Economy

Highlights Duration: Hawkish trade policy will continue to weigh on bond yields for at least the next few months, but a rebound in global economic growth should take hold before the end of the year. Ultimately, a growth rebound will lead to higher bond yields on a 12-month horizon, but the timing is difficult and investors should keep portfolio duration close to benchmark for the time being. High-Yield: The Fed’s accommodative policy stance and the likelihood of a global growth recovery argue for maintaining an overweight allocation to corporate credit. Within that allocation, junk bonds should outperform investment grade due to much more attractive valuations. 10-Year Treasury Yield: The current shock to global economic growth is of a similar magnitude to the one that occurred in 2015/16. However, wage and inflationary pressures are higher now than they were back then. This means that the 10-year Treasury yield will not re-visit the 2016 trough of 1.37%, and is probably already close to its floor. Feature Regular readers will be aware of our Fed Policy Loop framework for analyzing the wiggles in financial markets. The Loop works as follows: Step 1: A dovish shift in Fed policy leads to a favorable market reaction, easing financial conditions. Step 2: Easier financial conditions suggest to the Fed that economic growth will strengthen in the future. The Fed can therefore respond by adopting a more hawkish policy stance. Step 3: The Fed’s hawkish policy shift leads to a negative market reaction, tightening financial conditions. Step 4: Tighter financial conditions suggest to the Fed that economic growth will weaken in the future. The Fed is forced to ease monetary policy at the margin. Return to Step 1 But it appears that BCA readers aren’t the only ones aware of the Fed Policy Loop. President Trump has also been exploiting the two-way relationship between Fed policy and financial conditions as he escalates his trade war with China. Chart 1 illustrates how this has been working. Step 1 of the Fed policy loop continues to function exactly as described above. However, the last few times that financial conditions have eased, the President has seized the opportunity to ratchet up trade tensions. Much like the Fed, the President reasons that periods of easier financial conditions are when the economy and financial markets can best handle a negative shock. The fall-out is that financial conditions tighten in response to the hawkish trade announcement, and the Fed is forced to respond to tighter financial conditions by turning even more dovish. The end result is that the part of the Fed Policy Loop labeled “Hawkish Fed” is by-passed. Without that step it is impossible for bond yields to rise (Chart 2). Chart 2The Back-Drop Of The Interrupted Fed Policy Loop Our Geopolitical Strategy service provided a comprehensive breakdown of U.S./China trade negotiations in last week’s report.1 The overall message is that the 2020 election is the President’s main constraint. He views hawkish trade policy as a winning issue, but only insofar as it can be accomplished without a significant decline in the stock market or economic activity. Faced with that constraint, the President will continue to interrupt the Fed Policy Loop, and the Fed will continue to do its job by adopting a more dovish monetary policy to offset possible trade shocks. At present, this means that another rate cut is likely in September. Against the back-drop of the “interrupted” Fed Policy Loop, Treasury yields can only move higher if global economic growth strengthens. In that case, the policy loop will remain operative, but at an overall higher level of yields. With that in mind, while hawkish trade policy will continue to weigh on bond yields for at least the next few months, a rebound in global economic growth should take hold before the end of the year. This will lead to higher bond yields on a 12-month horizon. Still Tracking The 2015/16 Roadmap In our research, we have repeatedly pointed out the similarities between the 2015/16 episode of flagging global growth and the current period. Specifically, we continue to witness weak manufacturing data – both in the U.S. and abroad – but a resilient service sector and strong labor market. Much like in 2015/16, we expect that the shifts toward easier monetary policy in the U.S. and more accommodative credit conditions in China will eventually put a floor under the global manufacturing cycle. The Fed will continue to do its job by adopting a more dovish monetary policy to offset possible trade shocks. At present, this means that another rate cut is likely in September. Case in point, even as President Trump has tightened global financial conditions at the margin through his hawkish trade policy, overall global financial conditions have eased since the beginning of the year (Chart 3). In 2016, easier financial conditions eventually led to upturns in crucial measures of global growth such as the Goldman Sachs Current Activity Indicator (Chart 3, top panel), the Global Manufacturing PMI (Chart 3, panel 2), and the CRB Raw Industrials index (Chart 3, bottom panel). The same dynamic should play out this time around. It’s likely that the main reason why global growth has not responded as quickly as it did in 2016 is that Chinese policy easing has not been as rapid (Chart 4). Our China Investment Strategy service’s Li Keqiang Leading Indicator – a composite measure of money and credit indicators designed to lead Chinese economic activity – has clearly bottomed, but has not yet surged as it did in 2015/16. However, Chinese policy easing continues to ramp up, a process that will continue in the months ahead. The most recent indication of this trend was China’s decision to de-value its currency versus the U.S. dollar, causing the exchange rate to jump above the important psychological threshold of 7 yuan per dollar (Chart 4, bottom panel). China took similar measures to de-value its currency in August 2015, a move that initially roiled markets but eventually helped usher in a rebound in global growth. Chart 3The 2015/2016 Scenario Has Yet To Play Out... Chart 4...As Long As China Does Not Stimulate More When it comes to strategy, we remain confident that global growth is close to a trough, but admit that timing the rebound is difficult. One indicator that should help with timing is the ratio between the CRB Raw Industrials index and Gold (Chart 5). This ratio is tightly correlated with the 10-year Treasury yield, and will only rise when the perceived improvement in global growth – proxied by the CRB index – starts to outpace the perceived dovish tilt to Fed policy – proxied by the rising gold price. Chart 5Keep Tracking The CRB / Gold Ratio In light of these difficulties with timing, we recommend that investors keep portfolio duration close to benchmark, but position for a rebound in global growth by maintaining an overweight allocation to credit risk and by running a heavily barbelled Treasury portfolio, overweighting the long and short ends of the curve while avoiding the 5-year and 7-year maturities. The barbell strategy increases average portfolio yield, and also avoids the part of the yield curve that will suffer the most when yields rise. Take Credit Risk In Junk As mentioned above, we recommend that investors maintain an overweight allocation to corporate credit versus Treasuries, despite our recent shift to benchmark duration.2 This is particularly true for high-yield bonds, where spreads are very attractive. Charts 6A and 6B show one of our favorite ways of looking at corporate bond spreads. The charts show the 12-month breakeven spread for each credit tier as a percentile rank relative to history.3 We show each credit tier individually to control for the time-varying average credit rating of the overall indexes. Similarly, we show breakeven spreads instead of the average option-adjusted spreads to control for the time-varying average duration of the bond indexes. Chart 6A shows the following valuation for investment grade credit tiers: Throughout history, Aaa credits have been more expensive than they are today only 13% of the time. Aa credits have been more expensive than they are today 19% of the time. A-rated credits have been more expensive 20% of the time. Baa credits have been more expensive 33% of the time. Chart 6B shows that the corresponding valuation for high-yield is much more compelling: Ba credits have been more expensive than today 55% of the time. B credits have been more expensive 81% of the time. Caa credits have been more expensive 84% of the time. Chart 6AInvestment Grade Breakeven Spreads Chart 6BHigh-Yield Breakeven Spreads In general, this way of looking at spreads shows that investment grade credits are quite expensive, while high-yield credits are either fairly valued or cheap. However, there is one more adjustment we can make to get an even better picture of corporate bond value. Adjusting For The Phase Of The Cycle A useful tool for cyclical portfolio allocation is to split the cycle into three phases based on the slope of the yield curve (Chart 7). We define the three phases as: Chart 7The Three Phases Of The Cycle Phase 1: From the end of the last recession until the 3/10 Treasury slope flattens to below 50 bps. Phase 2: When the 3/10 slope is between 0 bps and +50 bps. Phase 3: From when the 3/10 slope inverts until the start of the next recession. We have previously discussed the implications of the different phases for bond portfolio allocation in more depth.4 This week, we simply want to point out that credit spreads tend to be tighter during Phase 2 of the cycle, when monetary policy has tightened, but not by enough to cause a surge in corporate defaults. The recent surge in investment grade net debt-to-EBITDA likely reflects the shift toward a greater concentration of Baa-rated issuers. With this cyclical decomposition in mind, we can calculate the median breakeven spread for each credit tier in past Phase 2 periods and use that as a spread target for this cycle. We then convert our breakeven spread targets into average option-adjusted spread targets using current index duration. Charts 8A and 8B show how far each credit tier’s spreads are from target. The message is quite clear. Outside of Aaa, investment grade credits are more or less fairly valued, while high-yield credits appear very cheap. Chart 8AInvestment Grade Spread Targets Chart 8BHigh-Yield Spread Targets One might reasonably challenge this approach to corporate bond valuation by noting that, outside of looking at credit tiers individually, we have not taken fundamental credit quality trends into account. That is, we have made no adjustment for the fact that the credit quality of a Ba-rated issuer might be worse today than in prior cycles. We are skeptical that fundamental credit metrics matter more than the phase of the monetary policy cycle when it comes to corporate bond spread forecasting.5 However, this point of view is still worth exploring, especially considering that net debt-to-EBITDA for the median corporate bond issuer is quite elevated compared to history (Chart 9). Note that we have not attempted to maintain consistent weightings between the different credit tiers in the bottom-up samples shown in Chart 9. This means that the recent surge in investment grade net debt-to-EBITDA likely reflects the shift toward a greater concentration of Baa-rated issuers. Nonetheless, the net debt-to-EBITDA ratio of the median junk issuer is clearly worse than during the past two recoveries. But even if we take this into account by looking at the ratio between the junk index 12-month breakeven spread and the median net debt-to-EBITDA, we see that the ratio is still close to its historical median (Chart 10). In other words, at current spread levels junk investors appear reasonably compensated for the elevated median net debt-to-EBITDA ratio Chart 9Elevated Corporate Leverage Chart 10Favor Junk Bonds Bottom Line: The Fed’s accommodative policy stance and the likelihood of a global growth recovery argue for maintaining an overweight allocation to corporate credit. Within that allocation, junk bonds should outperform investment grade due to much more attractive valuations. Close To The Floor Chart 11Now Vs. Mid-2016 In a prior report we walked through the process of creating a macroeconomic fair value model for the 10-year Treasury yield, with a focus on describing the different independent variables that might be included in such a model, and the rationale for each one.6 This week, we focus on two vital macroeconomic variables and use them to demonstrate why the 10-year Treasury yield is unlikely to re-visit its mid-2016 trough of 1.37%. The two main variables we focus on are (i) the pace of economic growth, and (ii) the size of the output gap. All else equal, a stronger pace of economic growth leads to expectations for a higher policy rate in the future and a higher 10-year Treasury yield today. However, it is not just the pace of growth that matters. The same rate of economic growth generates more inflationary pressure when the output gap is small than when it is large. This means that bond yields should be higher when the output gap is smaller (or more specifically, less negative). We have found that the Global Manufacturing PMI is probably the indicator of economic growth that correlates best with the 10-year Treasury yield. Similarly, measures of wage growth – and to a lesser extent core inflation – tend to give the best read on the output gap. With that in mind, we can see how these factors look today relative to when the 10-year yield troughed at 1.37% in mid-2016 (Chart 11). Global economic growth looks slightly worse, but not dramatically so. The Global Manufacturing PMI is at 49.3 today. It troughed at 49.9 in 2016. If this were the only variable that mattered, we might reason that the 10-year yield should be below 1.37% already. But we also need to consider that wage growth and inflation are both much higher than in 2016. Average hourly earnings are growing at a year-over-year rate of 3.2%, compared to a rate of 2.8% when the 10-year troughed in 2016. Similarly, the Atlanta Fed’s measure of median wage growth is up to 3.7% for the un-weighted sample and 3.9% for the sample that is weighted to more closely match the demographic characteristics of the overall population (Chart 11, panel 3). It’s true that core PCE inflation is running below where it was in mid-2016, but the trimmed mean measure is much higher (Chart 11, bottom panel). The core PCE inflation measure also has a strong track record of converging toward the trimmed mean, a process we expect is playing out again. The core PCE inflation measure also has a strong track record of converging toward the trimmed mean, a process we expect is playing out again. Bottom Line: The current shock to global economic growth is of a similar magnitude to the one that occurred in 2015/16. However, wage and inflationary pressures are higher now than they were back then. This means that the 10-year Treasury yield will not re-visit the 2016 trough of 1.37%, and is probably already close to its floor.