Economy

Special Report

Feature BCA Research (aka The Bank Credit Analyst) published its first report in 1949, a remarkable 70 years ago. This probably makes us the longest-running independent investment research firm in the world. As we age, it is normal to occasionally reflect on how the world has changed over the course of our lives. It is an interesting exercise in the case of BCA. We need to start with a little history. The Bank Credit Analyst began life as a small-circulation newsletter produced by Hamilton Bolton, a Montreal-based money manager. He had been sending out investment commentary to his clients for some time and was encouraged to start catering to a wider audience. Bolton was a visionary because he was one of the few market analysts at that time to understand the importance of money and credit in driving economic and market cycles. In those days, banks were the dominant financial intermediary, so an analysis of flows through the banking system provided accurate and leading signals about economic and market trends. That is why he named his new service “The Bank Credit Analyst”. Bolton developed a series of monetary-based indicators that allowed him to make some great market calls. He passed away in 1967, but his valuable contribution to financial research was acknowledged in 1987 when the CFA Institute posthumously awarded him the prestigious “Outstanding Contribution to Investment Research Award”.1 Hamilton Bolton was a product of his times in that his worldview was influenced heavily by having lived through the Great Depression. Like many of his generation, he had a strong aversion to excessive debt growth, and was highly sensitive to any buildup of financial imbalances that could tip the economy back into a severe downturn. In fact, widespread fears of renewed depression did not really fade until the late 1950s. That psychology helps explain why policymakers were complicit in allowing inflation to take hold in the 1960s because there is a common tendency to fight the last war. As long as depression/deflation is seen as the primary threat, then there will be complacency about inflation risks. Does This Sound Familiar? Let’s look at some of the conditions that existed in 1949, when The Bank Credit Analyst started publication. The U.S. long-term Treasury yield had been capped at 2.5% since April 1942. At the request of the Treasury Department, the Fed had given up control of the money supply by buying whatever bonds were needed to keep yields below 2.5%, in order to support the financing of war-inflated budget deficits. The level of federal debt was down from its wartime peak of 106% of GDP, but was still at a historically high 77.5%. The European and Japanese economies were in a complete mess, having been devastated during the war. As already noted, fears of renewed deflation and depression were prevalent. Inflation was tame with the U.S. personal consumption deflator declining by 0.8% in 1949 and rising by only 1.2% in 1950. There was considerable geopolitical upheaval. Most notably, the Cold War intensified as Russia extended its control over East Europe and other countries. Mao Zedong founded the People’s Republic of China in October 1949 after his communist forces defeated the Kuomintang led by Chiang Kai-shek. There were serious border clashes between North and South Korea in August 1949, a prelude to the North’s invasion in June 1950. It does not require a huge stretch of the imagination to see some parallels with the current environment. We currently are having (or have had): Massive central bank purchases of government debt (i.e. quantitative easing) and the explicit pegging of bond yields by the Bank of Japan. A huge increase in government debt levels, albeit not because of war-related spending. In a remarkable coincidence, U.S. federal debt reached 77.8% of GDP in fiscal 2018, almost exactly the same level as in 1949. The European and Japanese economies are moribund. However, unlike in 1949, this reflects structural forces, not war-related devastation. There are widespread fears about the long-run economic growth outlook, well captured by the secular stagnation thesis, promoted by Larry Summers. Central bankers are concerned that inflation is too low. Geopolitical concerns abound. These include U.S.-China tensions, Brexit, Korea (again), rising populism and Russia’s more aggressive stance on the world stage. In the end, the fears of 70 years ago that the world might slip back into depression proved unfounded. The 1950s and 1960s, for the most part, turned out to be golden decades for consumers, businesses and equity investors. Unfortunately, this does not mean that we can look forward to a repeat experience in the decades ahead, because we must now turn to the major differences between the present and the past. The Past Worked Out Just Fine The conditions for an economic boom in the 1950s and 1960s could hardly have been better. The U.S. armed forces employed more than 12 million men and women at the end of WWII, 7.6 million of whom were stationed overseas. After the war, these people were desperate to get back to a normal life, with civilian jobs, marriage and children. The inevitable result was a population boom and a surge in growth as pent-up demand for housing and consumer goods was unleashed. It was all aided by the 1944 G.I. Bill that provided low-cost mortgages and many other benefits. The improvement in economic growth boosted government tax receipts and, coupled with a drop in defense spending, this kept fiscal finances in check. During the 1950s and 1960s, the federal deficit averaged less than 1% of GDP and debt had fallen to less than 30% of GDP by 1969. This occurred despite a surge in federal infrastructure spending, helped by the Federal Highway Act of 1956 that authorized the construction of an interstate highway system. Meanwhile, the economy did not appear to be impeded by tax rates that were far above current levels. The reconstruction of the European economies was a monumental task that was beyond the financing capabilities of those shattered countries. However, between 1948 and 1951, the U.S. European Recovery Program (The Marshall Plan) transferred $100 billion in 2018 dollars to aid the recovery effort and this helped Europe get back on its feet. There also was a huge amount of U.S. aid to support the rebuilding of Japan. Economic growth in Japan averaged almost 9% a year in the 1950s and more than 10% in the 1960s. In Germany, the comparable figures were 7.7% and 4.2%. The growth of the world economy also was boosted by steady reductions in tariffs during the 1950s and 60s. The most notable was the Kennedy Round of 1964-67 that achieved a 38% weighted average drop in tariffs. Protectionism was in strong retreat in the decades after WWII. Finally, a word on the markets. At the end of 1949, the S&P 500 was trading at seven times trailing earnings while the dividend yield was at 6¾%. The market’s earnings yield of 14% compared to a 2.2% yield on 30-year Treasuries. In other words, stocks were incredibly cheap. Moreover, when the 1951 Treasury-Federal Reserve Accord ended the bond peg, yields inevitably rose steadily over the subsequent years, making bonds a poor investment. In the 1950s, U.S. equities delivered real compound returns of 16.6% a year compared to -3.3% for 30-year bonds. In the 1960s, the annualized real returns were a still-respectable 5.3% for stocks and -1.4% for bonds. In sum, the two decades after the launch of the BCA were a very favorable time and it was largely due to a very depressed starting point. However, the current environment is very different to that of 70 years ago. It’s a Different Picture Now Perhaps the most important difference with the past is the demographic outlook. In contrast to the post-WWII baby boom, the U.S. and most other developed economies face bleak population dynamics. Almost all developed economies – and many emerging ones – have seen the birth rate drop below replacement levels with the result that population growth has slowed dramatically. In many cases, populations are in actual decline – especially in the important working-age segment. That deprives economic