Economy

Highlights Duration: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. Fed: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. Negative Convexity: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Feature Chart 1Positive Surprises Driven By The Hard Data The next two months are crucial for the U.S economy. Measures of sentiment, on both the business and consumer side, are sending recessionary signals. However, measures of actual economic activity paint a more benign picture (Chart 1). This divergence between the “hard” and “soft” data will likely resolve itself within the next couple of months, and the outcome of U.S./China trade negotiations will play a major part in determining whether that resolution is positive or negative. On the “Hard” And “Soft” Data There is a ton of economic data available to investors these days, but all of it can generally be classified as either “soft” or “hard”. We call measures of actual economic activity, such as housing starts or retail sales, “hard” data. These are the sorts of measures used to calculate a nation’s GDP. Alternatively, we use the term “soft” data to describe survey measures where firms or consumers are asked to describe whether activity is improving or deteriorating, or whether they are becoming more or less optimistic about the future. Some examples of soft data are PMI surveys and measures of consumer confidence. Both sorts of measures have value. Soft data are usually timelier and often lead the hard data. However, they are also more prone to whipsaws. The hard data tend to be more reliable, but don’t always provide enough lead time to be actionable. The soft and hard data are sending very different signals. At present, the soft and hard data are sending very different signals. On the consumer side, core retail sales are growing at the robust year-over-year pace of 4.8%, even though consumer confidence has declined during the past year (Chart 2). On the business side, the ISM manufacturing PMI survey came in at 47.8 in September, the lowest print since 2009. However, industrial production has fallen by only 0.1% during the past year. Industrial production growth got as low as -4% during the 2015/16 period, when the ISM was at a higher level (Chart 3). Similarly, actual orders for core durable goods have barely contracted, even though CEO confidence is at recessionary levels (Chart 3, panel 2). Capacity utilization also remains fairly strong, well above its 2016 low (Chart 3, bottom panel) Chart 2Hard Vs. Soft Data: On The Consumer Side Chart 3Hard Vs. Soft Data: On The Business Side Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. All measures of housing activity are growing strongly, a rapid snapback following last year’s weakness (Chart 4). Chart 4Housing Activity Summary Trade Negotiations Are Pivotal The soft data started to lag the hard data at around the same time as the Global Economic Policy Uncertainty index shot higher last year (Chart 5). This leads us to conclude that worries about the trade war’s negative consequences have caused sharp declines in measures of sentiment and confidence, even though the trade war’s actual impact on the hard data has been minor. This is what makes the outcome of November’s U.S./China trade talks so important. If an agreement is reached that makes it clear that no new tariffs will be implemented, we expect that would remove enough uncertainty for the soft data to improve, converging with the hard data. However, if things fall apart, then we would expect the negative survey data to eventually drag the hard data lower. Housing is the only sector of the economy that doesn’t currently display a dichotomy between the hard and soft data. Our sense at the moment is that the looming 2020 U.S. election provides enough incentive for both sides to strike a deal, but the outcome could still go either way. Last Friday’s report from our Global Investment Strategy service discussed the outlook for trade negotiations in more detail.1 For bond investors, we are confident that a removal of trade uncertainty would lead to a rebound in important soft data measures such as the ISM manufacturing PMI and the CRB Raw Industrials index. Any increase in those measures would also send bond yields sharply higher. The ratio between the CRB Raw Industrials index and Gold continues to track the 10-year Treasury yield closely (Chart 6). Chart 5Trade War Worries Affecting ##br##Sentiment Chart 6Bond Yields Will Shoot Higher Once Trade Uncertainty Dissipates Bottom Line: Trade uncertainty has depressed survey measures of economic sentiment, but the hard economic data have been relatively robust. If the trade war starts to calm down during the next two months, as we expect, then the survey data will rebound, causing bond yields to move higher. The Fed Next Week The dichotomy between hard and soft data fits nicely with how the Fed has been describing the economic outlook for most of the year. That is, an economy who’s baseline outlook is favorable but that faces some downside risks. While that outlook doesn’t immediately suggest a policy response, low