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see Geopolitical Strategy Weekly Report, “The Rattling Of Sabers”, dated August 9, 2019, available at gps.bcaresearch.com 2 Please see U.S. Bond Strategy Portfolio Allocation Summary, “Underinsured”, dated August 6, 2019, available at usbs.bcaresearch.com 3 The 12-month breakeven spread is the basis point widening required on a 12-month horizon for each credit tier to break even with a duration-matched position in Treasuries. 4 Please see U.S. Bond Strategy Special Report, “2019 Key Views: Implications For U.S. Fixed Income”, dated December 11, 2018, available at usbs.bcaresearch.com 5 Please see U.S. Bond Strategy / Global Fixed Income Strategy Special Report, “The Risk From U.S. Corporate Debt: Theory And Evidence”, dated April 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “Bond Kitchen”, dated April 9, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Negative Interest Rates: Time will tell if negative bond yields are indeed the “new normal”. We need to see negative yields maintained outside of a growth slowdown to prove that thesis. USTs & Bunds: U.S. Treasuries and German Bunds both look overbought, amid extreme price/yield momentum and aggressively long duration positioning. Yet given the persistent headline risk from the U.S.-China trade dispute, and without signs of improving growth in China or Europe, it is too early to position for a reversal of the stretched yield moves. Maintain a neutral overall stance on global duration exposure.1 Feature Positive Headlines On Negative Yields? Investors should always be cautious of “new era” explanations to justify an elevated asset price after a massive rally. That is akin to internet stocks in the late 1990s that were valued on “clicks and eyeballs” in the absence of actual profits. Or the “peak oil” thesis, predicting an impending exhaustion of global petroleum supplies, that was trotted out during past periods when oil prices were already above $100/bbl. The latest such argument can be found in government bonds, where fundamental justifications for the growing inventory of negative yielding bonds being “the new normal” have started to proliferate. The arguments underlying the “Negative Normal Thesis” (which we will coin “NNT”, not to be confused with the MMT of Modern Monetary Theory!) are hardly new. Aging demographics, “savings gluts” and a dwindling supply of global safe assets have been widely cited as causes for low bond yields since early in the 21st century (remember former Fed Chair Alan Greenspan’s famous “bond conundrum”?). Proponents of NNT point to Japan as the textbook example of how rates can stay low forever when savings are high and demand for capital is low. They are now declaring the “Japanification” of Europe … with the U.S. next in line to eventually join the negative rate party. If the argument that negative interest rates are now normal were to hold, however, we would need to see bond yields continue to stay at negative (or at least extremely low) levels even after global economic growth has stabilized. Chart of the WeekIs This Really A “New Era” For Bond Yields? If the argument that negative interest rates are now normal were to hold, however, we would need to see bond yields continue to stay at negative (or at least extremely low) levels even after global economic growth has stabilized. For if negative yields are, in fact, structurally driven by excess savings and not just cyclically driven by weak nominal growth, then improving economic momentum should have little impact on the level of interest rates. That would be a true “Japanification” scenario. For now, as far as we can tell from the data, the big decline in bond yields over the past year can be fully explained by the classic drivers – slowing economic growth and soft inflation (Chart of the Week). Investors are keenly aware of the triggers for these moves by now: a) slowing global trade and capital spending, both victims of the ever-worsening U.S.-China trade dispute; b) the lagged impact of past monetary tightening (Fed rate hikes and, arguably, the end of ECB bond buying at the end of 2018); and c) the persistent strength of the U.S. dollar preventing global “reflation”. You do not have to be an aging saver to view those as good reasons to favor the near-term safety of government bonds. Right now, the steady drumbeat of weakening cyclical global growth indicators is fueling bullish bond sentiment, especially in the parts of the world most exposed to global trade like Europe. Looking ahead, however, we may get the first test of NNT much sooner than expected. The latest update of the OECD’s leading economic indicators (LEI) was released last week. The message is consistent with the modest improvement seen over the past several months (Chart 2), with meaningful gains seen in many economies sensitive to global growth like Mexico, Taiwan, Australia and, most importantly, China.   Our “leading leading” indicator – the diffusion index of the global LEI, which includes many of the individual country OECD LEIs – continues to show that the majority of countries are seeing a rise in their LEI. We have shown that the LEI diffusion index has, in the past, been a fairly reliable leading indicator of the direction of not only the global LEI itself but of global bond yields as well. At present, the relatively optimistic reading from the global LEI diffusion index is at odds with the sharp downward momentum in bond yields (see the middle panel of the Chart of the Week). NNT at work, or a sign of a bubble forming in government bond markets? Time will tell. To be sure, the shaken confidence of investors thanks to the intensifying U.S.-China trade dispute has likely weakened the link between growth and yields – at least temporarily. Investors need to see hard evidence that global growth is bottoming out before seriously reevaluating the current level of bond yields. Signs of improvement in Chinese growth momentum would go a long way to turning around depressed investor confidence. It is still a bit too soon, however, to expect a rebound in Chinese domestic demand given the long lags between leading indicators like the OECD measure (or the China credit impulse) and hard Chinese economic data (Chart 3). More likely, a change in trend for these series would not be visible until well into the 4th quarter of 2019, at the earliest. Chart 2A Ray Of Hope For Global Growth? Chart 3Still A Bit Too Soon To Expect A China Turnaround Signs of better growth in Europe – where negative bond yields are most prevalent, including in corporate bonds – would also help to reverse excessive investor pessimism. A turnaround there, however, also needs better growth in China, given the heavy exposure of European exporters to Chinese demand. So until we see signs of a pickup in Chinese growth momentum, the economic gloomsters, “Ice Agers” and NNT crowd are in charge of the global government bond market. Until we see signs of a pickup in Chinese growth momentum, the economic gloomsters, “Ice Agers” and NNT crowd are in charge of the global government bond market. Bottom Line: Time will tell if negative bond yields are indeed the “new normal”. We need to see negative yields sustained outside of a growth slowdown to prove that thesis. Have The Rallies In U.S. Treasuries & German Bunds Now Gone Too Far? Last week, we upgraded our overall global duration call to neutral on a tactical (0-3 month) basis.2 This was driven by the growing risk that the global central banks – most notably, the Federal Reserve – could be forced to become even more dovish because of the escalation in the U.S.-China trade war. Furthermore, our Global Duration Indicator has pulled back after the steady rise since late 2018, and is now in line with the aggregate level of 10-year bond yields in the major developed markets (Chart 4). This is consistent with a neutral tactical duration view. Chart 4The Signal From Our Duration Indicator Is Consistent With A Neutral Stance There are signs, however, that Treasuries are overbought: Even as Treasury yields are heading closer to the 2016 lows, U.S. inflation expectations derived from the TIPS market are closer to 2% than the lows below 1.5% seen in 2016 (Chart 5). That market pricing seems reasonable, with realized inflation higher, and the labor market tighter, than was the case three years ago. The price momentum for the 10-year Treasury yield is approaching the extremes seen in the “post Fed QE” era (Chart 6), with the 6-month rate of change of the Bloomberg Barclays U.S. Treasury index approaching 10%. The deviation of the 10-year Treasury yield from its 200-day moving average, which is also at the post-QE extreme of -75bps, tells a similar story. Chart 5A Different U.S. Inflation Backdrop Vs. 2016 Chart 6The Fall In UST Yields Looks Stretched Investor positioning has become VERY long, with the J.P. Morgan duration survey of Active Clients surging to the highest level in the two-decade history of the series (Chart 6, third panel). A similar story applies to the German bond market, where the entire yield curve out to 30-years is trading below 0% (raising a cheer from the NNTers): Market-based inflation expectations have collapsed, with the 5-year CPI swap, 5-years forward reaching a low of 1.2% – lower than 2016, despite a tighter overall euro area labor market, accelerating wage growth and core inflation remaining sticky around 1% (Chart 7). The 6-month total return of the German government bond index is reaching a post-European Debt Crisis extreme near 10%, while the 10-year Bund yield is trading around a similar extreme of 50bps below its 200-day moving average (Chart 8). Chart 7European Inflation: Expectations Worse Than Reality Chart 8The Fall in Bund Yields Is Looking Stretched While the near-term backdrop does not justify a tactically bearish view on Treasuries or Bunds, the stretched technical backdrop suggests that yields could snap back quite sharply on any sign of better global growth or an easing of U.S.-China trade tensions. While the near-term backdrop does not justify a tactically bearish view on Treasuries or Bunds, the stretched technical backdrop suggests that yields could snap back quite sharply on any sign of better global growth or an easing of U.S.-China trade tensions. Bottom Line: U.S. Treasuries and German Bunds both look overbought, amid extreme price/yield momentum and aggressively long duration positioning. Yet given the persistent headline risk from the U.S.-China trade dispute, and without durable signs of improving growth in China or Europe, it is too early to position for a reversal of the stretched yield moves. Maintain a neutral overall stance on global duration exposure.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcarsearch.com. 2 Please see BCA Global Fixed Income Strategy Weekly Report, “Trade War Worries: Once More, With Feeling”, dated August 6, 2019, available at gfis.bcarsearch.com. Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Special Report