growth of its main driver. The annual potential growth of U.S. real GDP averaged 4% in the 1950s and 4.3% in the 1960s. Potential growth in the next decade will average only 1.8% a year, according to the Congressional Budget Office (CBO). And it will be even lower in Europe and Japan. As far as pent-up demand is concerned, the picture also is very different. While the consumer industry works hard to develop new must-have goods and services, the reality is that demand is satiated for a lot of products. For example, in 2017, there were 259 million registered private and commercial autos and trucks in the U.S. compared to only 225 million licensed drivers. In 1950, the number of licensed drivers (62 million) far exceeded the number of registered vehicles (48 million). And it is hard to believe that the ownership penetration of most consumer durables has much upside. Turning to government finances, the current environment of bloated deficits and debt significantly constrains the room for fiscal stimulus. Yes, there is constant talk of the need for more infrastructure spending, but this has proven very difficult to implement without offsetting cuts in other spending or measures to boost revenues. The U.S. is saddled with unprecedented peacetime fiscal deficits and the CBO projects that federal debt will approach 100% of GDP within ten years, even without factoring in another recession. The comparison between the free trade era of the 1950s and 60s and the current situation speaks for itself. It is unclear at this stage just how far the move toward protectionism will go, but one thing seems clear. The rush toward globalization that followed the breakup of the Soviet Union and the entry of China into the global trading system is in retreat. This shows up not only in rising tariffs, but also in declining cross-border direct investment flows and increased antipathy to large-scale international migration. The irony is that the developed world needs more immigration to offset the weak growth in resident populations. What about the markets? The stock market certainly is not cheap, the way it was 70 years ago, with the S&P 500 trading at more than 18 times trailing operating earnings. Low interest rates are providing support, but future returns are likely to be in low single figures in a world where economic growth is moderate and there is little scope for profit margins and/or multiples to expand. Prospects for bonds do look somewhat similar to the situation in the early 1950s. Then, there was only one way for yields to go once the Fed’s peg ended. Today, yields will only fall sustainably if the economy sinks into a protracted downturn. We will get another recession in the next few years and yields could certainly hit new lows at that point. But the resulting policy response – both fiscal and monetary – seems almost certain to lead to higher inflation down the road. That would not bode well for the bond outlook, as was the case between the second half of the 1960s and the early 1980s. Concluding Thoughts Hamilton Bolton was fortunate to launch his new investment service ahead of a powerful economic revival and an almost two-decade bull market in stocks. He did not live long enough to witness the inflation upturn and volatile economic environment of the 1970s and 1980s, but BCA’s monetary focus allowed it to prosper during that period. Under the leadership of Tony Boeckh, the company’s then owner and Editor-in-Chief, BCA was strident in warning investors about the buildup of inflationary pressures and the dangers this posed for markets. During this time, BCA also developed the concept of the Debt Supercycle which helped investors understand the complex forces driving policy and the economic/market cycles. If Bolton was alive today, he would be horrified at the state of the world. He would not be able to understand how investors could be so complacent in the face of record government deficits and debt and by what he would regard as the reckless behavior of central banks. At the same time, he would be able to identify with the renewed focus on weak growth and deflation risks. The bottom line is that he would be advising investors to be extremely cautious. Investors currently are semi-obsessed with the timing of the next recession as that would be the signal to significantly downgrade risk assets. The official BCA stance is that a recession is not imminent and this creates a window for stocks to outperform. This matters for those investors who need to be concerned with relative performance. It is painful to sit on the sidelines if markets keep rising and you underperform your peers. However, for those more concerned with absolute performance, and that was true of most investors in Bolton’s time, the upside potential currently seems unattractive relative to the downside risks. Unfortunately, economists have a poor track record of forecasting recessions and bear markets thus often come as a complete surprise. Yes, low interest rates provide a floor under stocks, with the dividend yield comfortably above the 10-year Treasury yield. But rates are low for a reason: the economy and thus corporate earnings face major downside risks. Against this background, I would tend to side with what I imagine Bolton would say: this is a time to focus on capital preservation rather than taking risks to maximize returns. Let me try to end on a more positive note. As noted earlier, the long-term outlook turned out much better than Bolton probably anticipated 70 years ago. What could make that true this time around? Some things cannot be changed, at least over the next decade: adverse demographic trends, high ownership of consumer goods, and high levels of government debt. Geopolitical developments could go either way – for the better or worse – so I will make no predictions there. The one savior would be a marked revival in productivity because, ultimately, that is the only real source of rising living standards. Technology is changing rapidly and there are lots of exciting innovations. But to make a significant and lasting difference it will require more than developments such as autonomous vehicles or 3-D printing. We will need a new General Purpose Technology (GPT) that has a profound impact on the way economies and societies are structured. Previous examples include the steam engine, electricity and of course the internet. Perhaps Artificial Intelligence will do the trick, but that does not seem likely to be a near-term cure. Chart 1Then (1949) And Now (2019) In closing, we can be sure of one thing. The world changed in ways Hamilton Bolton could not have conceived and that also will be true for us today. BCA will endeavor to evolve with the times as it has done over the past 70 years and we look forward to keep helping our clients prosper in a complex and ever-changing world. 1949 – A Very Momentous Year Hamilton Bolton launches The Bank Credit Analyst The Peoples Republic of China, the Federal Republic of Germany and the German Democratic Republic (East Germany) are founded Indonesia gains independence from the Netherlands The civil war in Greece ends NATO is established The Geneva Convention is agreed The Soviet Union detonates its first atomic bomb Apartheid becomes official policy in South Africa Alfred Jones creates the first hedge fund The first non-stop circumnavigation of the world by an aircraft occurs The first commercial jet airliner, the De Havilland Comet, has its maiden flight EDSAC – the first practicable stored-program computer runs its first program at Cambridge University Products introduced that year included Lego, the 45 rpm record, the first Porsche car and the Xerox photocopier. George Orwell’s dystopian novel 1984 is published People born include Ivana Trump, Jeremy Corbyn, Benjamin Netanyahu, Meryl Streep and Bruce Springsteen 2019 – Not So Much Chaotic politics in the U.K., Italy and many other countries Trade wars   Martin H. Barnes, Senior Vice President Economic Advisor mbarnes@bcaresearch.com Footnotes 1 Previously known as the Nicholas Molodovsky Award  