inflation expectations make it pretty clear what the Fed’s course of action will be during the next few months. The 5-year/5-year forward TIPS breakeven inflation rate is currently 1.68%, well below the 2.3%-2.5% range that is consistent with the Fed’s inflation target (Chart 7). What’s more, the median 3-year inflation forecast from the New York Fed’s Survey of Consumer Expectations just hit an all-time low (Chart 7, bottom panel). The Fed must take appropriate action to drive inflation expectations higher. At present, this means that it must ensure that financial conditions stay accommodative so that the economic recovery can continue. Eventually, continued economic recovery will lead to higher realized inflation (Chart 7, panel 2), and inflation expectations will follow realized inflation higher. Chart 7Low Inflation Expectations Equals Accommodative Fed In order to keep financial conditions accommodative, the Fed must at least match the market’s current rate cut expectations. An October rate cut is more or less fully priced, and it is therefore highly likely that the Fed will cut rates next week. After that, the market is pricing in roughly 50/50 odds of a fourth rate cut in December. But those expectations will certainly change as we learn the outcome of November’s trade talks and as the economic data roll in. Ultimately, we expect that enough good news will hit the wire between now and December that a fourth rate cut will be unnecessary. But the more important message is that, as long as inflation expectations are low, the Fed will not risk upsetting market expectations. Balance Sheet Update The Fed decided not to wait until next week to unveil its revamped balance sheet policy. It didn’t really have the luxury of time, given the turmoil in money markets that we discussed in a recent report.2 The main conclusion from our report is that the Fed must inject more bank reserves into the economy if it wants to maintain control of interest rates. This is exactly what the Fed will do going forward. It announced that it will purchase Treasury bills at least until the second quarter of 2020, starting at an initial pace of $60 billion per month. It will also continue to reinvest the proceeds from maturing Treasury notes/bonds and MBS into newly issued Treasury notes/bonds. Continued economic recovery will lead to higher realized inflation. Assuming the pace of $60 billion per month stays constant, and making some other assumptions about the growth rates of non-reserve liabilities, we project that the Fed’s actions will cause the supply of reserves to rise from $1.53 to $1.63 trillion by next June, and that its securities holdings will rise from $3.59  to $4.05 trillion (see Chart 8 and Table 1). Chart 8The Fed's Balance Sheet Over Time Table 1Fed's Balance Sheet: Projections As we have argued in the past, now that the link between the Fed’s balance sheet and its interest rate policy has been severed, we see no investment implications from the Fed’s new balance sheet strategy. As per our Golden Rule of Bond Investing, changes in the fed funds rate relative to expectations will continue to drive bond yields.3 Since the Fed’s balance sheet strategy tells us nothing about its future interest rate plans, it should mostly be ignored. Bottom Line: With inflation expectations low, the Fed must ensure that financial conditions stay accommodative and that the economic recovery remains on track. This means that the Fed will meet market expectations and cut rates next week. Beyond that, we expect growth to improve enough that further cuts are unnecessary. A Good Time To Buy Negative Convexity We have repeatedly mentioned the attractiveness of high-yield bonds and Agency MBS during the past few weeks. The one thing those sectors have in common is that they are negatively convex. That is, unlike most fixed income instruments, their durations are positively correlated with yields. As a result, this year’s big drop in yields has led to large declines in duration for both high-yield and agency MBS (Chart 9). But despite this lower duration, junk spreads have remained relatively flat while MBS spreads have actually widened. In other words, expected return has not fallen even as the risk embedded in negatively convex securities has declined markedly. Chart 9Negatively Convex Products Are Attractive Last week we unveiled a new way of measuring risk for U.S. spread products.4 The Risk Of Losing 100 bps can be thought of as the number of standard deviations of annual spread change necessary for a sector to underperform duration-matched Treasuries by more than 100 basis points. A higher value means the sector is at a lower risk of losing 100 bps, and vice-versa. Chart 10 shows our new risk measure plotted against expected return for the investment grade and high-yield credit tiers, as well as for conventional 30-year Agency MBS. The y-axis shows each sector’s 12-month expected excess return, which we calculate as OAS less an adjustment for expected default losses. The x-axis shows the Risk Of Losing 100 bps. To put recent market moves in context, we show how each