Dear Client, Instead of our regular report, this week we are sending you a Special Report penned by Matt Gertken, Chief Geopolitical Strategist of our sister Geopolitical Strategy service, titled “The Polybius Solution.” In this report Matt argues that a full-fledged cold war with China would put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. We trust that you will find this Special Report useful and insightful. Best regards, Anastasios Avgeriou, U.S. Equity Strategist Highlights So What? U.S.-Iran risk is front-loaded, but U.S.-China is the greater risk overall. A full-fledged cold war with China will put a cap on American political polarization, putting China at a disadvantage. By contrast, a U.S. war with Iran would exacerbate polarization, giving China a huge strategic opportunity. War with Iran or trade war escalation with China are both ultimately dollar bullish – even though tactically the dollar may fall.  Feature The idea of the “Thucydides Trap” has gone viral in recent years – for good reason. The term, coined by Harvard political scientist Graham Allison, refers to the ancient Greek historian Thucydides (460-400 BC), author of the seminal History of the Peloponnesian War. The “trap” is the armed conflict that most often develops when a dominant nation that presides over a particular world order (e.g. Sparta, the U.S.) faces a young and ambitious rival that seeks fundamental change to that order (e.g. Athens, China).1 This conflict between an “established” and “revisionist” power was highlighted by the political philosopher Thomas Hobbes in his translation of Thucydides in the seventeenth century; every student of international relations knows it. Allison’s contribution is the comparative analysis of various Thucydides-esque episodes in the modern era to show how today’s U.S.-China rivalry fits the pattern. The implication is that war (not merely trade war) is a major risk. We have long held a similar assessment of the U.S.-China conflict. It is substantiated by hard data showing that China is gaining on America in various dimensions of power (Chart 1). Assuming that the U.S. does not want to be replaced, the current trade conflict will metastasize to other areas. If the U.S. and China really engage in an epic conflict, American political polarization should fall. There is an important but overlooked corollary to the Thucydides Trap: if the U.S. and China really engage in an epic conflict, American political polarization should fall. Polarization fell dramatically during the Great Depression and World War II and remained subdued throughout the Cold War. It only began to rise again when the Soviet threat faded and income inequality spiked circa 1980. Americans were less divided when they shared a common enemy that posed an existential threat; they grew more divided when their triumph proved to benefit some disproportionately to others (Chart 2). Chart 1China Is Gaining On The U.S. Chart 2U.S. Polarization Falls During Crisis   If the U.S. and China continue down the path of confrontation, a similar pattern is likely to emerge in the coming years – polarization is likely to decline. China possesses the raw ability to rival or even supplant the United States as the premier superpower over the very long run. Its mixed economy is more sustainable than the Soviet command economy was, and it is highly integrated into the global system, unlike the isolated Soviet bloc. As long as China’s domestic demand holds up and Beijing does not suppress its own country’s technological and military ambitions, Trump and the next president will face a persistent need to respond with measures to limit or restrict China’s capabilities. Eventually this will involve mobilizing public opinion more actively. Further, if the U.S.-China conflict escalates, it will clarify U.S. relations with the rest of the world. For instance, Trump’s handling of trade suggests that he could refrain from trade wars with American allies to concentrate attention on China, particularly sanctions on its technology companies. Meanwhile a future Democratic president would preserve some of these technological tactics while reinstituting the multilateral approach of the Barack Obama administration, which launched the “Pivot to Asia,” the Trans-Pacific Partnership, and intensive freedom of navigation operations in the South China Sea. These are all aspects of a containment strategy that would reinforce China’s rejection of the western order. Bottom Line: If the White House, any White House, were to pursue a consistent strategy to contain China, the result would be a major escalation of the trade conflict that would bring Americans together in the face of a common enemy. It would also encourage the U.S. to form alliances in pursuit of this objective. So far these things have not occurred, but they are logical corollaries of the Thucydides Trap and they will occur if the Thucydides thesis is validated. How Would China Fare In The Thucydides Trap? China would be in trouble in this scenario. The United States, if the public unifies, would have a greater geopolitical impact than it currently does in its divided state. And a western alliance would command still greater coercive power than the United States acting alone (Chart 3). External pressure would also exacerbate China’s internal imbalances – excessive leverage, pollution, inefficient state involvement in the economy, poor quality of life, and poor governance (Chart 4). China has managed to stave off these problems so far because it has operated under relative American and western toleration of its violations of global norms (e.g. a closed financial system, state backing of national champions, arbitrary law, censorship). This would change under concerted American, European, and Japanese efforts. Chart 3China Fears A Western 'Grand Alliance' Chart 4China's Domestic Risks Underrated Concerted external pressure would make it harder for China to manage its internal imbalances. How would the Communist Party respond? First, it could launch long-delayed and badly needed structural reforms and parlay these as concessions to the West. The ramifications would be negative for Chinese growth on a cyclical basis but positive on a structural basis since the reforms would lift productivity over the long run – a dynamic that our Emerging Markets Strategy has illustrated, in a macroeconomic context, in Diagram 1. This is already an option in the current trade war, but China has not yet clearly chosen it – likely because of the danger that the U.S. would exploit the slowdown. Diagram 1Foreign Pressure And Structural Reform = Short-Term Pain For Long-Term Gain Alternatively the Communist Party could double down on confrontation with the West, as Russia has done. This would strengthen the party’s grip but would be negative for growth on both a cyclical and structural basis. The effectiveness of China’s fiscal-and-credit stimulus would likely decline because of a drop in private sector activity and sentiment – already a nascent tendency – while the lack of “reform and opening up” would reduce long-term growth potential. This option makes structural reforms look more palatable – but again, China has not yet been forced to make this choice. None of the above is to say that the West is destined to win a cold war with China, but rather that the burden of revolutionizing the global order necessarily falls on the country attempting to revolutionize it. Bottom Line: If the Thucydides Trap fully takes effect, western pressure on China’s economy will force China into a destabilizing economic transition. China could lie low and avoid conflict in order to undertake reforms, or it could amplify its aggressive foreign policy. This is where the risk of armed conflict rises. Introducing … The Polybius Solution The problem with the above is that there is no sign of polarization abating anytime soon in the United States. Extreme partisanship makes this plain (Chart 5). Rising polarization could prevent the U.S. from responding coherently to China. The Thucydides Trap could be avoided, or delayed, simply because the U.S. is distracted elsewhere. The most likely candidate is Iran. A lesser known Greek historian – who was arguably more influential than Thucydides – helps to illustrate this alternative vision for the future. This is Polybius (208-125 BC), a Greek who wrote under Roman rule. He described the rise of the Roman Empire as a result of Rome’s superior constitutional system. Polybius explains domestic polarization whereas Thucydides explains international conflict. Polybius took the traditional view that there were three primary virtues or powers governing human society: the One (the king), the Few (the nobles), and the Many (the commons). These powers normally ran the country one at a time: a dictator would die; a group of elites would take over; this oligarchy would devolve into democracy or mob-rule; and from the chaos would spring a new dictator. His singular insight – his “solution” to political decay – was that if a mixture or balance of the three powers could be maintained, as in the Roman republic, then the natural cycle of growth and decay could be short-circuited, enabling a regime to live much longer than its peers (Diagram 2). Diagram 2Polybius: A Balanced Political System Breaks The Natural Cycle Of Tyranny And Chaos In short, just as post-WWII economic institutions have enabled countries to reduce the frequency and intensity of recessions (Chart 6), so Polybius believed that political institutions could reduce the frequency and intensity of revolutions. Eventually all governments would decay and collapse, but a domestic system of checks and balances could delay the inevitable. Needless to say, Polybius was hugely influential on English and French constitutional thinkers and the founders of the American republic. Chart 6Orthodox Economic Policy Has Made Recessions Less Frequent And Less Acute What is the cause of constitutional decay, according to Polybius? Wealth, inequality, and corruption, which always follow from stable and prosperous times. “Avarice and unscrupulous money-making” drive the masses to encroach upon the elite and demand a greater share of the wealth. The result is a vicious cycle of conflict between the commons and the nobles until either the constitutional system is restored or a democratic revolution occurs. Compared to Thucydides, Polybius had less to say about the international balance of power. Domestic balance was his “solution” to unpredictable outside events. However, states with decaying political systems were off-balance and more likely to be conquered, or to overreach in trying to conquer others. Bottom Line: The “Polybius solution” equates with domestic political balance. Balanced states do not allow the nation’s leader, the elite, or the general population to become excessively powerful. But even the most balanced states will eventually decline. As they accumulate wealth, inequality and corruption emerge and cause conflict among the three powers. Why Polybius Matters Today It does not take a stretch of the imagination to apply the Polybius model to the United States today. Just as Rome grew fat with its winnings from the Punic Wars and decayed from a virtuous republic into a luxurious empire, as Polybius foresaw, so the United States lurched from victory over the Soviet Union to internal division and unforced errors. For instance, the budget surplus of 2% of GDP in the year 2000 became a budget deficit of 9% of GDP after a decade of gratuitous wars, profligate social spending and tax cuts, and financial excesses. It is on track to balloon again when the next recession hits – and this is true even without any historic crisis event to justify it. U.S. polarization is contaminating foreign policy. The rise in polarization has coincided with a rise in wealth inequality, much as Polybius would expect (Chart 7). In all likelihood the Trump tax cuts will exacerbate both of these trends (Chart 8). Even worse, any attempts by “the people” to take more wealth from the “nobles” will worsen polarization first, long before any improvements in equality translate to a drop in polarization. Chart 7Polarization Unlikely To Drop While Inequality Rises Chart 8Trump Tax Cuts Fuel Inequality Most importantly, from a global point of view, U.S. polarization is contaminating foreign policy. Just as the George W. Bush administration launched a preemptive war in Iraq, destabilizing the region, so the Obama administration precipitously withdrew from Iraq, destabilizing the region. And just as the Obama administration initiated a hurried détente with Iran in order to leave Iraq, the Trump administration precipitously withdrew from this détente, provoking a new conflict with Iran and potentially destabilizing Iraq. Major foreign policy initiatives have been conducted, and revoked, on a partisan basis under three administrations. And a Democratic victory in 2020 would result in a reversal of Trump’s initiatives. In the meantime Trump’s policy could easily entangle him in armed conflict with Iran – as nearly occurred on June 21. Iranian domestic politics make it very difficult, if not impossible, to go back to the 2015 setting. Despite Trump’s recent backpedaling, his administration runs a high risk of getting sucked into another Middle Eastern quagmire as long as it enforces the sanctions on Iranian oil stringently. China would be the big winner if such a war occurred, just as it was one of the greatest beneficiaries of the long American distraction in Afghanistan and Iraq. It would benefit from another 5-10 years of American losses of blood and treasure. It would be able to pursue regional interests with less Interference and could trade limited cooperation with the U.S. on Iran for larger concessions elsewhere. And a nuclear-armed Iran – which is a long-term concern for the U.S. – is not in China’s national interest anyway. Bottom Line: The U.S. is missing the “Polybius solution” of balanced government; polarization is on the rise. As a result, the grand strategy of “pivoting to Asia” could go into reverse (Chart 9). If that occurs, the conflict with China will be postponed or ineffective. Chart 9Will The Pivot To Asia Reverse? Iran Is The Wild Card If the U.S. gets bogged down in the Middle East yet again, the “Pivot To Asia” will go into reverse and the “Thucydides