Highlights Portfolio Strategy Intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. The transition from a virtuous to a vicious EPS-to capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating relative balance sheet (b/s) and relative operating metrics compel us to put the cyclicals/defensives portfolio bent on downgrade alert. Recent Changes The cyclicals/defensives portfolio bent is now on our downgrade watch list. Table 1 Feature The SPX moved laterally last week, and remains below the critical 50-day moving average. Recession worries intensified on the back of the first sustained 10/2 yield curve slope inversion. Coupled with the trade war re-escalation, they remain the dominant macro themes. Worrisomely, BCA’s Equity Selloff Indicator captures these dynamics and continues to emit a distress signal (Chart 1). Equities have been relatively resilient in the face of these headwinds. Investors are hoping not only for a U.S./China trade deal, but also that the Fed’s cutting cycle will save the day. Chart 1Mind The Gap What caught our attention from all the speeches at the recent Jackson Hole Symposium was RBA Governor Philip Lowe’s speech, especially the section titled “Elevated Expectations That Monetary Policy Can Deliver Economic Prosperity”.1 Lowe highlighted that “When easing monetary policy, all central banks know that part of the transmission mechanism is a depreciation of the exchange rate. But if all central banks ease similarly at around the same time, there is no exchange rate channel: we trade with one another, not with Mars. There are, of course other transmission mechanisms, but once we cancel out the exchange rate channel, the overall effect for any one economy is reduced. If firms don't want to invest because of elevated uncertainty, we can't be confident that changes in monetary conditions will have the normal effect (stress ours).” The perception that the Fed is going to be the savior of the economy is a big risk, and when reality hits that President Trump’s tariffs are a shock to global final demand and presage profit contraction, volatility will skyrocket (please refer to Chart 3 from the August 19 Weekly Report). Importantly, the virtuous capex upcycle that has been in motion since the Trump inauguration when CEOs voted with their feet and started investing, has ground to a halt according to national accounts (Chart 2). U.S. non-residential fixed investment subtracted from GDP growth last quarter, and we doubt the Fed’s fresh interest rate cutting cycle will arrest the fall. Leading indicators of capital outlays point to additional pain in coming quarters (Chart 2). As a reminder, generationally low interest rates and a real fed funds rate near zero hardly restrict expansion plans. Chart 2Free Falling The shift from a virtuous to a vicious capex cycle is a theme that will start gaining traction as the year draws to a close. While pundits are dismissing the recent steep fall in capex as a one off, our indicators suggest otherwise. The middle panel of Chart 3 clearly depicts this emerging dynamic. Profit growth peaked in 2018 on the back of the massive fiscal easing package and capex is following suit, albeit with a slight lag. There are high odds that a looming profit contraction will further shatter frail animal spirits, sabotage the capex upcycle and tilt into a down cycle. Tack on the ongoing trade uncertainty, and CEOs are certain to, at least, postpone deploying longer-term oriented capital. Worryingly, this transition from a virtuous to a vicious capex cycle is not limited to a few cyclical sectors as we would have expected on the back of the re-escalating Sino-American trade tussle. In fact, basic resources’ and non-capital goods producers’ capital outlays are decelerating, warning that corporate America is in the early stages of retrenchment (bottom panel, Chart 3). Chart 3EPS-To-Capex Down Cycle Chart 4Capex… Charts 4, 5 & 6 break down sectorial capex growth using financial statement reported data from Refinitiv. Seven out of eleven sectors are steeply decelerating from near 20%/annum growth to half that; given that these sectors comprise more than 72% of the total capex pie, they will continue to weigh on overall stock market reported investment. Chart 5…Per… Chart 6…Sector Similarly, the news on the cyclicals versus defensives capex profile is grim. Trade uncertainty and the global growth soft patch has dealt a blow to deep cyclical expansion plans and leading indicators signal that the cyclicals/defensives capex will flirt with the contraction zone in the coming quarters (Chart 7). In sum, intensifying recession fears, rising risks of ineffectual monetary policy, and escalating trade policy uncertainty that is shattering corporate America’s capex plans, warn that sizable drawdown risks persist in the broad U.S. equity market in the upcoming 3-12 months. As a reminder, this is U.S. Equity Strategy’s view, which contrasts BCA’s sanguine equity market house view. Chart 7Relative Capex Blues This week we update our cyclicals versus defensives bias (we are currently neutral) and are compelled to put this portfolio bent on our downgrade watch list. Put The Cyclical/Defensive Tilt On Downgrade Alert Roughly two years ago, when nobody was talking about the brewing capex upcycle, we penned a report titled “Underappreciated Capex” and posited that: “It would be unprecedented if the current business cycle ended without a visible capex upcycle. Since the 1980s recession, all four recessions were preceded by stock market reported capex soaring to roughly a 20% annual growth rate. At the current juncture, capex is merely on the cusp of entering expansion territory and, if history at least rhymes, a significant capex upcycle is looming.” Fast forward to today and as historical empirical evidence had suggested, capex growth peaked near the 20%/annum mark (Chart 3 above). If our assessment is accurate that capex has now likely hit a wall and the virtuous EPS-to-capex cycle reverses to a vicious down cycle as EPS are now contracting, then deep cyclical high-operating leverage sectors are in for a rough ride. This will especially be true if the global recession warnings also morph into an actual recession on the back of the re-escalating Sino-American trade war. More specifically, our capex indicators are firing warning shots. Capex intentions according to a plethora of regional Fed surveys are sinking steadily, which bodes ill for cyclicals versus defensives (Chart 8). One key driver of the capex cycle is China and the emerging markets (EM). News on both fronts is grim. Our real-time indicator that gauges China’s reflation efforts (monetary and fiscal) turning into actual economic activity is Chinese excavator sales that remain in the doldrums (top panel, Chart 9). Chart 8Drop In Capex Will Weigh On Relative Profits Chart 9Elusive Global Growth Granted, global growth remains elusive as we highlighted last week and while softening Chinese economic activity is weighing on global growth, European and Japanese GDP growth is also decelerating with a number of economies already in the contraction zone (bottom panel, Chart 9). Melting global bond yields reflect these growth fears and warn that the relative share price ratio has more downside (middle panel, Chart 9). Export growth is an important indicator that closely tracks the ebbs and flows of global trade. When the trade-weighted U.S. dollar appreciates it dampens trade, the opposite is also true. Currently the Fed’s trade-weighted greenback based on goods has vaulted to cyclical highs, warning that the path of least resistance is lower for trade, thus a net negative for relative export and profit prospects (Chart 10). Similarly, EM capital outflows exacerbate the ongoing global growth blues and put additional strain on EM economies as depreciating currencies sap consumer purchasing power (top panel, Chart 10). The implication is that EM final demand is in retreat. The rising U.S. dollar not only deals a blow to basic resource exports via making them less competitive and leading to market share losses, but it also undermines cyclical sectors' pricing power. The top panel of Chart 11 shows that deflating commodity prices are exerting downward pull on relative share prices. The ISM manufacturing