’s current mantra as a “mid-cycle adjustment to policy” suggested that further cuts were far from guaranteed. To reinforce the point, Powell stated that the Fed was not at “the beginning of a lengthy cutting cycle.” “That’s not our perspective now, our outlook,” he added. Contributing to the hawkish backdrop, Esther George, the president of the Kansas City Fed, and Eric Rosengren, the once fairly dovish president of the Boston Fed, voted to keep rates unchanged. Equities initially plunged on Wednesday following Chair Powell’s press conference. Markets rallied back Thursday morning, only to tumble again in the wake of President Trump’s decision to further raise tariffs on Chinese imports. There is no shortage of theories purporting to explain the timing of Trump’s decision. Was he trying to send a message to the Fed that it had better keep easing? Was he annoyed that Elizabeth Warren, Bernie Sanders, and a number of other presidential contenders tried to outflank him on trade during the Democratic debate the prior evening by suggesting he was not protectionist enough? Regardless, risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated. Beyond then, the key question is whether the global economy is, in fact, experiencing a mid-cycle slowdown or is on the brink of a recession. If it is the former, as we think is the case, risk assets will bounce back. While a severe escalation of the trade war would tip the scales towards recession, the risk of such an outcome remains low. Negotiations with China are ongoing. The threat to further raise tariffs in September is consistent with the “maximum pressure” doctrine that has governed Trump’s policy decisions. Ultimately, the failure to reach a trade deal would weaken the U.S. economy, undermining Trump’s reelection prospects. The fact that the latest tranche of tariffs, unlike previous ones, will fall mainly on consumer goods could further hurt Trump in the polls. He does not want that. The Manufacturing Cycle: How Low Will It Go? Chart 1The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Trade tensions have undoubtedly exacerbated the global manufacturing downturn. However, trade policy hasn't been the only culprit, as evidenced by the fact that manufacturing activity began to decelerate even before the trade war heated up in earnest. As we explained in detail last week,1 manufacturing activity tends to follow a “natural cycle” lasting about three years, with output growth rising for the first 18 months, and falling for the next 18 months (Chart 1). The latest downleg began at the start of 2018. Thus, as long as the trade war does not spiral out of control, we should soon see a bottom in the manufacturing cycle based on this timing. For now, the evidence for such a bottom remains mixed. It is encouraging that data released this week showed an improvement in the Chinese Caixin Manufacturing PMI and a slight uptick in the new orders component of the U.S. ISM manufacturing survey. Nevertheless, both surveys remain weak in absolute terms. Meanwhile, the European PMIs have continued to deteriorate, taking the global manufacturing PMI down to 49.3 in July, the lowest level since October 2012.  What one can say more definitively is that at least so far, the manufacturing downturn has not infected the service sector to any significant degree (Chart 2). The U.S. non-manufacturing ISM will be released on Monday, but the June reading of 55.1, while below year-ago levels, was still in the middle of its historic range (Chart 3). Chart 2AThe Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) The Service Sector Has Softened Much Less Than Manufacturing (I) Chart 2BThe Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II) The Service Sector Has Softened Much Less Than Manufacturing (II)   Chart 3U.S. ISM Non-Manufacturing Still Close To Its Historic Average U.S. ISM Non-Manufacturing Still Close To Its Historic Average U.S. ISM Non-Manufacturing Still Close To Its Historic Average Strong demand for services has underpinned U.S. employment growth which, in turn, has supported consumption growth. Real PCE rose by 4.3% in Q2. The jump in the Conference Board’s index of consumer confidence in July suggests that U.S. consumers remain upbeat. Notably, the services PMI has increased in the euro area this year, even as the manufacturing sector has weakened there. In Germany, where the manufacturing PMI plunged to 43.2 in July, the non-manufacturing PMI still managed to clock in at 55.4, up from 51.8 in December 2018. Manufacturing: A Canary In The Coal Mine Or Just A Coal Mine? The fact that the overall German economy has not come crashing down despite its high reliance on manufacturing is reassuring. Nevertheless, many investors remain convinced that it is just a matter of time before manufacturing woes precipitate a broad-based economic downturn. Such concerns are well founded if protectionism causes the entire global trading system to come crashing down. However, provided that this does not occur, it is unlikely that slower manufacturing growth, in and of itself, will trigger a recession. Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. Contrary to conventional wisdom, there is little evidence that manufacturing leads the broader economy. Chart 4 clearly shows that manufacturing output tracks overall real GDP growth, with no clear lead-lag relationship. Chart 4Manufacturing Activity Moves In Sync With The Broad Economy Manufacturing Activity Moves In Sync With The Broad Economy Manufacturing Activity Moves In Sync With The Broad Economy Granted, manufacturing growth is more volatile than GDP growth, but that is simply because of the nature of manufacturing production. More than half of manufacturing output consists of durable goods. Purchases of durable goods tend to be lumpy over time. When unemployment starts to rise, households typically postpone purchases of, say, refrigerators and automobiles, while businesses postpone purchases of capital goods. As inventories pile up, manufacturers respond by cutting output. The opposite happens during expansions. The Declining Role Of Manufacturing In The Economy As a share of GDP, global manufacturing output currently stands at 16%. The manufacturing share has been trending lower in most countries (Chart 5). In the U.S., where the data goes back much further, manufacturing output has declined from over 25% of GDP in the 1950s to 11% of GDP at present. The share of manufacturing jobs in total employment has dropped in tandem (Chart 6). Chart 5The Declining Role Of Manufacturing Is A Global Phenomenon The Declining Role Of Manufacturing Is A Global Phenomenon The Declining Role Of Manufacturing Is A Global Phenomenon Chart 6The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling The Relative Size Of Manufacturing In The U.S. Economy Has Been Falling   The volatility of manufacturing growth rates has also fallen over time. This has occurred partly because of better inventory management techniques. Chart 7 shows that the ratio of real nonfarm inventories-to-domestic sales of goods and structures has been trending lower for the past 40 years. Diminished fears of oil embargos and price controls, which were rampant during the 1970s, have also allowed inventory levels to come down. Chart 7A Structural Decline In The Inventories-To-Sales Ratio Starting In The Early 1980s A Structural Decline In The Inventories-To-Sales Ratio Starting in The Early 1980s A Structural Decline In The Inventories-To-Sales Ratio Starting in The Early 1980s As manufacturing has become a smaller and less volatile part of the economy, its impact on the service sector has diminished. In fact, we estimate that all of the reduction in the variance of U.S. private sector GDP growth over the past 50 years can be attributed to a smaller contribution from the goods-producing sector, as well as a decline in the correlation between goods-producing and service-producing industries (Chart 8). Chart 8 Investment Conclusions Uncertainty over Fed policy and the trade war are likely to weigh on risk assets over the coming weeks. As long as the trade war does not boil over, global manufacturing activity should recover during the remainder of this year, boosting corporate earnings in the process. More cyclically-oriented stock markets and sectors will benefit the most. Non-U.S. stocks have the advantage of trading at a substantial discount to their U.S. peers. Chart 9 shows that U.S. stocks trade at 17.5-times forward earnings, while non-U.S. stocks trade at only 13.5-times forward earnings. We expect to upgrade European and EM equities over the coming months. Chart 9AEquities: Better Valuations Outside The U.S. (I) Equities: Better Valuations Outside The U.S. (I) Equities: Better Valuations Outside The U.S. (I) Chart 9BEquities: Better Valuations Outside The U.S. (II) Equities: Better Valuations Outside The U.S. (II) Equities: Better Valuations Outside The U.S. (II) Better global growth prospects should cause the dollar to weaken. Stronger growth should also allow government bond yields to rise and yield curves to steepen. Investors should favor stocks over bonds for the next 12 months. Housekeeping: We were stopped out of our long EUR/JPY trade for a loss of 5%. We will consider reopening this trade once market volatility settles down.   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 10 Tactical Trades Strategic Recommendations Closed Trades

Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon.  Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S. The Capex Slowdown Has Been Less Severe In The U.S. The Capex Slowdown Has Been Less Severe In The U.S.   A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Semiconductor And Manufacturing Cycles Tend To Overlap Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin.  The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The Ebb And Flow Of Lending And Capex Go Hand In Hand The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak U.S. Private Sector Leverage Remains Below Its Previous Peak U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Interest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging The Capital Stock Is Aging The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply.   Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner China: The Deleveraging Campaign Has Been Put On The Backburner China: The Deleveraging Campaign Has Been Put On The Backburner   A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral ...But No Imminent Threat Of A Wage-Price Inflationary Spiral ...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle.   Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14).  Chart 14Globalization Has Peaked Globalization Has Peaked Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally The Worker-To-Consumer Ratio Has Started Shrinking Globally The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17). Chart 16   Chart 17   Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves EM And Euro Area Equities Outperform When Global Growth Improves     As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small Big Has Crushed Small Big Has Crushed Small   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1    The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Chart 21 Tactical Trades Strategic Recommendations Closed Trades

Highlights The EM equity and currency rebounds should be faded. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. This is the case in EM and China. Our leading indicators for the Chinese business cycle continue to point to intensifying profit contraction in both China and EM. The ratio of global broad money supply to the current value of securities worldwide is at an all-time low. This casts doubt on the “too much money chasing too few assets” hypothesis. Feature Chart I-1EM Share Prices: Decision Time EM Share Prices: Decision Time EM Share Prices: Decision Time EM share prices are at a critical juncture (Chart I-1). Their ability to hold their recent lows and break above their April highs will signify that a sustainable cyclical rally is in the making. Failure to punch through April’s highs will pose a major breakdown risk. In brief, EM is facing a make-it-or-break-it moment. Fundamentally, the outlook for EM risk assets and currencies largely hinges on economic growth in general and corporate profits in particular. In our June 20 report, we illustrated that the primary drivers of EM risk assets and currencies have historically been their business cycles and profit growth – not U.S. interest rates. Falling interest rates are positive for share prices when profits are expanding, even if at a slower rate. However, when corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Hence, lower global interest rates in of themselves are not a sufficient condition to foster a sustainable cyclical EM rally. As to EM corporate profits, the rate of their contraction will continue deepening. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. That is why BCA’s Emerging Markets Strategy team contends that EM risk assets and currencies, as well as China-plays, face the risk of a breakdown. This differs from BCA’s house view, which is positive on global risk assets in general. Global And Chinese Business Cycles: No Recovery So Far Chart I-2Chinese A-Share EPS Is Heading Into Contraction Chinese A-Share EPS Is Heading Into Contraction Chinese A-Share EPS Is Heading Into Contraction The rebound in EM risk assets and currencies since last December has occurred despite no improvement in both China’s business cycle and global trade, and despite the deepening contraction in EM corporate profits. Since early this year, we have been arguing that expectations of recovery in the Chinese economy and global trade are unwarranted. So far, our baseline economic view has played out – mainland growth has been rather weak, and global trade has contracted. Yet EM financial markets have done better than we had anticipated. China’s domestic industrial new orders lead Chinese A-share earnings per share growth rate by about nine months and point to intensifying profit slump into early 2020 (Chart I-2). Furthermore, China’s adjusted narrow money(M1+)1 growth leads Chinese investable stocks earnings per share (EPS) by about nine months, and is also pointing to further compression (Chart I-3). Finally, Korea’s exports are shrinking, as are EM EPS (Chart I-4, top panel). Chart I-3Chinese Investable Companies' EPS Is Already Shrinking Chinese Investable Companies' EPS Is Already Shrinking Chinese Investable Companies' EPS Is Already Shrinking Chart I-4Korean Exports And EM EPS Korean Exports And EM EPS Korean Exports And EM EPS   Notably, both Korean exports values and EM EPS in U.S. dollars terms are on par with their early  2011 levels (Chart I-4, bottom panel). This indicates that neither Korean exports nor EM EPS have expanded sustainably over the past eight years. Chart I-5Global Stocks Did Not Lead Global PMI Historically Global Stocks Did Not Lead Global Manufacturing PMI Historically