Trap” with China will be delayed. A war with Iran manifestly runs afoul of the Trump administration’s and America’s national interests, whereas a trade war with China does not. First, although an Iranian or Iranian-backed attack on American troops would give Trump initial support in conducting air strikes, the consequences of war would likely be an oil price shock that would sink his approval rating over time and reduce his chances of reelection (Chart 10). We have shown that such a shock could come from sabotage in Iraq as well as from attacks on shipping in the Strait of Hormuz. Iran could be driven to attack if it believes the U.S. is about to attack. Second, not only would Democrats oppose a war with Iran, but Americans in general are war-weary, especially with regard to the Middle East (Chart 11). President Trump capitalized on this sentiment during his election campaign, especially in relation to Secretary Hillary Clinton who supported the war in Iraq. Over the past two weeks, he has downplayed the Iranian-backed tanker attacks, emphasized that he does not want war, and has ruled out “boots on the ground.” Chart 10Carter Gained Then Lost From Iran Oil Shock Third, it follows from the above that, in the event of war, the United States would lack the political will necessary to achieve its core strategic objectives, such as eliminating Iran’s nuclear program or its power projection capabilities. And these are nearly impossible to accomplish from the air alone. And U.S. strategic planners are well aware that conflict with Iran will exact an opportunity cost by helping Russia and China consolidate spheres of influence. The wild card is Iran. President Hassan Rouhani has an incentive to look tough and push the limits, given that he was betrayed on the 2015 deal. And the regime itself is probably confident that it can survive American air strikes. American military strikes are still a serious constraint, but until the U.S. demonstrates that it is willing to go that far, Iran can test the boundaries. In doing so it also sends a message to its regional rivals – Saudi Arabia, the Gulf Arab monarchies, and Israel – that the U.S. is all bark, no bite, and thus unable to protect them from Iran. This may lead to a miscalculation that forces Trump to respond despite his inclinations. The China trade war, by contrast, is less difficult for the Trump administration to pursue. There is not a clear path from tariffs to economic recession, as with an oil shock: the U.S. economy has repeatedly shrugged off counter-tariffs and the Fed has been cowed. While Americans generally oppose the trade war, Trump’s base does not, and the health of the overall economy is far more important for most voters. And a majority of voters do believe that China’s trade practices are unfair. Strategic planners also favor confronting China – unlike Trump they are not concerned with reelection, but they recognize that China’s advantages grow over time, including in critical technologies. Bottom Line: While the media and market focus on China and Iran risks can alternate in the short run, the Trump administration is likely to continue downgrading the conflict with Iran and upgrading the conflict with China over the next six-to-18 months. Neither politics nor grand strategy support a war with Iran, whereas politics might support a trade war with China and grand strategy almost certainly does. China Could Learn From Polybius Too China also lacks the Polybius solution. It suffers from severe inequality and social immobility, just like the Latin American states and the U.S., U.K., and Italy (Chart 12). But unlike the developed markets, it lacks a robust constitutional system. Political risks are understated given the emergence of the middle class, systemic economic weaknesses, and poor governance. Over the long run, Xi Jinping will need to step down, but having removed the formal system for power transition, a succession crisis is likely. China’s imbalances could cause domestic instability even if the U.S. becomes distracted by conflict in the Middle East. But China has unique tools for alleviating crises and smoothing out its economic slowdown, so the absence of outside pressure will probably determine its ability to avoid a painful economic slump. China also lacks the “Polybius solution” of balanced government – and it even lacks a robust constitutional system. This helps to explain China’s interest in dealing with the U.S. on North Korea. President Xi Jinping’s first trip to Pyongyang late last month helped pave the way for President Trump to resume negotiations with the North’s leader Kim Jong Un at the first-ever visit of an American president north of the demilitarized zone (DMZ). China does not want an unbridled nuclear North Korea or an American preventative war on the peninsula. If Beijing could do a short-term deal with the U.S. on the basis of assistance in reining in North Korea’s nuclear and missile programs, it could divert U.S. animus away from itself and encourage the U.S. to turn its attention toward the next rogue nuclear aspirant, Iran. It would also avoid structural economic concessions. Of course, a smooth transition today means short-term gain but long-term pain for Chinese and global growth. Productivity and potential GDP will decline if China does not reform (Diagram 3). But this kind of transition is the regime’s preferred option since Beijing seeks to minimize immediate threats and maintain overall stability. Diagram 3Stimulus And Delayed Reforms = Socialist Put = Stagflation If Chinese internal divisions do flare up, China’s leaders will take a more aggressive posture toward its neighbors and the United States in order to divert public attention and stir up patriotic support. Bottom Line: China suffers from understated internal political risk. While U.S. political divisions could lead to a lack of coherent strategy toward China, a rift in China could lead to Chinese aggression in its neighborhood, accelerating the Thucydides Trap. Investment Conclusions If the U.S. reverses the pivot to Asia, attacks Iran, antagonizes European allies, and exhausts its resources in policy vacillation, its budget deficit will balloon (Chart 13), oil prices will rise, and China will be left to manage its economic transition without a western coalition against it. The implication is a weakening dollar, at least initially. But the U.S. is nearing the end of its longest-ever business expansion and an oil price spike would bring forward the next recession, both of which will push up the greenback. Much will depend on the extent of any oil shock – whether and how long the Strait of Hormuz is blocked. Beyond the next recession, the dollar could suffer severe consequences for the U.S.’s wild policies. Chart 13An Iran War Will Bust The Budget Persian Gulf risks are coming to the fore. But over the next six-to-18 months, U.S.-China conflict will be the dominant marketmover. If the U.S. continues the pivot to Asia, and the U.S. and China proceed with tariffs, tech sanctions, saber-rattling, diplomatic crises, and possibly even military skirmishes, China will be forced into an abrupt and destabilizing economic transition. The U.S. dollar will strengthen as global growth decelerates. Developed market equities will outperform emerging market equities, but equities as a whole will underperform sovereign bonds and other safe-haven assets. Our highest conviction call on this matter is that any trade deal before the U.S. 2020 election will be limited in scope. It will fall far short of a “Grand Compromise” that ushers in a new era of U.S.-China engagement – and hence it will be a disappointment to global equities. Our trade war probabilities, updated on July 26, can be found in Diagram 4. The combined risk of further escalation is 60% -- meaning that the U.S. will either implement the final batch of tariffs or refuse to renew Huawei’s trade license, or both. We are maintaining our risk-off trades: long JPY/USD, long gold, long Swiss bonds, and long USD/CNY. Diagram 4U.S.-China Trade War Decision Tree (Updated July 26, 2019)   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Graham Allison, “The Thucydides Trap: Are The U.S. And China Headed For War?” The Atlantic, September 24, 2015, and Destined For War: Can America and China Escape Thucydides’s Trap? (New York: Houghton Mifflin Harcourt, 2017).

Highlights A lot has changed in a week and a half, … : The FOMC meeting that we thought would mark the end of global market-moving news until September turned out to be a prelude for the real fireworks. … as U.S.-China trade tensions escalated, … : The imposition of tariffs on the only remaining subset of Chinese imports that had escaped duties so far inspired China to let the yuan fall below a key technical level. … and other countries braced for the fallout: China’s devaluation opened up a new front in the conflict, turning a bilateral tariff spat into a threat to other countries’ well-being and competitiveness. Asia-Pacific central banks swiftly followed with larger-than-expected rate cuts. Below-benchmark-duration positioning is no longer appropriate in the near term, and we recommend moving to benchmark duration: Interest rates will be hard-pressed to rise with global central banks squarely in easing mode. Although we still believe that inflation and the fed funds rate will surprise to the upside, it’s going to take a while. Feature Dear Client, There will be no U.S. Investment Strategy next week as we take our final summer break. U.S. Investment Strategy will return on Monday, August 26th. Best regards, Doug Peta So much for the idea that the July 30-31 FOMC meeting would be the last market-moving event before Labor Day. By lunchtime on August 1st, the S&P 500 was back to its July 30th close above 3,010; the 10-year Treasury yield had settled around 1.96%, ten basis points (“bps”) lower than its pre-meeting level; and gold had fallen by ten bucks, to $1,420, as markets digested the news that the Fed was less concerned about the economy than they were. Then the trade war reared its ugly head in the form of new tariffs on Chinese imports to the U.S., and the S&P slid to 2,822, the 10-year Treasury yield tumbled to 1.59%, and gold surged to $1,510. The new round would ensnare the subset of goods that had previously been spared from import duties, and Beijing promised to retaliate. It’s hard for rates to rise when every central bank has an easing bias as it nervously eyes the U.S.-China tilt.   Chart 1Beijing Plays The Currency Card The retaliation arrived Sunday night in the U.S., when Chinese officials allowed the renminbi to trade above 7 to the dollar for the first time since 2008 (Chart 1). The move provoked a global equity selloff, and the S&P 500 lost 3% in its worst session of the year. With the currency floodgates opened, the trade war morphed from a bilateral tariff spat into a global battle for competitiveness, and central banks in India, Thailand and New Zealand responded with larger-than-expected rate cuts. India is a comparatively closed economy battling a domestic downturn, but it is clear that countries with any reliance on exports are loath to be saddled with a strong currency that will hamstring their global competitiveness. It turns out that the Fed isn’t the only central bank that sees the appeal of taking out some insurance. That is an unfriendly backdrop for below-benchmark-duration positioning, and we are joining our fixed-income colleagues in raising our duration recommendation from underweight to neutral over the tactical timeframe (0-3 months). While we still believe that the fed funds rate and long yields will surprise to the upside, they cannot do so while bond investors are adamant that the Fed is going to have to adopt an easing bias over the near term. Our rates checklist, discussed in the rest of this report, supports the decision. The shift in the rates backdrop undermines our newly established agency mortgage REIT recommendation, and we are watching it closely. The Rates Checklist: The Fed Table 1Rates View Checklist Turning to our rates view checklist (Table 1), the first item is derived from our U.S. Bond Strategy service’s golden rule of bond investing.1 The golden rule asks one simple question to anchor views on Treasuries: Over the next 12 months, will the Fed move the fed funds rate by more or less than the bond market is currently discounting? Since 1990, when the Fed has surprised dovishly (the fed funds rate has turned out to be lower than the money market implied twelve months earlier), Treasuries have almost always generated positive excess returns over cash. Periods of negative excess returns have occurred nearly exclusively when the Fed has delivered a hawkish surprise. We still think inflation will become a problem, but it certainly isn’t one yet. Since we rolled out the checklist last year, we have consistently expected a hawkish surprise. Though we continue to believe that an extended cycle of rate cuts is not in the cards, markets disagree, and we concede that the Fed now has a near-term easing bias, despite Chair Powell’s demurrals at the post-meeting press conference. We are leaving the box unchecked because we believe that nearly four more 25-bps cuts over the next twelve months, equating to a target fed funds rate of 1.25-1.50% (Chart 2), are unlikely. The spread between our expectations and the market’s expectations is still wide enough to merit a below-benchmark-duration view over the next twelve months, even if benchmark