sector has moved within Chart 10 since spreads last troughed, about one year ago. Notice that last October, Ba and B rated junk bonds offered more expected return than Baa-rated corporates, with similar risk. Now, Ba and B offer a similar return advantage, but with much less risk. Caa-rated junk now strictly dominates the Baa sector in terms of risk and reward. Chart 10Risk-Reward Tradeoff Favors Negatively Convex Securities Turning to Agency MBS, we see again that the large fall in duration has led to a substantial risk reduction since last October. This is why we recently recommended upgrading Agency MBS at the expense of Aaa, Aa, and A corporates.5 Bottom Line: This year’s large decline in yields has increased the attractiveness of negatively convex assets, in risk-adjusted terms. Investors should favor high-yield over investment grade corporates. They should also favor Agency MBS over Aaa, Aa and A rated corporates. Ryan Swift U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Global Investment Strategy Weekly Report, “Kumbaya”, dated October 18, 2019, available at gis.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “What’s Up In U.S. Money Markets?”, dated September 24, 2019, available at usbs.bcaresearch.com 3 Please see U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Weekly Report, “A Perspective On Risk And Reward”, dated October 15, 2019, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy Weekly Report, “Two Themes And Two Trades”, dated October 1, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

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

Highlights The currency market is bifurcated in terms of shorter-term expectations versus longer-term factors. The Swedish krona, Norwegian krone, and British pound are solid long-term buys, but could remain very volatile in the short term. We continue to focus on the crosses rather than outright dollar bets. Remain long SEK/NZD, GBP/JPY, and NOK/SEK. Tighten stops on long GBP/JPY to protect profits. EUR/SEK should top out once global growth improves. Sell the gold/silver ratio at 90, as recommended in last week’s report.1 Feature Chart I-1One Way Street Since 2018 Of all the G10 currencies we follow, the Swedish krona is probably the one that is the most perplexing. The Riksbank is one of the few central banks to have raised rates this year, but the krona remains the weakest G10 currency. Admittedly, the performance of the Swedish manufacturing sector has been dismal, and was especially so in September, but this has not been a story specific to Sweden alone. The euro area, which is also experiencing a deep manufacturing recession, has seen better currency performance despite a more dovish European Central Bank (ECB). The underperformance of the krona begs the question of whether it signals a much prolonged global manufacturing recession, or is indicative of something more endogenous to Sweden. Put another way, has the driver of USD/SEK (and even USD/NOK) strength been an appreciating dollar, or more domestic factors (Chart I-1)? And if it is the latter, what are the important signposts to look out for should a turnaround be around the corner? The Soft Versus Hard Data Debate The big question for Sweden is whether the manufacturing sector is just in a volatile bottoming process, or about to contract much further. Industrial production is currently growing at 4% year-over-year, but the signal from the soft data is that it should be contracting in the double digits (Chart I-2, top panel). As such there is either a big disconnect between the perception of investors and reality, or we are on the verge of a much deeper manufacturing slump. Exchange rates tend to be extremely fluid in discounting a wide swath of economic data, and in the case of Sweden, in discounting the outcome for global growth. However, with EUR/SEK at 10.8 and USD/SEK at 9.7 – the latter well above its 2008 highs – it is fair to assume that anything other than a deep recession will justify a stronger SEK.  One of the more consistent ratios in calling a bottom in the Swedish manufacturing sector in particular (and that of the Eurozone in general) is the manufacturing new orders-to-inventories ratio (Chart I-2, bottom panel). The tick down in September was disconcerting. However, unlike the manufacturing PMI, this ratio is not hitting new lows, tentative evidence that we might be in a volatile bottoming process rather than a protracted slump. The last time we encountered such a divergence was in 2011/2012, at the height of the European debt crisis; in that instance, Swedish hard data ended up sending the right signal for the overall economy. The deterioration in the manufacturing sector has yet to hit domestic consumption in general or the labor market in particular.  