survey’s prices paid subcomponent corroborates this deflationary backdrop. Keep in mind that operating leverage cuts both ways, and now that the pendulum is swinging the opposite way revenue contraction in these high fixed costs industries will fall straight off the bottom line (Chart 11). Chart 10Rising Dollar Dollar Dampens Trade And… Chart 11…Saps Pricing Power Our macro-based cyclicals/defensives EPS growth models do an excellent job in capturing all these moving parts and signal that defensives have the upper hand in the coming quarters (bottom panel, Chart 8). Turning to operating metrics, the inventory buildup in the past few quarters coupled with a softness in overall business sales underscore that relative share prices will continue to trend lower (top panel, Chart 12). On the balance sheet front, relative net debt-to-EBITDA has troughed and widening junk spreads and the inverted yield curve warn that a further relative b/s degrading looms (second & third panels, Chart 12). If our thesis pans out in the coming months, then cash flow growth will come under pressure as the vicious capex cycle flexes its muscles foreshadowing a rise in bankruptcy filings. Already, the news on the profit margin front is disconcerting. Historically, the ISM manufacturing index and relative operating profit margins have been joined at the hip and the recent flirting of the former with the boom/bust line points toward an ominous relative margin squeeze (bottom panel, Chart 12). Chart 12Poor Financial & Operating Backdrop… Chart 13…But Excellent Valuations And Technicals Finally, soft versus hard data surprise oscillations have an excellent track record in forecasting relative share price movements. The current message is to expect additional weakness in relative share prices (second panel, Chart 13). While most of the indicators we track signal that the time is ripe to downgrade this portfolio bent to an underweight stance, bombed out relative valuations, and oversold technicals keep us at bay, at least for the time being (third & bottom panels, Chart 13). However, we are compelled to put the cyclicals/defensives ratio on downgrade alert to reflect the transition from a virtuous to a vicious EPS-to-capex cycle, souring global growth, the firming U.S. dollar that is weighing on cyclical/defensive pricing power and exports, and deteriorating b/s and operating metrics. The way we will execute this downgrade will be via a downgrade of the S&P tech sector (for additional details on the S&P tech sector's downgrade mechanics please refer to last Friday’s U.S. Equity Strategy Insight Report). Bottom Line: Stay on the sidelines in the S&P cyclicals/S&P defensives ratio, but put it on downgrade alert.     Anastasios Avgeriou, U.S. Equity Strategist anastasios@bcaresearch.com     Footnotes 1      https://www.rba.gov.au/speeches/2019/sp-gov-2019-08-25.html Current Recommendations Current Trades Size And Style Views Stay neutral cyclicals over defensives (downgrade alert) Favor value over growth Favor large over small caps

Feature In investment, there are times when your view and your strategy should not be the same. Our view remains that the global economy is likely to avoid recession over the next 18 months, that the Fed will cut rates once or twice more as an “insurance” but not enter a full easing cycle, that global bond yields will rise, and that risk assets will outperform over the next 12 months. But the risks to that view have increased, and so we want to bolster the hedge against our view being wrong. We don’t see Recommended Allocation Chart 1GAA Portfolio Volatility Relative To Benchmark government bonds as an attractive hedge at this level of yield, and so are moving to a “barbell” strategy, with overweights in equities and cash, and an underweight in fixed income. This lowers the volatility of our recommended portfolio to close to that of the benchmark (Chart 1). First, the good news. Although the manufacturing sector globally continues to deteriorate, with many PMIs falling to below 50, services and consumption remain robust almost everywhere (Chart 2). With central banks easing monetary policy, and in some countries (Italy, the U.S., the U.K., maybe even Germany) governments loosening fiscal policy, financial conditions are improving, which will eventually support growth (Chart 3). Intra-cyclical manufacturing downturns typically last around 18 months, and this one is close to its sell-by date (Chart 4). Chart 2Manufacturing Weak, Services Fine So what has changed? First, manufacturing has continued to decline for longer than we expected. In the early summer, there were signs of a bottoming in Europe, but these are no longer evident. The diffusion index of the global manufacturing PMI (i.e. the percentage of countries with a rising versus falling PMI), which typically leads the PMI by six months, suggests the PMI has further to fall (Chart 5). Chart 3Easing Financial Conditions Will Help Chart 4Close To The Bottom?   Chart 5Further Downside For PMIs? Chart 6China's Reluctant Monetary Stimulus   The most likely cause of this is that China has been more reluctant to ramp up monetary stimulus than we expected. It has eased fiscal policy, but monetary policy has been tentative: despite a moderate increase in credit creation this year, M3 money supply growth has barely accelerated (Chart 6). This has been enough to stabilize Chinese growth, but has been insufficient to give the sort of boost to global growth that China provided in 2016. There are two reasons for China’s reluctance to stimulate. The authorities seemingly continue to prioritize debt deleveraging and clamping down on shadow banking. And, also, maybe they do not want to give a boost to the global economy that would help the U.S. avoid recession and increase the probability of President Trump’s being reelected. China has been more reluctant to ramp up monetary stimulus than we expected. The Trade War is an increasing risk. BCA’s geopolitical strategists continue to assign a 40% probability to a resolution by year-end,1 but it is becoming harder to see how (or, indeed, why) President Xi would offer concessions to the U.S. that would lead to a deal. Ultimately, if Chinese growth slows significantly and U.S. stocks fall sharply, China will boost monetary stimulus and President Trump will push for even a superficial trade agreement. But things will need to get worse first. Meanwhile, the rise in global political uncertainty – and the mercurial nature of Trump’s foreign and trade policies – are a risk for markets (Chart 7). Chart 7Global Political Risks Rising Chart 8Consumers (Mostly) Remain Confident   We are also concerned about how long consumption can remain robust in this environment. So far, consumer confidence has remained resilient in the U.S., though it has dipped a little in Europe and Japan (Chart 8). But, if corporate profits remain weak, companies will start to delay hiring decisions and begin to lay off workers. This would be the transmission mechanism for the manufacturing slowdown to spread into the broader economy. So far, fortunately, there are few signs it is happening: German unemployment is at a record low, and U.S. initial claims continue to run at or below last year’s level (Chart 9). Chart 9No Signs Of Weakening Labor Market Table 1GAA Recession Checklist     In the recession checklist we have published for the past two or more years, we are starting to have to tick off more warning signs (Table 1 and Chart 10). Chart 10Some Worrying Signs Chart 11Risk Of Recession No Longer Negligible   For example, the yield curve has inverted both for the 3-month/10 year and 2-year/10-year. Although the yield curve has been an almost infallible predictor of recession in the past 70 years, there are some reasons to argue that it may not be as good this time: for example, central bank purchases have artificially pulled down long-term rates. But inversion is probably a self-fulfilling prophesy. For example, in a recent Fed Senior Bank Loan Officers Survey, 40% of banks said they would tighten credit standards simply because of a moderate inversion of the yield curve. Formal models of recession 12 months ahead that incorporate the yield curve slope, put recession risk now at about 25% (Chart 11).   