duration makes more sense for the rest of the year. Chart 2Four More Rate Cuts Are A Stretch The yield curve’s inversion has become more pronounced in the wake of the re-escalation of the trade war (Chart 3), and we duly check the second box. As a reminder, we track the 3-month/10-year segment of the yield curve to define inversion because it is less susceptible to estimate error, and has been a timelier indicator of recessions, than the more frequently cited 2-year/10-year segment. We have argued before that the unprecedentedly large negative 10-year term premium makes the curve more prone to invert and makes it a less sensitive economic barometer, but part of the rationale of creating a checklist is to limit one’s discretion in interpreting events. Chart 3More Rate Cuts, Please The Rates Checklist: Inflation Inflation has gone AWOL around the globe. Although the U.S. no longer faces the negative output gaps that remain in other major economies, its main measures of consumer prices (Chart 4) do nothing to counteract the widespread view that the Fed has a free pass to devote its energies to shoring up growth. Inflation break-evens were making progress toward the 2.3-2.5% range consistent with the Fed’s 2% inflation target when we launched the checklist last year, but the plunge in oil prices stopped them in their tracks (Chart 5). Rather than encouraging the Fed to hike, soft inflation expectations helped drive the Fed’s dovish pivot. Chart 4Realized Inflation Is Below Target, ... Chart 5... And So Are Inflation Expectations Our view that the seeds of inflation pressures have been sown has not changed. After slowing on a real final domestic demand basis in the first quarter from the one-two punch of the government shutdown and the fourth quarter’s sharp tightening of financial conditions, the U.S. economy has resumed operating above capacity. Though we check the “sluggish-inflation” boxes, and acknowledge that inflation is not going to inspire a more restrictive turn in Fed policy any time soon, we do think it will become an issue down the road. The Rates Checklist: The Labor Market The labor market remains robust. The headline unemployment rate remains at a level last seen in 1969, and is well below the CBO’s estimate of NAIRU. NAIRU is the minimum structural unemployment rate, and wage gains quicken when the unemployment rate falls below it (Chart 6). The broader definition of unemployment, encompassing discouraged workers and involuntary part-time workers, fell to its lowest level since 2000 in July (Chart 7), and the job openings and job quits rates (Chart 8) indicate that demand for workers remains high. Chart 6Wage Gains Will Accelerate, ... Chart 7... As Slack Has Been Absorbed, ... Chart 8... And Demand Is Robust   3.2% year-over-year growth in average hourly earnings may not be thrilling, but wages do remain in an uptrend. The laws of supply and demand (Chart 9), and the Fed’s best efforts, suggest that the uptrend will continue. We do not check any of the labor market boxes, and expect that we will not over the rest of the year. The Rates Checklist: Instability At Home And Abroad Chart 10No Overheating Yet There continue to be no signs of cyclical overheating in the U.S. economy, as the most cyclical segments of the economy are nowhere near the red end of the tachometer (Chart 10). Financial imbalances have moved to the back burner, but they are part of the Fed’s post-crisis mandate, and we are leaving the imbalances box unticked to reflect that the “low spreads and loosening credit terms” Governor Brainard decried last September2 may stay the Fed from embarking on a full-on easing cycle. We are checking the international duress box, at least for the time being, given the potential for a self-reinforcing rate-cutting cycle that could hold down the entire term structure of rates around the world. Bottom Line: The inverted yield curve, a lack of consumer price inflation, and the cloud cast by the trade war all suggest that bond markets will require some convincing before they allow rates to rise much higher. We conclude that a neutral duration stance is appropriate in the near term. Keeping Score We have been staunch supporters of below-benchmark duration positioning since the end of last July,3 given that we thought the 10-year Treasury yield was too low relative to our assessment of the strength of the U.S. economy and the potential for inflation to begin to rise. It appears that our stronger-than-consensus economic view was correct, but we were myopic in failing to grasp how punk growth in the rest of the world would keep long-maturity Treasury yields from making a sustained move higher. We were way early on inflation’s ETA, and slow to grasp how sensitive the Fed would be to faltering global growth and escalating trade tensions in its absence. In short, both our model of the Fed’s reaction function and the inputs to our model turned out to be faulty. The duration call stings, but our asset allocation recommendations have worked out. The fix we are making is to wait until inflation is a clear and present danger before assuming that the Fed will respond to it. Although we got the duration call wrong, investment-grade and high-yield corporate bonds have outperformed Treasuries in the aggregate since we upgraded them to overweight versus Treasuries at the end of January (Chart 11). BCA as a house niftily sidestepped the fourth-quarter selloff in equities by downgrading them to equal weight, and raising cash to overweight, late last June. We upgraded equities to overweight versus cash and fixed income in our first publication of the year, and the S&P 500 has handily outperformed Treasuries since that date, despite the nasty selloff following the July FOMC meeting and the new round of tariffs (Chart 12). Chart 11Spread Product Has Modestly Outperformed Treasuries, ... Chart 12... But Equities Have Crushed Them Agency Mortgage REIT Implications We recommended agency mortgage REITs a day before the FOMC meeting, suggesting that investors allocate capital away from equities and high yield as a way to reduce equity beta and boost portfolio income away from the herd chasing lower and lower high-yield bond yields. Through Thursday’s close, the Bloomberg Mortgage REIT Index has gained about 35 bps on a total return basis, while the Barclays High Yield Index is off 70 bps and the S&P 500 is down 2.7%. Unfortunately, the agency mREITs we sought out for their yield curve exposure have lagged badly as the yield curve has relentlessly flattened. For now, only the one agency mREIT with a dedicated adjustable-rate mortgage portfolio faces immediate earnings pressure. The rest are subject to refinancing volumes, which are likely to be higher than we expected when we projected that the 10-year Treasury yield wouldn’t fall much below 2%. The specter of increased prepayments makes the agency mREITs a less attractive investment than we thought they would be two weeks ago. On the other hand, their exclusively domestic exposure, and low credit risk, increases their value as a haven from global turmoil. Net-net, we are sticking with them, though they are now on a far shorter leash than they were when we made the recommendation. We will not stick with a position to save face, or to avoid looking irresolute. Flexibility and a willingness to admit mistakes are essential characteristics of successful investors. When the facts change, we change our mind, without the faintest hint of embarrassment. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com Footnotes 1 Please see the July 24, 2018 U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing,” available at usbs.bcaresearch.com. 2 Brainard, Lael (2018). “What Do We Mean by Neutral And What Role Does It Play in Monetary Policy,” speech delivered at the Detroit Economic Club, Detroit, Mich., September 12, 2018. 3 Please see the July 30, 2018 U.S. Investment Strategy Weekly Report, “The Rates Outlook,” available at usis.bcaresearch.com.

Highlights A unified push among central banks to drop their currencies inevitably leads to lower interest rates, which eventually sows the seeds of a recovery. However, with prospects of a full-blown trade war in front view, fundamentals could be put to the wayside for longer, as markets keep the switch on risk aversion. The new round of tariffs could pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops. The breakdown in the AUD/JPY cross is precarious. Stay short USD/JPY, but focus on the crosses rather than on outright bets versus the dollar. The RBNZ’s dovish surprise was a positive catalyst for our AUD/NZD and SEK/NZD positions. Remain long. Feature Chart I-1Summer Blues Just as summer trading volumes are falling close to new lows, central banks appear to be weaponizing their exchange rates in a renewed currency war salvo. Both the Reserve Bank of India (RBI) and the Reserve Bank of New Zealand (RBNZ) surprised market participants this week by slashing rates by more than expected. In retrospect, the European Central Bank probably fired the first shot at its forum in Sintra, Portugal this June. ECB President Mario Draghi highlighted back then that if the inflation outlook failed to improve, the central bank had considerable headroom to launch a fresh expansion of its balance sheet. What has followed is a renewed wave of dovishness by global central banks, which should intensify, given the latest flare-up in the trade war. For currency strategy, this means fundamentals could be temporarily put to the wayside, as markets keep the switch on risk aversion (Chart I-1). This is because there is little visibility on either the political or the economic front. Our strategy remains three-fold: First, maintain tight stops on tactical positions. Second, we prefer trades at the crosses rather than versus the dollar, for now. Finally, maintain portfolio insurance by being short the USD/JPY. USD/CNY And The Economics Of Tariffs Chart I-2Sino-U.S. Trade Is Small Relative To Domestic Demand Standard theory suggests that exchange rates should move to equalize prices across any two countries. The question that naturally follows is by how much? The answer is that the exchange rate should move by exactly the same percentage point as the price change, everything else equal. If both countries produce homogeneous goods, then it is easy to see why, since there is perfect substitution. All demand will flow to one country, until its currency rises by enough to equalize prices across borders again. However, assume countries ‘A’ and ‘B’ produce heterogeneous goods (‘A’ being the U.S. in this case, and ‘B’ China). Then the loss of purchasing power in Country ‘A’ will lead to less demand for Country ‘B’’s goods. The former loses purchasing power because prices of imports have increased by the amount of the tariff. This means the latter’s currency will have to adjust downwards for the markets to clear. The decrease has to match the magnitude of the price increase, if there are no other outlets to liquidate Country ‘B’’s goods. This is obviously a very simplified version of the real world economy, but it highlights an important point that is central to the discussion: The currency move necessary to realign competitiveness will always be equal to, or less than, in percentage point terms, to the price increase. In the case where the entire production base is tradeable, it will be the former. But with a rise in the number of trading partners, a more complex export basket, import substitution, shipping costs, and many other factors that influence tradeable prices, the currency adjustment needed should be smaller. Since the onset of 2018, the U.S. has slapped various tariffs on China, the latest of which is 10% on $300 billion worth of Chinese goods. The U.S. currently imports $509 billion worth of goods from China, about 16% of its total imports. However, as a percentage of overall U.S. demand, this only represents 2.4% (Chart I-2). This suggests that at best, a 25% tariff on all Chinese imports will only lift import prices by 4% and consumer prices by much less. On the Chinese side of the equation, exports to the U.S. account for 18.4% of total exports, a ratio that has been falling since 2018. Therefore, a tariff of 25% should only lift export prices by 4.5%. The conclusion is that the yuan and the dollar only need to adjust by 4-5% to negate the impact of a 25% tariff. Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing. This brings us to an important point: Part of the rise in the dollar and fall in the RMB has been due to tariffs, but it has mostly been due to the fact that global trade has been slowing (Table I-1). The DXY index is up 10% since its 2018 trough, while the USD/CNY has risen by 12%. This is much more than economic theory would suggest. In quantity terms, the IMF estimated that a 20% import tariff from East Asia would lift the U.S. dollar’s REER by 5% over five years, while dropping output by 0.6% over the same timeframe.1 But if past is prologue, the new round of tariffs will pin USD/CNY at about 7.3-7.4, given the impact from negative feedback loops – mainly a slowing global economy and a slowing Chinese economy. With no corresponding export subsidy for U.S. goods, however, the rise in the dollar makes exporters worse off. And with over 40% of S&P 500 sales coming from outside the U.S., this will make a meaningful dent in corporate profits. This is an important political impediment. Historically, trade wars are usually synonymous with recessions. As such, there are acute political constraints inching both sides towards an agreement. A Disorderly Breakdown Or Steady Depreciation? The RMB has been trading like a pro-cyclical currency, meaning it is becoming an important signaling mechanism for the evolution of the cycle. The USD/CNY has been moving tick-for-tick with emerging market equities, Asian currencies, and even some commodity prices (Chart I-3). It has also closely mirrored the broad trade-weighted dollar (Chart I-4). This has implications for developed market currencies, especially those tied to Chinese demand. Therefore, it will be important to see if the RMB has a disorderly breakdown towards 7.4 or if it stabilizes at higher levels. A few barometers will be key to watch: Chart I-3The Yuan Is Pro-cyclical Chart I-4Is The Dollar Headed Higher? In a world of rapidly falling yields, Chinese rates remain attractive. Historically, USD/CNY has moved in line with interest rate differentials between the U.S. and China. The current divergence is unsustainable (Chart I-5). Typically, offshore markets have had a good track record of anticipating depreciation in the yuan. Back in 2014, offshore markets started pricing in a rising USD/CNY rate, and maintained that view all the way through to 2018, when the yuan eventually bottomed. Right now, not much depreciation is being priced in (Chart I-6). The reason offshore markets in Hong Kong and elsewhere can be prescient is because more often than not, they are the destination for illicit flows out of China. Chart I-5The Chinese Bond Market Is Attractive Chart I-6Forward Markets Not Concerned As In 2015 Chinese money and credit growth, especially forward-looking liquidity indicators such as M2 relative to GDP, have bottomed. Historically, this led the cycle by a few months. The drop in Chinese bond yields is also reflationary, and should soon stimulate imports, especially if the improvement in exports continues (Chart I-7). Chinese government expenditures are likely to inflect higher, especially given acute weakness in the July manufacturing data. Again, this suggests stimulus this time around may be more fiscal than monetary (Chart I-8). In addition, the recent VAT cuts for manufacturing firms, a cut to social security contributions, and a pickup in infrastructure spending are all net positives. Chart I-7Trade War Extends Traditional Lags Chart I-8Government Spending Set To Increase The housing market remains healthy. A revival in the property market will support construction activity and investment. House prices have been rising to the tune of 10% year-on-year, and real estate stocks in China remain firm relative to the overall index. If house prices roll over, this will be a negative development (Chart I-9). The housing market remains healthy. A revival in the property market will support construction activity and investment. If house prices roll over, this will be a negative development. In terms of market dynamics, the AUD/JPY cross breached the important technical level of 72 cents, but has since recovered. This is important, since the cross failed to break below this level both during the euro area debt crisis in 2011-2012 and the China slowdown of 2015-2016. It will be especially important to see a clear breach to signal we are entering a deflationary bust (Chart I-10). Chart I-9China Housing Is Fine Chart I-10AUD/JPY Breakdown Is Precarious Bottom Line: We are watching a few key reflationary indicators to gauge whether it pays to be contrarian. The message is that it is not time yet, given the ramp-up in the trade war rhetoric.  Notes On The RBNZ Chart I-11AUD/NZD Is Cheap This week, the RBNZ surprised markets by cutting interest rates by 50 basis points to parity (expectations were for a 25-basis-point cut). From an external standpoint, this makes sense. Australia and China are New Zealand’s biggest trading partners, and have been easing policy much earlier. The RBNZ’s bet was that demand was probably going to recover by now. The latest salvo in the trade war probably dashed those hopes. Meanwhile, over the last 35 years, the AUD/NZD cross has spent more than 95% of the time over 1.06. With the AUD/NZD near record lows, the cross is cheap on a real effective exchange rate basis (meaning NZD is expensive) (Chart I-11).  This suggests that even though interest rates are aligning in both Australia and New Zealand, the Aussie should be 11% higher relative to the Kiwi because of the valuation starting point (Chart I-12). The market remains more dovish on Australia relative to New Zealand, in part due to a more accelerated downturn in house prices and a significant slowdown in China. The reality is that the downturn in Australia has allowed some cleansing of sorts, and brought it far along the adjustment path relative to New Zealand. Economic data in New Zealand are now converging to the downside relative to Australia (Chart I-13). Chart I-12Interest Rates Could Move In Favor Of AUD Chart I-13New Zealand Has More Economic Downside The RBNZ began a new mandate on April 1st to include full employment in addition to inflation targeting. But given that the RBNZ has been unable to fulfill its price stability mandate over the last several years, it is hard to argue it will find a dual mandate any easier. Business confidence is rapidly falling, and employment will soon follow suit (Chart I-14). Meanwhile, for an economy driven by agricultural exports, productivity gains will be hard to come by. Economic data in New Zealand are now converging to the downside relative to Australia. The final catalyst for the AUD/NZD cross will be a terms-of-trade shock which, at the moment, is turning in favor of the Aussie (Chart I-15). Iron ore prices may face further downside, given that supply from Brazil is back online, but China’s clear environmental push has lifted the share of liquefied natural gas in Australia’s export mix. Since eliminating pollution is a strategic goal in China, this will be a multi-year tailwind. As the market becomes more liberalized and long-term contracts are revised to reflect higher spot prices, the Aussie will get a boost. Chart I-14Employment Growth Could Collapse In New Zealand Chart I-15Terms Of Trade Favors##br## Aussie Bottom Line: Remain long AUD/NZD as a strategic position and SEK/NZD as a tactical position. Housekeeping The stop on our short XAU/JPY position was triggered at 158,000 with a loss of -3.27%. This was a mean-reversion trade between two safe-havens, likely to work even if volatility remains elevated. Put it back on. Finally, lift the limit sell on EUR/GBP to 0.95.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Maurice Obstfeld, “Tariffs Do More Harm Than Good At Home,” IMFBlog, September 8, 2016. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mostly positive: Labor market remains tight: Unemployment rate was steady at 3.7%; Participation rate increased to 63%; Average hourly earnings increased by 3.2% year-on-year; Nonfarm payrolls increased by 164 thousand. Initial jobless claims fell to 209 thousand last week. Trade balance narrowed slightly to $55.2 billion in June. Michigan sentiment index was unchanged at 98.4 in July. Markit composite and services PMI both increased to 52.6 and 53 respectively in July, while ISM non-manufacturing PMI fell to 53.7 in July. DXY index fell by 1% this week, erasing the gains following the Fed’s hawkish surprise last week. Weakness in the dollar given a ramp-up in trade war rhetoric suggest that dollar tailwinds are facing diminishing marginal returns. A few of our favorite dollar indicators, including the bond-to-gold ratio, are sending a warning signal. Report Links: Focusing On the Trees But Missing The Forest - August 2, 2019 Global Growth And The Dollar - July 19, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have continued to deteriorate: Producer price inflation fell to 0.7% year-on-year in June. Retail sales increased by 2.6% year-on-year in June, surprising to the upside. Markit composite PMI was unchanged at 51.5 in July, while services PMI fell slightly to 53.2. Sentix investor confidence fell further to -13.7 in August, the lowest since 2014. EUR/USD increased by 1% this week. In the most recent Economic Bulletin, the ECB highlighted the risk of a weaker Q2 global services PMI which might lead to a more broad-based deterioration in global growth. With negative interest rates and diminishing marginal returns to monetary policy, the euro area will be ever dependent on fiscal stimulus. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Composite PMI was unchanged at 51.2 in July, while services PMI fell to 51.8. Household spending yearly growth fell to 2.7% in June. That said, previous growth of 4% was too high relative to Japan’s potential. Wages increased by 0.4% year-on-year in June. Leading economic index and coincident index both fell to 93.3 and 100.4 respectively in June. The trade balance increased to ¥759.3 billion in June. Current account balance narrowed to ¥1,211 billion in June. USD/JPY fell by 0.9% this week. In the Summary of Opinions released this week, the BoJ concluded that the Japanese economy has been moderately expanding, a trend that is likely to continue in the second half. However, this may be too ambitious. As we go to press, Q2 GDP growth is still pending, and a marked slowdown could be a harbinger for a much softer second half, especially given renewed trade tensions. That said, the path to easier monetary policy will be lined by a stronger yen. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 Short USD/JPY: Heads I Win, Tails I Don’t Lose Too Much - May 31, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been mostly positive: Markit composite PMI increased to 50.7 in July. Services and construction components also increased to 51.4 and 45.3 respectively. Retail sales increased by 0.1% year-on-year in July. Halifax house prices contracted by 0.2% month-on-month in July. GBP/USD has been very volatile but returned flat this week. All eyes are on the new PM Boris Johnson and new Brexit developments. Our Geopolitical strategist is assigning 21% risk of a no-deal Brexit, and the probability would rise to 30% if negotiations with the EU fail. We believe that the pound could easily drop to 1.10-1.15 if there is no deal. That being said, we are looking to sell EUR/GBP at 0.94, given Europe will also absorb some collateral damage from a hard Brexit. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mostly positive: Producer price inflation increased to 2% year-on-year in Q2. Retail sales grew by 0.4% month-on-month in June. Both composite and services PMI increased to 52.1 and 52.3 respectively in July. Australian Industry Group (AiG) construction index fell to 39.1 in July. Exports grew by 1% month-on-month in June, while imports contracted by 4% month-on-month. This nudged the trade surplus to A$8 billion in June, a record. AUD/USD fell by 1.8% initially, then rebounded, returning flat this week. The RBA held interest rates unchanged at 1% on Tuesday, after cutting by 25 bps both in June and July. Long-term government bond yields declined to record-lows. Currency markets are currently focused on interest rate differentials. Once the focus shifts to other fundamentals as global interest rates converge, the Aussie dollar will get a boost. 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 positive: Consumer confidence decreased by 5.1% month-on-month in July. On the labor market front, the participation rate was steady at 70.4% in Q2; Unemployment rate fell to 3.9%; Wages increased by 2.2% year-on-year in Q2. NZD/USD fell by 0.8% this week. RBNZ shocked the market with the half-percentage point rate cut this Wednesday, stating that a larger initial move would be best to meet the inflation and employment objectives in New Zealand. The RBNZ also lowered 2-year inflation expectations from 2.01% to 1.86% in Q3. Relative terms-of-trade favors our long AUD/NZD position. Stay with it. Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been mostly positive: Imports and exports both fell to C$50.2 billion and C$50.3 billion in June. The trade balance thus narrowed to C$0.14 billion. Bloomberg Nanos confidence index increased to 58.6 last week. Ivey PMI increased to 54.2 in July. New housing price index contracted by 0.2% year-on-year in June. USD/CAD increased by 0.2% this week. The sudden oil prices drop has dragged down the Canadian dollar. WTI crude oil prices plunged by more than 10% during the past week, and Western Canadian Select crude oil spot prices fell by 14.5%. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been mostly negative: Headline and core consumer price inflation dropped to 0.3% and 0.4% year-on-year respectively in July. Manufacturing PMI fell to 44.7 in July. Consumer confidence fell to -8 in July. Real retail sales increased by 0.7% year-on-year in June. USD/CHF fell by 1.2% this week. The concerns over the global growth, an escalating trade war, a potential hard-Brexit, political tensions in the Middle East and East Asia continue to weigh on investors’ sentiment. VIX once again touched 24 following Trump’s tweet to threaten to impose 10% tariffs over $300 billion Chinese goods last Thursday. We continue to favor the safe-haven Swiss franc as a tactical portfolio hedge. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 There is little data from Norway this week: Manufacturing production yearly growth fell from 5% in May to 3% in June. USD/NOK has been flat this week.  