Global Stocks Did Not Lead Global Manufacturing PMI Historically Is it possible that the current gap between global share prices and global manufacturing is due to the fact that financial markets are forward-looking and lead business cycles? Historical evidence suggests that global share prices have not led the global manufacturing PMI, as exhibited in Chart I-5. In fact, global share prices have actually been coincident with the global manufacturing PMI not only throughout this decade but before that as well. The de-coupling between share prices and the manufacturing PMI is currently also present in EM, albeit in a less-striking form. Chart I-6 illustrates that the EM manufacturing PMI has slipped below 50 line, yet share prices have recently rebounded and sovereign spreads have tightened. In a nutshell, the divergence between global share prices and the global manufacturing PMI is unprecedented. This cannot be explained by falling global bond yields either. The latter were falling in the previous business cycle downtrends (2011-12 and 2015), yet share prices did not deviate from the global manufacturing PMI during those episodes (Chart I-5). Chart I-6EM PMI And EM Risk Assets EM PMI And EM Risk Assets EM PMI And EM Risk Assets Chart I-7The Rest Of World's Exports To China Will Continue Shrinking The Rest Of Worlds' Exports To China Will Continue Shrinking The Rest Of Worlds' Exports To China Will Continue Shrinking It seems that the global equity and credit markets expect an imminent recovery in the global business cycle in general and in China in particular. As we elaborated in the previous reports, the current global manufacturing recession stems primarily from China. Our leading indicators of the mainland business cycle suggest that more growth disappointments are likely before China’s growth and other economies’ shipments to the mainland hits a bottom (Chart I-7). For example, Korea’s exports to China in June were still dropping by 24% from a year ago. The primary reason for the lack of revival in growth is that China’s stimulus efforts have so far not been large enough, and the marginal propensity to spend among households and companies is diminishing, offsetting the positive effect of the stimulus, as we have discussed in previous reports. Will the recent G20 trade truce between the U.S. and China boost business confidence worldwide and in China? In our view, it is unlikely to produce a quick and meaningful recovery in business confidence among multinational companies and Chinese businesses. Corporate managers have probably come to realize that the U.S.-China row is not about import tariffs but rather geopolitical confrontation between the existing hegemon and a rising superpower. Hence, there is no easy solution that will satisfy both parties. An acceptable resolution for China will be unacceptable for the U.S., and vice versa. Hence, it will be hard to find a formula that gratifies both sides politically and economically. Overall, we reckon there are low odds in the next six months of an agreement between the U.S. and China that removes tariffs, addresses structural issues and satiates both nations. Korea’s exports are shrinking, as are EM EPS. Finally, even though the S&P 500 is hovering around its previous highs, under-the-surface dynamics have been less upbeat. Specifically, the equal-weighted share price index of U.S. high-beta stocks in cyclical sectors such as industrials, technology and consumer discretionary versus the S&P 500 has been tame and has not yet broken above its 200-day moving average (Chart I-8, top panel). The same holds true for the relative performance of an equal-weighted stock index of global cyclical sectors such as industrials, materials and semiconductors against the overall global equity benchmark (Chart I-8, bottom panel). Conversely, despite its recent setback, the U.S. dollar has technically not yet broken down (Chart I-9, top panel). In fact, our composite momentum indicator for the broad trade-weighted dollar has troughed at zero – a sign that downside is limited and another up-leg will likely emerge soon (Chart I-9, bottom panel). Chart I-8Cyclical Stocks Have Been Underperforming bca.ems_wr_2019_07_04_s1_c8 bca.ems_wr_2019_07_04_s1_c8 Chart I-9The U.S. Dollar Has Technically Not Broken Down The U.S. Dollar Has Technically Not Broken Down The U.S. Dollar Has Technically Not Broken Down   Bottom Line: The EM equity and currency rebounds should be faded. As EM currencies depreciate, sovereign and corporate credit spreads will likely widen. Asset allocators should continue underweighting EM equities and credit markets relative to their DM peers. Too Much Money Chasing Too Few Assets? Many investors identify “liquidity” as the main reason why global equity and credit markets have done so well this year, despite the relapsing global business cycle. Yet there are as many definitions of “liquidity” as there are investors. Many commentators use the term “liquidity” to denote balance sheet expansion by global central banks. As part of their quantitative easing programs, central banks in the U.S., U.K., Japan, the euro area, Switzerland and Sweden have expanded their balance sheets enormously. In line with their asset expansion, their liabilities – the monetary base, consisting primarily of commercial banks’ excess reserves – have also mushroomed. Nevertheless, broad money supply has grown only modestly in these economies.2 The principal reason behind this phenomenon has been a collapse in the money multiplier due to both banks’ unwillingness to boost lending proportionally to their swelling excess reserves, and a persistent lack of demand for credit among households and businesses. This computation casts doubt on the “too much money chasing too few assets” hypothesis. Broad money supply includes all types of deposits at commercial banks and cash in circulation. Crucially, it does not include commercial banks’ excess reserves at central banks. This differentiation between broad money and excess reserves at central banks is vital because excess reserves are not used to purchase goods, services or assets/securities. Hence, a true measure of purchasing power for assets, goods and services is broad money supply. Consistently, the pertinent liquidity ratio for financial markets can be computed by dividing global broad money supply by the value of all securities outstanding excluding those owned by central banks. The top panel of Chart I-10 depicts the ratio of the sum of broad money supply in 12 economies3 - excluding China - to the market value of investable global equities and bonds. The latter is calculated as the market cap of the Datastream World Equity Index plus the market value of the Barclays Aggregate Bond Index, excluding securities owned by central banks (Chart I-11). Bonds include both government and corporate issues. Chart I-10Comparing Global Broad Money And Market Value Of Outstanding Securities Comparing Global Broad Money And Market Value Of Outstanding Securities Comparing Global Broad Money And Market Value Of Outstanding Securities Chart I-11Broad Money, Securities Absorbed By QEs And Value Of Outstanding Securities Broad Money, Securities Absorbed By QE And Value Of Outstanding Securities Broad Money, Securities Absorbed By QE And Value Of Outstanding Securities   We exclude China from this calculation because its money supply (deposits) is not internationally “mobile” – i.e., due to capital controls, Chinese residents cannot convert their renminbi deposits to other currencies, or use them to purchase international securities. Likewise, we exclude Chinese on-shore equity and bond markets from the calculation because they are not easily accessible to all foreign investors. This broad money supply-to-asset values ratio can be regarded as a rough proxy for available liquidity for financial markets.4 Our interpretation is that a lower ratio means investors have lower cash balances relative to the value of financial assets they hold, and vice versa. Interestingly, the ratio of global broad money to the current value of securities worldwide is at an all-time low (Chart I-10, top panel). Hence, this computation casts doubt on the “too much money chasing too few assets” hypothesis. By flipping this ratio, we compute the ratio of market value of all investable securities (excluding the ones owned by central banks) to broad money supply (Chart I-10, bottom panel). It is at all-time high entailing that the market value of globally investable publically-traded securities has expanded much more than global broad money supply/deposits. Bottom Line: We recognize that this is a simplistic macro exercise, and a more comprehensive methodology is required to compute global cash balances that are available to purchase securities worldwide. However, at minimum the above casts doubt on the hypothesis that “too much money is chasing too few assets”. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Footnotes 1      M1+ is calculated as M1 plus household demand deposits and deposits at third-party payment platforms. 2      Note that when a central bank purchases securities from commercial banks, this operation originates excess reserves, but not a new deposit at commercial banks. However, when a central bank acquires securities from a non-bank entity, such as a pension fund or an insurance company, this transaction creates both excess reserves and a bank deposit that did not exist before. Hence, QE programs have created some deposits but less so than excess reserves. 3      Economies included into this aggregate are the U.S., the euro area, the UK, Japan, Canada, Australia, Switzerland, Sweden, Korea, Taiwan, Hong Kong and Singapore. 4      This calculation does not strip out transactional demand for money, i.e., how much money is required to finance regular  economic activity. Given transactional demand for money is not stable, it is hard to estimate and adjust for it.   Equity Recommendations Fixed-Income, Credit And Currency Recommendations Chart I-