The deterioration in the manufacturing sector has yet to hit domestic consumption in general or the labor market in particular. The import component of the PMI index remains well above that of exports. Meanwhile, the employment component of the PMI index began to stabilize around the middle of this year, meaning employment growth should bottom at around 1% or so (Chart I-3). Swedish exports are higher up the manufacturing food chain than in most other developed economies, and autos are quite important. But so far, the Swedish economy has weathered the auto slowdown quite well, with production still clocking in at 7% per year. Chart I-2Soft Data Is Much Worse Chart I-3Domestic Demand Is Holding Up Well The tick up in the Swedish unemployment rate is problematic, but we do not believe it constitutes a major change in labor market dynamics. Sweden has a long history of higher openness toward asylum seekers and refugees than many other European countries. The Syrian crisis a couple of years ago led to an exceptional surge, where the number of asylum seekers skyrocketed to over 150,000 or almost 1.5% of the total population (Chart I-4). Historically, immigration has provided a big labor dividend to Sweden, allowing growth to outpace both the U.S. and the euro area. But this has also been a source of frictional unemployment, as new migrants integrate into the labor force. Chart I-4A New Pool Of Labor That Has To Be Integrated Foreign-born workers now constitute about 20% of the total population, a big portion of which need to learn a new language and adopt new skills (Chart I-5A). This growth dividend will be reaped for many years to come. Integration is a politically contentious issue, and so the highly restrictive asylum and reunification law adopted in mid-2016 probably means the immigration boom is behind us. The rise of the anti-immigration Sweden Democrats in the September 2018 elections is a case in point. However, the pivot of the democratic population towards the right has been a global phenomenon, and so is not as negative for Sweden on a relative basis. All that to say, compared to most developed nations, Sweden still enjoys a relatively positive demographic outlook (Chart I-5B). Chart I-5AA Huge Labor Dividend Chart I-5BNo Apparent Demographic Cliff The inflow of migrants has a mixed impact on inflation. While there is downward pressure on wages, due to an increase in the share of employment that pays lower wages, there is still upward pressure on housing and consumption in response to the increased number of workers. This comes on top of a fiscal boost as the government spends more on social services. Meanwhile, the unemployment rate among foreign-born people is around 15%. This means that the Phillips curve is flat for the first few years, before it starts to steepen. But as the new labor force is finally absorbed into the economy, it should start to generate meaningful wage pressures. The Riksbank clearly understands these dynamics, which is why over the prior years, its stance has been dovish even when the Swedish economy has been holding up well. Interest rates were cut to negative territory in 2015 and held at -0.5% (lower than the ECB policy rate) all through the global recovery in 2016 and 2017. Quantitative easing has also been extended up until 2020, well ahead of the ECB’s renewed asset purchase program announcement. Both have tremendously eased monetary conditions in Sweden, including via a weaker currency. Going forward, there are a few key reasons to believe  the path of least resistance for the krona is now up: A weak krona has typically helped the manufacturing sector with a lag of twelve months.  A weak krona has typically helped the manufacturing sector with a lag of twelve months. Negative divergences only tend to happen ahead of deep recessions. Unless we are in that particular situation now, better demand for relatively cheaper Swedish goods (think Volvo versus BMW) should lead to a stronger krona (Chart I-6). Yes, the Riskbank has been conducting QE, but the pace of expansion in its balance sheet has been slowing in recent quarters. USD/SEK has tended to track relative balance sheet trends between the Riksbank and the Fed, but a gaping wedge has opened up in favor of the krona (Chart I-7). Meanwhile, with the Fed about to re-expand its balance sheet, this should also favor a stronger SEK versus the USD. Chart I-6Swedish Krona And Manufacturing Chart I-7USD/SEK And Relative Balance Sheets The Swedish housing market is becoming a thorn in the Riksbank’s side. When negative rates were introduced in 2015, growth in house prices exploded to the tune of 15% year-on-year (Chart I-8). More recently, a curb on migration has allowed a cooling of sorts, but Swedish household leverage remains very elevated. With the memory of the 1990s housing crisis still fresh in their minds, this is making the Riksbank quite uncomfortable with its current policy stance. The carry cost is lower from being short NZD compared to being short the U.S. dollar. Our bias is that though Governor Stefan Ingves prefers to renormalize policy as quickly as possible, given that he is managing a small-open economy with trade a whopping 45% of GDP, but is held hostage to external conditions. The SEK is the cheapest currency in the G10 universe, and could bounce sharply on even the softest evidence indicating global growth has bottomed. Furthermore, rising global growth will tighten