Chart 1218 Months Of Ups And Downs Given all this, we think it is appropriate to take some risk off. As far back as February 2018, we argued that “investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now”.2 Given the ups and down of markets in the past 18 months, we suspect that those risk-averse investors would not have been unhappy with that advice (Chart 12), although they would also have missed some nice equity rallies over that time, if they had been nimble enough to time entry and exit points. Since a majority of the subscribers to this service are rather conservative, we are now extending that advice to all clients. On a 12-month time horizon, we raise cash to overweight. We are also reducing somewhat both our equity overweight and bond underweight. In this period of increased uncertainty, a portfolio closer than usual to benchmark makes sense. (BCA’s House View is a little more bullish, remaining neutral on cash and overweight equities on the 12-month horizon). Fixed Income: Absent recession, we see little room for rates to fall further. The U.S. 10-year Treasury yield (now 1.5%) should stay above its July 2016 historic low of 1.37%. The Fed is unlikely to cut rates by 100 basis points over the next 12 months, as futures imply. We would expect only two 25 bp rate cuts: in September and either October or December. Yields are likely eventually to move up over the next 12 months (particularly given that inflation continues to trend higher). But they may not move much for a while, and so we move from underweight to neutral on duration for now. Eventually, we see investors understanding that government bonds are no longer an attractive hedge at current yields. Even if German 10-year yields fell to -1.2% (probably around the lowest possible), one-year total return would only be 5% (Table 2). The U.S. looks a little better, though. One could imagine the yield falling to zero in the next recession, which would give a return of 16%. On credit, we remain neutral: it represents a low-beta play on equities. So far this year, both investment-grade and high-yield bonds have eked out a small positive excess return (Chart 13). Table 2Not Much Room For Positive Returns Chart 13Credit Returns Have Not Been Bad Chart 14Downside For Cyclicals?   Equities: To offset our overweight on equities, we continue with a low-beta country/regional tilt. We recommend an overweight on the U.S., and underweight on Emerging Markets. The key for upside to U.S. equities remains earnings. Analysts have a pessimistic forecast of only 2.5% EPS growth in 2019 for the S&P500. A rough proxy for earnings growth (nominal GDP growth of 4.5%, wage growth of 3.5% leading to some margin expansion, 2% buybacks) points to EPS growth of around 7-8%. Q3 earnings (where analysts forecast -2% year-on-year) are likely to surprise on the upside, as did Q1 and Q2, though the strong dollar and weak overseas growth are risks. In our next Quarterly, to be published on October 1, we may make some adjustments to further dial down risk, for example in our equity sector recommendations, which currently have a slight cyclical tilt. The relative performance of cyclicals has started to wobble, and the message from bond markets is that cyclicals have further to fall in relative terms (Chart 14). Investors will come to understand that government bonds are no longer an attractive hedge at current yields. Currencies: The trade-weighted dollar has broadly moved sideways in the past year (Chart 15), weakening against the yen, but strengthening against the euro and EM currencies. We remain neutral on the dollar. It will continue to be pulled by two opposing forces: weak global growth is a positive, but the Fed has more room to cut rates than the rest of the world and so interest rate differentials will shift against the dollar. The renminbi is likely to continue to weaken, as the Chinese use currency policy as the least painful offset against U.S. tariffs. The latest  set of tariffs suggests that the CNY needs to fall to around 7.5-7.6 to the USD to offset their impact but, if Trump implements all the tariffs he has threatened, it could fall as far as 8.0 (Chart 16). This would pull other EM currencies down further. GBP will continue to be buffeted by Brexit scenarios. A no-deal Brexit could bring it down to 1.00 against the USD, whereas Remain or a very soft Brexit would take it back to PPP, 1.43. The current level is a probability weighted average of the two. Chart 15Dollar Has Moved Broadly Sideways Chart 16CNY Could Fall Much Further     Commodities: The oil price has been hurt by a slowing of demand in developed economies (Chart 17). Supply, however, remains tight, and our energy strategists have cut their forecast for Brent this year only modestly to an average of $66 a barrel (from an earlier forecast of $70, and from a current spot price of $60).3 Industrial commodities continue to struggle because of China’s slowdown (Chart 18) and are unlikely to recover until China’s stimulus is beefed up. Gold remains a good insurance for investors worried about geopolitical risk, recession, and inflation.   Chart 17EM Oil Demand Has Been Weak   Chart 18Industrial Commodities Hurt By China       Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com 1      Please see Geopolitical Strategy Weekly, “Big Trouble In Greater China,” dated August 23, 2019, available at gps.bcareseach.com 2      Please see Global Asset Allocation, “GAA Monthly Portfolio Update,” dated February 1, 2018, available at gaa.bcaresearch.com. 3      Please see Commodity & Energy Strategy, “USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl,” dated August 22, 2019, available at ces.bcaresearch.com Recommended Asset Allocation  

Highlights Our cyclical view is unchanged, … : Despite the evident risks from escalating trade tensions, soft global economic data, and widespread recession concerns, we expect the expansion and the bull markets in spread product and equities will remain intact. … as fiscal largesse has provided the U.S. economy with ample cushion: Per the IMF’s estimates, the fiscal stimulus package centered on the Tax Cuts and Jobs Act of 2017 amounted to about 70 basis points (“bps”) of fiscal thrust in 2018 and another 40 bps in 2019. But how is Congress’ unprecedented experiment shaping up beyond 2019?: The first-order impact of the tax cuts on government revenues is straightforward. The ultimate net effect turns on how lower taxes alter the course of corporate investment and work force participation. The CBO’s latest projections have the federal deficit widening by an additional $1 trillion over the next decade: Supply-side benefits from the 2017 Act have underwhelmed so far, and the fate of the federal budget depends on lawmakers’ restraint. We are long-run bearish on Treasuries and the dollar. Feature The fundamental backdrop remains mixed in the United States and the rest of the world. Global trade has slowed, and the world is experiencing a sharp manufacturing slowdown. The consensus of BCA researchers expects that manufacturing will soon find a footing, and the global economy will revive, helped along by easier monetary policy. A fiscal pick-me-up is long overdue, and would be especially welcome, but we are not holding our breath, especially when Japan finally seems prepared to impose its repeatedly-postponed VAT increase. Opinion within BCA is notably split, and the glass-half-full and glass-half-empty camps remain far apart. The mixed tone of the macro data offers something for bulls and bears, and contributed to the sharp single-day moves that characterized August’s equity action. Although the S&P 500 moved at least 1% in half of its sessions, however, it was down less than 2% for the month through Thursday. After slipping from its 3,000 perch amidst a 5% decline across August’s first three sessions on renewed trade hostilities, it traded in a narrow range between 2,825 and 2,945 the rest of the way (Chart 1). Chart 1Big Daily Swings, But A Tight Monthly Range The Fed is caught in a loop of responding to inorganic shocks. It tightened policy