Next week, the Norges Bank is likely to reverse its well-telegraphed forward guidance of rate hikes, following global developments. With oil prices down, and a new trade war, they will stand pat in line with market expectations, but an interest rate cut cannot be ruled out. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mixed: Industrial production contracted by 0.7% year-on-year in June. Services production yearly growth also fell to 1.3% in June. However, industrial orders increased by 7.5% year-on-year in June, the strongest since July 2018.  Budget balance widened to SEK 28.2 billion in July. USD/SEK fell by 0.9% this week. The upside surprise in industrial orders is mainly led by transport equipment. Mining and quarrying also rebounded to 9.3% compared with -7.8% in May. Our SEK/NZD position is now 0.4% in the money. The negative carry has been narrowed following RBNZ’s 50 bps rate cut. 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, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights So What? Tariffs and currency depreciation will likely lead to military saber-rattling in Asia Pacific. Why? President Trump is not immune to the market’s reaction to his trade war escalation. Yet China’s currency depreciation is a major escalation and the near-term remains fraught with danger for investors. Military shows of force and provocations could crop up across Asia Pacific, further battering sentiment or delaying trade talks. Remain short CNY-USD, short the Hang Seng index, long JPY-USD, and long gold. Overweight the U.S. defense sector relative to global stocks. Feature The Osaka G20 tariff ceasefire has collapsed; U.S. President Donald Trump is threatening tariffs on all Chinese imports; the People’s Bank of China has allowed the renminbi to depreciate beneath the important 7.0 exchange rate to the dollar; and the United States has formally labeled China a “currency manipulator.” What a week! The spike in volatility is likely to be accompanied by a rise in credit risk, as measured by the TED spread (Chart 1). Safe havens like gold, treasuries, and the Japanese yen are rallying in a classic risk-off episode, while messengers of global growth like copper, the Australian dollar, and the CRB raw industrials index are stumbling (Chart 2). Only green shoots in Chinese trade and German manufacturing have kept the selloff in check this week by improving the cyclical outlook despite elevated near-term risks. Chart 1So Much For The Osaka G20 Tariff Ceasefire! Chart 2Key Risk-On/Risk-Off Indicators Breaking Down While we anticipated the re-escalation of U.S.-China tensions, now is the time to take stock and reassess. President Trump is a political animal. While he has demonstrated a voracious risk appetite throughout the year, he is ultimately focused on reelection in November 2020. The United States will survive without a trade deal by then, but Trump may not. Presumably, Trump’s reason for increasing pressure on China throughout 2019 is to secure a deal by the end of the year. This would be to see China’s concessions translate into trade perks for the U.S. markets and economy in 2020 by the time he hits the campaign trail. The experience of Q4 2018 suggests that Trump changed his negotiating tack after U.S. equities fell by only 4% from their peak – but we consider an equity correction a clear pain threshold (Chart 3). Trump is closely associated with the economic fortunes of the country, even more so than the average president. Bear markets tend to coincide with recessions. Trump – beset by controversy and scandal at home – must assume that a recession will be the coup de grâce. Chart 3Where Is President Trump's Pain Threshold? Chart 4Will Huawei Ban Hit The Tech Sectors? Investors will get some clarity next week when the Commerce Department decides whether to renew the general temporary license for American companies to trade with Chinese telecoms giant Huawei. A full denial of the license would signal that Trump is unconcerned with recession and reelection probabilities and focusing exclusively on the national security threat from China. It would send technology sectors and the broader equity market into a plunge on both sides of the Pacific (Chart 4) and could significantly increase the risk that the global economy begins a downturn. Positive signals are scarce as we go to press: New tariff is on track: The U.S. Trade Representative is preparing a final list of $300 billion in goods to fall under a new 10% tariff, despite reports that Trump overrode USTR Robert Lighthizer in announcing the new tariff. This does not guarantee that the tariff will go into effect on September 1 but it does make it more likely than not. Huawei is under pressure: Office of Management and Budget has disqualified Huawei from any U.S. government contracts as of August 13 – a ban to be extended to any third parties contracting Huawei as of the same date next year. This is not encouraging for Huawei but it is a separate and more limited determination from that of the Commerce Department. Still, we expect the Trump administration to take some moves to offset the ongoing trade escalation. While we are inclined to think the new tariff will take effect, Huawei will likely get a reprieve in the meantime. This will help to ensure that the September trade talks in Washington, DC go forward. The administration has an interest in keeping the trade negotiations alive. Furthermore, there is some evidence that President Trump is recognizing the need to calm other “trade wars” to mitigate the impact of the central China trade war. In September the administration will attempt ratification of the USMCA in Congress – we still think this is slightly favored to go through. We also expect a U.S.-Japan trade agreement to materialize rapidly – likely at the UN General Assembly from September 17-30. Another positive sign is that the European Union has agreed to expand beef imports from the United States. Real movement on agriculture, while China cancels U.S. ag imports, implies that President Trump is less likely to impose car tariffs on Europe for national security reasons on November 13-14.1 The problem is that the fallout from China’s currency depreciation and the new tariffs will hit the market before anything else, which means we remain tactically bearish. Heightened trade tensions are also likely to spill into the strategic sphere in the near term. Saber-rattling – military shows of force and provocations – will increase the geopolitical risk premium across the globe, especially in East Asia. A frightening U.S.-China clash may ultimately encourage real compromises in the trade negotiations, but the market would get the negative news first. If Washington does not make any reassuring moves but expands the current policy assault on China – including through a Huawei ban – then we will consider shifting to a defensive posture cyclically as well as tactically. Bottom Line: We recognize that President Trump may be forced by the risk of a recession to relax the trade pressure and accept some kind of China deal – we may upgrade this 40% chance if and when the U.S. veers toward an equity bear market. In the meantime we expect further negative fallout from the past week’s aggressive maneuvers by both sides. Currency War Assuming that an equity correction is inevitable at some point and that Trump goes crawling back to the Chinese for trade talks: How will they respond? Will Xi Jinping, the strongman general secretary of a resurgent Communist Party, return to talks and reassure global markets at Trump’s beck and call? Or will he refuse, let the market do what it will, and let Trump hang? By letting the currency drop … Beijing is expressing open defiance. The renminbi’s depreciation – through PBoC inaction on August 5, then through action on August 8 – is a warning that Trump is approaching the point of no return. His initial grievance has always been Chinese “currency manipulation” but until now he has refrained from formally leveling this accusation (only using it on Twitter). By letting the currency drop well beneath the level at which Trump was inaugurated (6.8 CNY-USD), and beyond the global psychological threshold, Beijing is expressing open defiance and threatening essentially to break off negotiations. Chart 5China Sends Warning Via Currency Depreciation The effect of continued depreciation would be to offset the effect of tariffs and ease financial conditions in China. This is fully in keeping with our view that China has opted for stimulus over reform this year. China is likely to follow up with further cuts to banks’ reserve requirement ratios and a cut to the benchmark policy interest rate (Chart 5). The July Politburo statement showed a greater willingness to stimulate the economy and it occurred prior to Trump’s new volley of tariffs. Currency appreciation is the surest way to rebalance China’s economy toward household consumption and obviate a strategic conflict with the United States. By contrast, yuan depreciation will exacerbate the U.S. trade deficit and give Trump’s Democratic rivals convenient evidence that the “Art of the Deal” is counterfeit. How far will the renminbi fall? Chart 6 updates our back-of-the-envelope calculation of the implication from different tariff scenarios assuming that the equilibrium bilateral exchange rate depreciation will equal the tariffs collected as a share of total exports to the United States. (10% tariff on $259 billion = $25.9 billion, which is 5% of $509 billion total.) The yuan is now approaching Scenario D, 25% tariffs on the first half of imports and 10% on the second half, which points toward 7.6 CNY-USD. There are reasons to believe that this simple framework won’t apply, at least in terms of the magnitude of the impact, but it gives an indication of considerable downward pressure. Chart 6The Yuan Will Fall, But Not Freely Chester Ntonifor of our Foreign Exchange Strategy sees the yuan falling to around 7.3-7.4 if the new tariffs are applied based on the fact that the 25% tariff on $250 billion worth of goods produced a roughly 10% decline in the bilateral exchange rate. Our Emerging Markets Strategy also expects about a 5% drop in the CNY-USD. Having tightened capital controls during the last bout of depreciation in 2015-16, China is probably capable of controlling the pace of depreciation, preventing capital outflows from becoming a torrent, by selling foreign exchange reserves, further tightening capital controls, or utilizing foreign currency forward swaps. But Asian currencies, global trade revenues in dollars, and EM currencies and risk assets will suffer – and they have more room to break down from current levels.2 Meanwhile even a modest drop in the renminbi – amid a return to dovish monetary policy in global central banks – has revived concerns about a global currency war. A rising dollar is anathema to President Trump, who aims to reduce the trade deficit, encourage the on-shoring of manufacturing, and maintain easy financial conditions for the U.S. economy. Table 1U.S. Demands On China In Trade Talks Chart 7U.S. Allies' Share Of Treasuries Rises Trump’s decision to slap a sweeping new tariff on China – reportedly at the objection of all of his trade advisers except the ultra-hawkish Peter Navarro (Table 1) – was at least partly driven by his desire to see the Fed cut rates beyond the 25 basis point cut on July 31 and weaken the dollar. Yet the escalation of the trade war weighs on global trade and growth, which will push the dollar up. This reinforces the above argument that Trump will probably seek to offset the recent trade war escalation with some mitigating moves. Beyond inducing the Fed to cut further, it is difficult for President Trump to drive the dollar down. The Treasury Department can intervene in foreign exchange markets, but direct intervention does not have a successful track record. Interventions usually have to be sterilized (expansion of the money supply externally must be addressed at home by mopping up the new liquidity), which in the context of free-moving global capital means that any depreciation will be short-lived. An unsterilized intervention would be extremely unorthodox and is unlikely short of a major crisis and breakdown in institutional independence. The U.S. could attempt to engineer an internationally coordinated currency intervention, as we have highlighted in the past. But it is highly unlikely to succeed this time around. The U.S. is less dominant of a military and economic power than it was when it orchestrated the Smithsonian Agreement of 1971 and the Plaza Accord of 1985. Neither the European nor the Japanese economies are in a position to tighten monetary policy or financial conditions through currency appreciation. While China weans itself off treasuries, U.S. allies and others fill the void. Indeed, after a long period in which American allies declined as a share total holders of treasuries – as China and emerging markets increased their forex reserves and treasury holdings momentously – allies are now taking a greater share (Chart 7). Chart 8China Diversifies While It Depreciates China is driving down the yuan not by buying more treasuries but by buying other things – diversifying away from the USD into alternative reserve currencies and hard assets, such as gold and resources tied to the Belt and Road Initiative (Chart 8). As trade, globalization, and global growth have slowed down, and as China’s growth model and the U.S.-China special relationship expire, global dollar liquidity is shrinking. Dollar liquidity is the lifeblood of the global financial system and the consequence is to tighten financial conditions, including via equity markets (Chart 9). The solution would be a trade deal in which China agrees to reforms to pacify the U.S., including an appreciation renminbi, while the U.S. abandons tariffs, enabling global trade, growth, commodity prices, and dollar liquidity to recover. Yet China was never likely to agree to a new Plaza Accord because it is delaying reform to its economy in order to maintain overall political stability – and the financial turmoil of 2015-16 only hardened this position. Chart 9Dollar Liquidity A Risk To Global Equities Moreover Japan in 1985 was already a subordinate ally and had a security guarantee from the United States that was not in question. By contrast, China today is asserting its “equality” as a nation with the U.S., and has no guarantee that Americans are not demanding economic reforms so as to debilitate China’s political stability and strategic capability. After tariffs and currency war comes saber-rattling. Comparing China to Japan in the decades leading up to the Plaza Accord shows how remote of a possibility this solution is: China’s currency has been moving in precisely the opposite direction (Chart 10). Chart 10So Much For Plaza Accord 2.0 The Plaza Accord is a useful analogy for another reason: it marked the peak in Japanese market share in the U.S. economy. In Japan’s case, currency appreciation was the primary mover, while Japan also relocated production to the United States. Chart 11The Real Analogy With The Plaza Accord In China’s case, if currency appreciation is ruled out and production is not relocated due to a failure to secure a trade agreement, then U.S. protectionism will remain the primary means of capping China’s share of the market (Chart 11). The dollar will remain strong and this will continue to weigh on global markets. Bottom Line: China’s recent currency depreciation is a warning signal to the U.S. that the trade negotiations could be broken off. There is further downside if the U.S. implements the new tariffs or hikes tariff rates further. The renminbi is unlikely to enter a freefall, however, because China maintains tight capital controls and is stimulating its economy. It is doubtful that the Trump administration can engineer a depreciation of the dollar through a multilateral agreement. It lacks the geopolitical heft of the 1970s-80s, and it does not have a strategic understanding with China that would enable Beijing to make the same degree of concessions that Tokyo made in 1985. Saber-Rattling After tariffs and currency depreciation, the next likeliest manifestation of strategic tensions lies in the military sphere. While the U.S. threatens to cut off Chinese tech companies like Huawei, Beijing has signaled that countermeasures would include an embargo on U.S. imports of rare earth elements and products.3 When China implemented a partial rare earth export ban on Japan (Chart 12), the context was a maritime-territorial dispute in the East China Sea in which military and strategic tensions were also escalating. The threat to industry only amplified these tensions. There are several locations in East Asia where conditions are ripe for clashes and incidents that could add to negative global sentiment. Indeed, saber-rattling has already begun in Hong Kong, Taiwan, the Koreas, and the East and South China Seas. The following areas are the most likely to darken the outlook for U.S.-China negotiations: Direct U.S.-China tensions: The U.S. and China have experienced several minor clashes since the beginning of the Trump administration. The near-collision of a Chinese warship with the USS Decatur occurred in October 2018, after the implementation of the first sweeping tariff on $200 billion worth of goods – a period of tensions very similar to that of today.4 October 1 marks the 70th anniversary of the People’s Republic of China, an event that will be marked by outpourings of nationalism and a flamboyant military parade displaying advanced new weapons. The government in Beijing will be extremely sensitive in the lead-up to this anniversary, leading to tight domestic controls of news and media, hawkish rhetoric, and the potential for provocations on the high seas. Hong Kong and Taiwan: Chinese officials, including the People’s Liberation Army garrison commander in Hong Kong, the director of the Office of Hong Kong and Macao Affairs, and the city’s embattled Chief Executive Carrie Lam have warned in various ways that if unrest spirals out of control, it could result in mainland China’s intervention. A large-scale police exercise in Shenzhen, Guangdong, just across the water, has highlighted Beijing’s willingness to take forceful action. The deployment of mainland troops would likely lead to casualties and could trigger sanctions from western countries that would have common cause on this issue. The Tiananmen Square incident shows that such an event could lead to a non-negligible hit to domestic demand and foreign exports under sanctions (Chart 13). Hong Kong is obviously a much smaller share of total exports to China these days, but when combined with Taiwan – where there could also be a hit to sentiment from Hong Kong unrest and possibly separate economic sanctions – the impact could be substantial (Chart 14). Chart 13Mainland Intervention In Hong Kong Could Prompt Sanctions Chart 14HK/Taiwan A Significant Share Of Greater China Trade Why would Taiwan get worse as a result of Hong Kong? Unrest in Hong Kong has already galvanized opposition to the mainland’s policies in Taiwan, where the presidential election polling has shifted in incumbent President Tsai Ing-wen’s favor (Chart 15). Beijing has imposed new travel restrictions and held a number of intimidating military exercises, while the U.S. has increased freedom of navigation operations in the Taiwan Strait. These trends could worsen over the next year. Japan and the East China Sea: Japan’s top military official – General Koji Yamazaki – recently warned that Chinese military intrusions are increasing around the disputed Senkaku (Diaoyu) islands in the East China Sea. He called particular attention to China’s change of the Coast Guard from civilian to military control, which he said posed new risks of escalation in disputed waters. Japan itself may have an interest in a more confrontational stance over the coming year. The Japanese government has seen a rise in public opposition to its plan to revise the constitution to enshrine the Self-Defense Forces and thus move toward a more “normal” Japanese military and security posture (Chart 16). A revival of trouble in the South China Sea: China has not reduced its assertive foreign policy in order to win regional allies amid its conflict with the United States. On the contrary, it has continued asserting itself to the point of alienating governments that have largely sought to warm up to the Xi administration, including both Vietnam and the Philippines. The Vietnamese have engaged in a month-long standoff over alleged Chinese encroachments in its Exclusive Economic Zone. And a clash near Sandy Cay in the Spratly Islands is forcing Philippine President Rodrigo Duterte, who has otherwise avoided confrontation with China, to address President Xi over the international court decision in 2016 that ruled out China’s claims of sovereignty over the disputed islands. The South China Sea is important because it is a vital supply line for all of the countries in the region. Even if the United States washed its hands of Beijing’s efforts to control the sea lanes, U.S. allies would still face a security threat that would drive tensions in these waters. This is a formidable group of Asian nations that China fears will seek to undermine it (Chart 17). And of course the Americans are not washing their hands of the region but actually reasserting their interest in maintaining a western Pacific defense perimeter. The Korean peninsula: North Korea has resumed testing short-range missiles, causing another hiccup in U.S. attempts at diplomacy (Chart 18). These tensions have the potential to flare as the U.S.-China trade talks deteriorate, since Beijing has offered cooperation on North Korea’s missile and nuclear program as a concession. Chart 17U.S. Asian Allies Formidable Chart 18North Korean Provocations Still Low-Level Ultimately North Korea needs to be part of the U.S.-China solution, so as long as tensions rise it sends a negative signal regarding the status of talks. And vice versa. South Korea is another case in which China is not reducing its foreign policy aggressiveness in order to win friends. On July 23, a combined Russo-Chinese bomber exercise over the disputed Dokdo (Takeshima) islands in the Sea of Japan led to interception by both Korean and Japanese fighter jets and the firing of hundreds of warning shots. The incident reveals that South Korean President Moon Jae-in is not seeing an improvement in relations with these countries despite his more pro-China orientation and his attempt to engage with North Korea. It also shows that while South Korea’s trade spat with Japan can persist for some time, it may take a back seat to these rising security challenges. As long as North Korean tensions rise it sends a negative signal regarding U.S.-China talks. Chart 19Russia May Need To Distract From Domestic Unrest Russia, like China, is feeling immense domestic political pressure, including large protests, that may result in greater foreign policy aggression (Chart 19). And as China and Russia tighten their informal alliance in the face of a more aggressive U.S., American allies face new operational pressures and the potential for geopolitical crises will rise. Bottom Line: The whole panoply of East Asian geopolitical risks is heating up as U.S.-China tensions escalate. While the U.S. and China may engage in direct provocations or miscalculations, their East Asian neighbors are implicated in the breakdown of the regional strategic order. A crisis in any of these hotspots could jeopardize the already unfavorable context for any U.S.-China trade deal over the next year, especially during rough patches like the very near term. Investment Implications Chart 20A Strategic Investment The potential for saber-rattling in the near term – on top of a series of critical U.S. decisions that could mitigate or exacerbate the increase in tensions surrounding the new tariff hike – argues strongly against altering our tactically defensive positioning at the moment. In this environment we advise clients to stick with our two strategic defense plays – long the BCA global defense basket in absolute terms, and long S&P500 Aerospace and Defense equities relative to global equities. The U.S. Congress’s newly agreed bipartisan budget deal provides a substantially improved fiscal backdrop for American defense stocks, which are already breaking out amid positive fundamentals. A host of non-negligible geopolitical risks speaks to the long-term nature of this trade (Chart 20). Our U.S. Equity Strategy recently reaffirmed its bullish position on this sector. We maintain that the U.S. and China have a 40% chance of concluding a trade agreement by November 2020. Note, however, that even a “no deal” scenario does not entail endless escalation. Presidents Trump and Xi could agree to another tariff ceasefire; negotiations could even lead to some tariff rollback in 2020. That would be, after all, Trump’s easiest way to “ease” trade policy amid recession risks. Nevertheless, our highest conviction call is not about whether there will be a deal, but that any trade truce that is reached will be shallow – an attempt to mitigate the trade war’s damage, save face, and bide time for the next round in U.S.-China conflict. We give only a 5% chance of a “Grand Compromise” by November 2020 that greatly expands the U.S.-China economic and corporate earnings outlook over the long haul. In this sense the ultimate trade deal will be a disappointment for markets.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 At the signing ceremony President Trump reminded his European interlocutors that the risk of car tariffs is not yet off the table. He concluded the celebration saying, “Congratulations. And we’re working on deal where the European Union will agree to pay a 25 percent tariff on all Mercedes-Benz’s, BMWs, coming into our nation. So, we appreciate that. I’m only kidding. (Laughter.) They started to get a little bit worried. They started — thank you. Congratulations. Best beef in the world. Thank you very much.” 2 See Emerging Markets Strategy Weekly Report, “EM: Into A Liquidation Phase?” August 8, 2019, ems.bcaresearch.com. 3 The national rare earth association holding a special working meeting and pledging to support any countermeasures China should take against U.S. tariffs. See Tom Daly, “China Rare Earths Group Supports Counter-Measures Against U.S. ‘Bullying,’” Reuters, August 7, 2019. 4 Military tensions are already heating up as Beijing criticizes the U.S. over the new Defense Secretary Mark Esper’s claim during his Senate confirmation hearings that new missile defense may be installed in the region in the coming years. This comes in the wake of the U.S. withdrawal from the 1987 Intermediate-Range Nuclear Forces Treaty, partly due to China’s not being a signatory of the agreement. Missile defense is a long-term issue but these developments feed into the current negative atmosphere.