resource utilization, which should begin to boost underlying inflationary pressures in Sweden (Chart I-9) Chart I-8House Prices In Sweden##br## Are Bubbly Chart I-9Resource Utilization And Inflation In Sweden In terms of SEK trading strategy, USD/SEK and NZD/SEK tend to be highly correlated; since the SEK has a higher beta to global growth than the kiwi (Sweden exports 45% of its GDP versus 27% for New Zealand). On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the SEK/NZD an attractive way to play USD/SEK downside. Meanwhile, the carry cost is lower from being short NZD compared to being short the U.S. dollar (Chart I-10). As for EUR/SEK, the cross could consolidate at current levels before heading lower but will ultimately peak once global growth reaccelerates. Chart I-10Remain Long SEK/NZD Bottom Line: We remain long the SEK/NZD as a relative value play, but the true upside lies in the SEK/USD cross. Our bias is that SEK weakness has been driven by the market’s focus on disappointing soft data, while hard data remains relatively resilient. Once it becomes clearer that the global growth environment is not as precarious as the surveys suggest, the krona could bounce sharply. Housekeeping Our long GBP/JPY position hit 5% this week. We are tightening stops to 138 in order to protect profits. We were also stopped out of short EUR/NOK for a 2% loss. We are standing aside for now. EUR/NOK is now trading above 2008 recession levels, which is only justifiable by a prolonged growth recession, but risk management warrants patience for now. Stay tuned.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “On Money Velocity, EUR/USD And Silver,” dated October 11, 2019, available at fes.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been soft: Retail sales contracted by 0.3% month-on-month in September. Industrial production fell by 0.4% month-on-month. Both export and import prices fell by 1.6% year-on-year in September. Michigan Consumer Sentiment Index grew to 96 in October, up from 93.2 in the previous month. NY Empire State Manufacturing Index increased to 4 in October, up from 2 in September. Building permits and housing starts both fell by 2.7% and 9.4% month-on-month in September, but the housing recovery remains intact. Initial jobless claims increased to 214K for the week ended Oct 11th. The DXY index depreciated by 0.7% this week. The latest Beige Book summarized that the U.S. economy expanded at a slight-to-modest pace. The slowdown in the manufacturing sector remains the biggest risk to the economy, while trade tensions continue to weigh on business sentiment and capex intensions. The most recent “entente” in trade discussions might represent a pivotal shift from heightened uncertainty that has prevailed throughout the summer. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area remain subdued: Headline inflation fell to 0.8% year-on-year in September, the slowest in nearly three years. Core inflation however, increased to 1% year-on-year. Industrial production in the euro area continued to contract, by 2.8% year-on-year in August. The ZEW sentiment in the euro area fell further to -23.5 in October, however this is well above expectations of -33. The ZEW sentiment for Germany also fell to -22.8 in October. It is worth noting that expectations continue to improve relative to the current situation. The trade balance in the euro area improved to €20.3 billion in August, up from the downward-revised €17.5 billion in July. However, this is mostly due to a contraction in imports. EUR/USD rose by 0.9% this week, in part helped by broad dollar weakness. The trade dynamics in the euro area remain worrisome: exports fell by 2.2% year-on-year in August, while imports plunged by 4.1% year-on-year. Notably, year-to-date, the EU’s trade surplus with U.S. grew to €103 billion, up from €91 billion a year earlier, while the trade deficit with China widened further to €127 billion from €116 billion. Report Links: On Money Velocity, EUR/USD And Silver - October 11, 2019 A Few Trade Ideas - Sept. 27, 2019 Battle Of The Central Banks - June 21, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan continue to disappoint: Industrial production fell by 4.7% year-on-year in August. Capacity utilization decreased by 2.9% month-on-month in August. The Japanese yen fell by 0.8% against the U.S. dollar this week. Kuroda has again emphasized that the BoJ will not hesitate to act if economic developments continue to deteriorate. On the other hand, while the Fed and the ECB are both on course to expand their balance sheets through asset purchases, it is an open question as to how much more the BoJ can do, beyond yield curve control. We remain long the yen in anticipation that it will require a “Lehman moment” for the BoJ to act aggressively. Report Links: A Few Trade Ideas - Sept. 27, 2019 Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly negative: The ILO unemployment rate slightly increased to 3.9% in August. Average earnings quarterly growth slowed to 3.8%, however this was above expectations of 3.7%. The Retail price index grew by 