in 2018 while nervously looking over its shoulder at a sizable injection of procyclical fiscal stimulus that wound up exerting less overheating pressure than it had feared. Now it finds itself uncomfortably drawn into the vortex of the trade war, cutting rates to keep the expansion from being snuffed out prematurely by self-inflicted wounds. Various Fed officials seem to be chafing under the burden of serving as a bulwark against the drag from the tariff fights. As Chair Powell admonished in his Jackson Hole address, “[M]onetary policy … cannot provide a settled rulebook for international trade.” Like it or not, the Fed is stuck cleaning up other policymakers’ messes. Jackson Hole would normally have brought down the curtain on any meaningful market news until after Labor Day. But Bill Dudley, the head of the New York Fed from 2009 to 2018, had other ideas. He argued in a Bloomberg opinion column that the Fed should refuse to abet foolhardy trade policy with rate cuts that offset its ill effects. He went on to posit that it is within the Fed’s remit to set policy with an eye toward influencing the outcome of the 2020 presidential election. Dudley’s grenade enlivened a slow news day and had the effect of unifying the economics community in condemnation of his polemic. The Fed swiftly distanced itself from the comments, reiterating that its “decisions are guided solely by its congressional mandate,” and that “political considerations play absolutely no role.” It is hard to know what Dr. Dudley intended to accomplish, but he ensured that we will be at BCA’s 40th Annual Investment Conference bright and early on Friday, September 27th when he kicks off its second day. Initial Estimates Soon after the 2017 Tax Cuts and Jobs Act was passed, the Congressional Budget Office (“CBO”) assessed how its provisions would affect the U.S. economy. Although calculating the components involves myriad complex estimates, the budget equation is quite simple: Budget Surplus/(Deficit) = Revenues – Outlays. Cutting taxes clearly reduces revenues, and the reductions in individual tax rates, partially offset by limits on deductions, were estimated to cost the federal government roughly $300 billion over the next decade. The 10-year tab for lower corporate rates, and immediate expensing of business investments through 2022, was estimated to run about $1 trillion. Relief from some spending constraints brought the total estimated cost to $1.7 trillion. A trillion here, and a trillion there, and pretty soon you’re talking real money. Though the Act was sure to worsen the deficit, it contained provisions meant to encourage investment and labor supply. Corporate tax cuts and the full immediate expensing of investments in software and eligible equipment were expected to permanently increase the nation’s capital stock, thereby boosting the trend pace of productivity growth. A reduced individual income tax burden was expected to encourage more people to enter the workforce and incumbents to work longer hours. Ultimately, the CBO projected that the Act would boost the level of real potential GDP by 0.7%, on average, through 2029.  Six Quarters On It follows that people might work more if they are able to keep more of what they earn, but the data since individual income tax rates were reduced at the beginning of 2018 are inconclusive. The labor force participation rate has been treading water for several years (Chart 2, solid line), as it battles against the drag from baby boomer aging (Chart 2, dashed line). Prime-age labor force participation has risen very slowly off of its 2015 bottom, and has spent 2019 unwinding its gains from late last year (Chart 3). Average weekly hours worked remain locked in the narrow range that has prevailed since 2012 (Chart 4). Though it is difficult to isolate the drivers of participation gains, the part rate’s erratic 2018-9 course suggests that the Act has not yet had a discernible work force impact. Chart 2The Baby Boomers Have Become A Demographic Headwind Chart 3Labor Supply ##br##Gains ... Chart 4... Have Yet To Materialize Residential investment, which lost some tax subsidies via the Act’s limits on mortgage interest and state and local tax deductions, has declined in every quarter since it was passed, and we back it out of fixed investment to assess the Act’s impact on corporate investment. As with labor supply, the record so far is mixed. Fixed investment (ex-residential investment) built on its 4Q17 acceleration over the first three quarters of 2018 only to slide in the three subsequent quarters (Chart 5). Publicly traded corporations have proven more eager to share their cash windfall with shareholders than they have been to invest it. Chart 5Investment Stimulus? What Investment Stimulus? Looking Ahead – Activity Effects We accept that lower individual income tax rates make work more attractive. People respond to incentives, and more after-tax pay, all else equal, should encourage some discouraged workers to rejoin the labor market and push some of the currently employed to want to work more. The changes are modest, though, with take-home pay increasing $324, or 2%, for someone earning $20,000, and $1,299, or 3%, for someone earning $50,000 (Table 1). We see the Act as having no more than a modest marginal effect on labor supply, though it should help boost consumption until households begin to factor in seemingly inevitable future tax hikes. Table 1Take-Home Pay Is Up, But Not By Much If the 2017 Act really is going to boost the potential trend rate of growth, it will have to do so by pushing the rate of productivity growth higher.1 Workers are able to produce more in a given block of time when they’re endowed with more and better tools, and new tools require investment. If fixed investment doesn’t accelerate, there’s no reason to expect that productivity will (Chart 6). The capex outlook from the NFIB survey and the various Fed regional manufacturing surveys is iffy, and BCA has previously noted how an aging population and a shift to more capital-light businesses may restrain investment. Chart 6Investment Drives Productivity It will not be an easy matter to boost productivity by boosting capex, though some of businesses’ after-tax cash will likely find its way to investment. To help the process along, Congress incorporated a familiar provision: accelerated depreciation. Accelerated depreciation’s empirical record as an investment catalyst is hardly clear (Box), and we don’t find its theoretical basis terribly compelling. We think the Act’s trend growth impacts are more likely to disappoint the CBO’s expectations than exceed them. Investment confronts demographic headwinds, too. Pushing trend growth higher will not be easy. Box - An Anodyne Prescription A celebrated provision of the Act allows for the immediate expensing of qualified investments until 2022. Accelerated depreciation programs, which allow for more rapid expensing of investments in property, equipment and other depreciable assets in an attempt to stimulate investment, are a stock measure in lawmakers’ stimulus toolkit, but their effectiveness is hardly assured. For one thing, they’re not new, and businesses may have built up an immunity to them, as they have been a continuous feature of the tax code since 1981. The immediate expensing allowed under the 2017 Act is a form of bonus depreciation, which was initially introduced in the wake of the September 11th attacks. It has remained in place for all but one subsequent year, and though investment peaked during the other stretch that provided for immediate write-offs (September 2010 - December 2011), we are skeptical that it will materially increase the size of the capital stock going forward. Accelerated depreciation schemes encourage investment via the time value of money. They do not increase the depreciation benefit provided by a particular investment, they simply speed up its recognition. Savvy businesses may adjust the timing of their investments to take advantage of temporary bonus periods, but they will not necessarily invest more.2 With rock-bottom interest rates squeezing the time value of money, it’s possible that bonus depreciation’s impact may be especially muted this time. Looking Ahead – The Budget Deficit The CBO’s updated projections through 2029, released two weeks ago, call for the budget shortfall to widen by $800 billion more than previously estimated in January. Despite a downward revision of over $1 trillion in projected interest expense, additional spending has weakened the deficit outlook. It appears that elected officials simply can’t help themselves. In a climate in which neither Congress nor voters evince any desire to rein in the deficit, it seems foolishly naïve to assume that future sessions of Congress will abide by built-in expenditure limits like sunset provisions and spending caps. Although the CBO projects that federal revenues will rise across its 10-year forecasting horizon, they will not do so fast enough to keep up with outlays swollen by interest payments on the growing pile of Treasuries (Chart 7). The CBO sees debt as a share of GDP rising to 95% by 2029, within reach of the all-time high recorded after World War II (Chart 8). Financial markets don’t care now, and we don’t think they will any time in the near future, but the CBO’s baseline projections, which assume future Congresses abide by their stated commitments, probably represent an optimistic scenario. We are more inclined to expect the alternative scenarios, in which sunset provisions are ignored, and pre-set spending caps are set aside, to come to pass. Chart 7A Widening Budget Gap ... Chart 8... Leads To An Increased Debt Burden Investment Implications Chart 9The Dollar's Long-Run Direction Is Down Treasury yields are currently within sight of their July 2016 Brexit-inspired lows, and may well revisit them. Negative yields are a common feature well out the maturity curve in core Europe and Japan. A sustained move higher is not in the cards in the near term, and though we do expect yields to rise as the global economy gains some traction later this year, we do not foresee a disruptive move higher even over the next couple of years. The very long-term outlook for Treasuries is lousy, however, and the dollar also faces secular pressures (Chart 9). The U.S. is not likely to turn into Japan, but the next decade’s returns will likely pale beside those earned since 1982. We are congenitally optimistic about humanity, and Americans seem to have a particular knack for pulling rabbits out of hats. We do not see the U.S. turning into Argentina, Greece or even Japan. The debt burden will weigh on potential growth down the road, however, as debt service will limit Congress’ ability to deploy countercyclical adjustments and longer-term investments, and debt issuance will eventually crimp private entities’ access to capital. All of these factors will limit potential economic growth and contribute to softening returns on equity and credit. We continue to foresee tepid returns over the next ten years relative to the returns investors have grown accustomed to over the last four decades, and we would much rather borrow at current rates for the next 20 or 30 years than lend at them.   Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Economic growth is the sum of growth in productivity and growth in the size of the labor force. Since the Act does not bear on immigration or birthrates, productivity represents its best shot at moving the growth needle. 2 Congressional Research Service Report RL31852, The Section 179 and Section 168(k) Expensing Allowances: Current Law and Economic Effects, by Gary Guenther, May 1, 2018.  

Highlights While a self-fulfilling crisis of confidence that plunges the global economy into recession cannot be excluded, it is far from our base case. Provided the trade war does not spiral out of control, it is highly likely that global equities will outperform bonds over the next 12 months. The auto sector has been the main driver of the global manufacturing slowdown. As automobile output begins to recover later this year, so too will global manufacturing. Go long auto stocks. As a countercyclical currency, the U.S. dollar will weaken once global growth picks up. We expect to upgrade EM and European equities later this year along with cyclical equity sectors such as industrials, energy, and materials. Financials should also benefit from steeper yield curves. We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Feature “The Democrats are trying to 'will' the Economy to be bad for purposes of the 2020 Election. Very Selfish!” – @realDonaldTrump, 19 August 2019 8:26 am “The Fake News Media is doing everything they can to crash the economy because they think that will be bad for me and my re-election” – @realDonaldTrump, 15 August 2019 9:52 am Bad Juju Chart 1Spike In Google Searches For The Word Recession President Trump’s remarks, made just a few days after the U.S. yield curve inverted, were no doubt meant to deflect attention away from the trade war, while providing cover for any economic weakness that might occur on his watch. But does the larger point still stand? Google searches for the word “recession” have spiked recently, even though underlying U.S. growth has remained robust (Chart 1). Could rising angst induce an actual recession? Theoretically, the answer is yes. A sudden drop in confidence can generate a self-fulfilling cycle where rising pessimism leads to less private-sector spending, higher unemployment, lower corporate profits, weaker stock prices, and ultimately, even deeper pessimism. Two things make such a vicious cycle more probable in the current environment. First, the value of risk assets is quite high in relation to GDP in many economies (Chart 2). This means that any pullback in equity prices or jump in credit spreads will have an outsized impact on financial conditions.   Chart 2The Total Market Value Of Risk Assets Is Elevated Chart 3Not Much Scope To Cut Rates Second, policymakers are currently more constrained in their ability to react to adverse shocks, such as an intensification of the trade war, than in the past. Interest rates in Europe and Japan are already at zero or in negative territory (Chart 3). Even in the U.S., the zero-lower bound constraint – though squishier than once believed – remains a formidable obstacle. Chart 4 shows that the Federal Reserve has cut rates by over five percentage points, on average, during past recessions. It would be impossible to cut rates by that much this time around if the U.S. economy were to experience a major downturn.   Chart 4The Fed Is Worried About The Zero Bound Fiscal stimulus could help buttress growth. However, both political and economic considerations are likely to limit the policy response. While China is stimulating its economy, concerns about excessively high debt levels have caused the authorities to adopt a reactive, tentative approach. Japan is set to raise the consumption tax on October 1st. Although a variety of offsetting measures will mitigate the impact on the Japanese economy, the net effect will still be a tightening of fiscal policy. Germany has mused over launching its own Green New Deal, but so far there has been a lot more talk than action. President Trump floated the idea of cutting payroll taxes, only to abandon it once it became clear that the Democrats were unwilling to go along. On The Positive Side Despite these clear risks, we are inclined to maintain our fairly sanguine 12-to-18 month global macro view. There are a number of reasons for this: First, the weakness in global manufacturing over the past 18 months has not infected the much larger service sector (Chart 5). Even in Germany, with its large manufacturing base, the service sector PMI remains above 50, and is actually higher than it was late last year. This suggests that the latest global slowdown is more akin to the 2015-16 episode than the 2007-08 or 2000-01 downturns. Chart 5AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 5BThe Service Sector Has Softened Much Less Than Manufacturing (II) Second, manufacturing activity should benefit from a turn in the inventory cycle over the remainder of the year. A slower pace of inventory accumulation shaved 90 basis points off of U.S. growth in the second quarter and is set to knock another 40 basis points from growth in the third quarter, according to the Atlanta Fed GDPNow model. Excluding inventories, U.S. GDP growth would have been 3% in Q2 and is tracking at 2.7% in Q3 – a fairly healthy pace given the weak global backdrop (Chart 6). Chart 6The U.S. Economy Is Still Holding Up Well Outside the U.S., inventories are making a negative contribution to growth (Chart 7). In addition to the official data, this can be seen in the commentary accompanying the Markit manufacturing surveys, which suggest that many firms are liquidating inventories (Box 1). Falling inventory levels imply that sales are outstripping production, a state of affairs that cannot persist indefinitely. Third, and related to the point above, the automobile sector has been the key driver of the global manufacturing slowdown. This is in contrast to 2015-16, when the main culprit was declining energy capex. According to Wards, global vehicle production is down about 10% from year-ago levels, by far the biggest drop since the Great Recession (Chart 8). The drop in automobile production helps explain why the German economy has taken it on the chin recently. Chart 7Inventories Are Making A Negative Contribution To Growth Chart 8Auto Sector: The Culprit Behind The Manufacturing Slowdown Importantly, motor vehicle production growth has fallen more than sales growth, implying that inventory levels are coming down. Despite secular shifts in automobile ownership preferences, there is still plenty of upside to automobile usage. Per capita automobile ownership in China is only one-fifth of what it is in the United States, and one-fourth of what it is in Japan (Chart 9). This suggests that the recent drop in Chinese auto sales will be reversed. As automobile output begins to recover later this year, so too will global manufacturing. Investors should consider going long automobile makers. Chart 10 shows that the All-Country World MSCI automobiles index is trading near its lows on both a forward P/E and price-to-book basis, and sports a juicy dividend yield of nearly 4%.1 Chart 9The Automobile Ownership Rate Is Still Quite Low In China Chart 10Auto Stocks Are A Compelling Buy   Fourth, our research has shown that globally, the neutral rate of interest is generally higher than widely believed. This means that monetary policy is currently stimulative, and will become even more accommodative as the Fed and a number of other central banks continue to cut rates. Remember that unemployment rates have been trending lower since the Great Recession and have continued falling even during the latest slowdown, implying that GDP growth has remained above trend (Chart 11). As diminished labor market slack causes inflation to rebound from today’s depressed levels, real policy rates will decline, leading to more spending through the economy.  Chart 11Unemployment Rates Keep Trending Lower The Trade War Remains The Biggest Risk The points discussed above will not matter much if the trade war spirals out of control. It is impossible to know what will happen for sure, but we can deduce the likely course of action based on the incentives that both sides face. President Trump has shown a clear tendency in recent weeks to try to de-escalate trade tensions whenever the stock market drops. This is not surprising: Despite his efforts to deflect blame for any selloff on others, he knows full well that many voters will blame him for losses in their 401(k) accounts and for slower domestic growth and rising unemployment. What about the Chinese? An increasing number of pundits have warmed up to the idea that China is more than willing to let the global economy crash if this means that Trump won’t be re-elected. If this is China’s true intention, the Chinese will resist making any deal, and could even try to escalate tensions as the U.S. election approaches. It is an intriguing thesis. However, it is not particularly plausible. U.S. goods exports to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. account for 3.4% of Chinese GDP. Total manufacturing value-added represents 29% of Chinese GDP, compared to 11% for the United States. There is no way that China could torpedo the U.S. economy without greatly hurting itself first. Any effort by China to undermine Trump’s re-election prospects would invite extreme retaliatory actions, including the invocation of the War Powers Act, which would make it onerous for U.S. companies to continue operating in China. Even if Trump loses the election, he could still wreak a lot of havoc on China during the time he has left in office. Moreover, as Matt Gertken, BCA’s Chief Geopolitical Strategist, has stressed, if Trump were to feel that he could not run for re-election on a strong economy, he would try to position himself as a “War President,” hoping that Americans rally around the flag. That would be a dangerous outcome for China.  Chart 12Would China Really Be Better Off Negotiating With A Democrat As President? In any case, it is not clear whether China would be better off with a Democrat as president. The popular betting site PredictIt currently gives Elizabeth Warren a 34% chance of winning, followed by Joe Biden with 26%, and Bernie Sanders with 15% (Chart 12). This means that two far-left candidates with protectionist leanings, who would stress environmental protection and human rights in their negotiations with China, have nearly twice as much support as the former Vice President. All this suggests that China has an incentive to de-escalate the trade war. Given that Trump also has an incentive to put the trade war on hiatus, some sort of détente between the U.S. and China, as well as between the U.S. and other players such as the EU, is more likely than not. Investment Conclusions Provided the trade war does not spiral out of control, it is very likely that global equities will outperform bonds over the next 12 months. Since it might take a few more months for the data on global growth to improve, equities will remain in a choppy range in the near term, before moving higher later this year. As we discussed last week, the equity risk premium is quite high in the U.S., and even higher abroad, where valuations are generally cheaper and interest rates are lower (Chart 13).2 Chart 13AEquity Risk Premia Remain Quite High (I) Chart 13BEquity Risk Premia Remain Quite High (II) The U.S. dollar is a countercyclical currency (Chart 14). If global growth picks up later this year, the greenback should begin to weaken. European and emerging market stocks have typically outperformed the global benchmark in an environment of rising global growth and a weakening dollar (Chart 15). We expect to upgrade EM and European equities – along with more cyclical sectors of the stock market such as industrials, materials, and energy – later this year. Chart 14The U.S. Dollar Is A Countercyclical Currency Chart 15EM And Euro Area Equities Usually Outperform When Global Growth Improves     Thanks to the dovish shift by central banks around the world, government bond yields are unlikely to return to their 2018 highs anytime soon. Nevertheless, stronger economic growth should lift long-term yields at the margin, causing yield curves to steepen (Chart 16). Steeper yield curves will benefit beleaguered bank stocks. Chart 16Stronger Economic Growth Should Lift Long-Term Bond Yields, Causing Yield Curves To Steepen Finally, a word on gold: We still like gold as a long-term investment. However, the combination of higher bond yields and diminished trade tensions could cause bullion to sell off in the near term. As such, we are closing our tactical long gold trade for a gain of 20.5%. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Box 1 Evidence of Inventory Liquidation In The Manufacturing Sector Footnotes 1 The top ten constituents of the MSCI ACWI Automobiles Index are Toyota (22.6%), General Motors (7.8%), Daimler (7.3%), Honda Motor (6.2%), Ford Motor (5.7%), Tesla (4.8%), Volkswagen (4.8%), BMW (3.8%), Ferrari (3.0%), Hyundai Motor (2.4%). 2 Please see Global Investment Strategy Special Report, “TINA To The Rescue?” dated August 23, 2019. 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