2.4% year-on-year in September, a slowdown from 2.6% in the previous month. Headline inflation was unchanged at 1.7% year-on-year in September, while core inflation jumped to 1.7% from 1.5%. Retail sales grew by 3.1% year-on-year in September, up from 2.6% in the previous month. GBP/USD surged by 3.3% this week on optimism towards the European Council Summit on Brexit. From a valuation perspective, the pound is trading at a large discount to its fair value. Should positive Brexit news continue to hit the headlines, the pound could continue to soar. We are long GBP/JPY, which is above 5% in the money. Tighten stop to 138. Report Links: A Few Trade Ideas - Sept. 27, 2019 United Kingdon: Cyclical Slowdown Or Structural Malaise? - Sept. 20, 2019 Battle Of The Central Banks - June 21, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been modest: NAB business confidence fell further to -2, while conditions improved to 1 in Q3. On the labor market front, the unemployment rate fell further to 5.2% in September. 14.7K jobs were created, consisting of 26.2K full-time jobs and a loss of 11.4K part-time jobs. AUD/USD increased by 0.4% this week. RBA minutes were released earlier this week. Interestingly, it presents a sharp debate about the effects of low rates. On the one hand, lower rates have been theoretically justified to achieve full employment and the inflation target. On the other hand, some RBA members fear that low rates could fuel already inflated house prices. The probability for another rate cut has thus decreased post RBA minutes. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been negative: Visitor arrivals increased by 1.8% year-on-year in August, slightly down from 2% in the previous month. Headline inflation slowed to 1.5% year-on-year in Q3. NZD/USD has been more or less flat this week. Closely tied to global growth, the New Zealand dollar has been fluctuating with the ebb and flow of the U.S.-China trade headlines. The two countries have agreed on a partial deal last week, however the details remain vague. While the kiwi is a high beta currency, it should unerperform at the crosses. We continue to play the kiwi weakness through the Aussie dollar and the Swedish Krona. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been relatively strong: The unemployment rate decreased further to 5.5% in September. Moreover, average hourly wages continued to grow by 4.3% year-on-year, up from 3.8% in the previous month. Lastly, 53.7K jobs were created in September, well above expectations of 10K. Both headline and core inflation were unchanged at 1.9% year-on-year in September. The Canadian dollar has appreciated by 1% against the U.S. dollar, on the back of the positive employment data last Friday. All eyes are on the federal election this month, which could be crucial for the future of the Canadian energy sector and environment policies.  Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been positive: The trade surplus (excluding precious metals) widened sharply to CHF 2.88 billion in September. Notably, Swiss exports grew by 8.2% month-on-month to CHF 20.3 billion, led by higher sales of chemical and pharmaceutical products. Swiss imports slightly dropped by 1.4% month-on-month to CHF 17.4 billion. Producer and import prices continued to fall by 2% year-on-year in September. USD/CHF fell by 1% this week. The Swiss franc will continue to fight a tug-of-war between being a defensive currency, but a tool of manipulation by the SNB. Our guestimate is that EUR/CHF 1.06 is an ultimate stress point.  Global portfolios should hold the Swiss franc as insurance, for the simple reason that the currency is a structural outperformer. Report Links: Notes On The SNB - October 4, 2019 What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been depressed: The trade balance shifted to a deficit of NOK 1.2 billion in September. That’s a decrease of NOK 24 billion year-on-year. The Norwegian krone has depreciated by nearly 1% against the U.S. dollar this week. Energy prices remain subdued over the past few weeks. Moreover, the Norwegian trade balance has shifted to a deficit for the first time since November 2017. Exports plunged by 19.5% year-on-year, due to lower sales of energy products, while imports jumped by 12.9% year-on-year. The message is clear – Norway continues to hold up well domestically, but dependence on petroleum exports is introducing volatility into any growth forecasts. BCA has lowered its oil price projections for 2019, which has dampened the appeal of the Norwegian Krone. Stay tuned. Report Links: A Few Trade Ideas - Sept. 27, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been neutral: The unemployment rate was unchanged at 7.1% in September. USD/SEK fell by 1.1% this week. As the worst performing G-10 currency this year, the Swedish krona is now trading at a large discount to its fair value. Please refer to our front section this week which presents an in-depth analysis on the Swedish economy and the krona. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 201 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades