Economy

Dear Client, In addition to this week’s Global Investment Strategy report, I am sending you a Special Report on Japan written by Amr Hanafy, Research Associate of BCA’s Global Asset Allocation service. Best regards, Peter Berezin, Chief Global Strategist Highlights The trade war is likely to get worse before it gets better, implying some near-term downside risks to global equities and corporate credit. Nevertheless, both sides have a strong incentive to keep the conflict from spiraling out of control.  Unlike in the earlier rounds, consumer goods represent the bulk of the imports subject to tariffs in the latest round. Many of these Chinese imports also do not have readily-available foreign or domestic alternatives. If U.S. retail prices start rising, voter attitudes – which are not that supportive of the trade war to begin with – will sour further, hurting President Trump’s re-election prospects. Investors should overweight global equities over a 12-month horizon. We intend to upgrade EM and European stocks. However, we are waiting for the trade war to simmer down and global growth to revive before we do so. Feature Tariffied Last week, we wrote that “Risk assets are likely to struggle over the next few weeks as investors grapple with both renewed trade war anxiety and the realization that the Fed’s “insurance cuts” may not be as generous as they had anticipated.”1 Stocks have been on a rollercoaster ride since then. S&P 500 futures were down almost 8% on Monday evening compared to last Thursday’s intraday highs before recovering much of their losses over the subsequent days (Chart 1). Needless to say, the brewing trade war between China and the U.S. remains foremost in investors’ minds. In what has become a familiar pattern of events, China moved quickly to retaliate against President Trump’s decision to raise tariffs on the remaining $300 billion of Chinese imports. The Chinese government announced that state-owned enterprises would suspend purchases of U.S. agricultural goods. The People’s Bank of China also allowed the USD/CNY exchange rate to move above 7, long regarded as a key psychological level. This prompted the U.S. Treasury to officially label China a “currency manipulator.” In and of itself, the decision to label China a currency manipulator means little. The designation was applied to China based on the loose criteria for manipulation used in the 1988 Omnibus Trade And Competitiveness Act, rather than under the more stringent criteria that the U.S. Treasury has employed since 2015 (the latest Treasury report issued in May, using this more stringent criteria, did not find China guilty of currency manipulation). The Treasury statement self-servingly said that Secretary Mnuchin “will engage with the International Monetary Fund to eliminate the unfair competitive advantage created by China’s latest actions.” Given that the IMF indicated as late as three weeks ago that China’s “current account is broadly in line with fundamentals,” we doubt that much will come of this.2 Nevertheless, the designation further sours the atmosphere surrounding the trade talks, suggesting that the conflict will probably get worse before it gets better. Tough Luck, I Am Hitting Send The Chinese were apparently blindsided by President Trump’s decision to raise tariffs. According to media reports, Trump brushed off suggestions from his advisors during a tense Oval Office meeting last Thursday to notify the Chinese, as a courtesy, of the pending tariff announcement, choosing instead to send his tweet while everyone was still present in the room. (With Trump’s permission, Robert Lighthizer did try to place a phone call to Liu He, China’s Vice Premier and lead trade negotiator. The call went unanswered).3  Trump has reportedly become incensed that the Chinese, in his view, are stalling, secretly hoping that they will have a more conciliatory counterparty to deal with following next year’s presidential elections. From Trump’s perspective, a key goal of the tariffs is to make a strategy of running out the clock less appealing. Having successfully used the threat of tariffs to prompt Mexico to take stronger steps to curtail the flow of migrants to the U.S., Trump now feels emboldened to use strong-arm tactics to extract concessions from China. It’s a risky gambit. The Chinese will resist locking in any structural reforms that could weaken Beijing’s authority. The protests in Hong Kong have only added urgency for China’s leaders to look and act tough in the presence of what they describe as “foreign meddling.” All this means that a deal to prevent the latest tranche of tariffs from taking effect on September 1st is unlikely to be hatched. Mutually Assured Destruction? How bad could things get? The good news is that both sides have a strong incentive to keep the conflict from spiraling out of control. For the Chinese, it is not just a matter of losing access to the vast U.S. market. It’s also about losing access to vital technologies that China needs to further its ambitions in everything from robotics, to AI, to genomics. Chart 2Voters Are Not That Supportive Of Protectionism From Trump’s perspective, a severe trade war could hurt his re-election chances. Unlike late last year, the stock market’s recent plunge can be squarely attributed to the intensification of the trade war. If stocks keep falling, many voters with sagging 401(k) accounts will blame Trump. The initial rounds of U.S. tariffs focused on capital goods. In contrast, consumer goods represent the bulk of the imports subject to the latest tranche of duties. If retail prices start rising, voter attitudes – which are not that supportive of the trade war to begin with (Chart 2) – may sour further. It is also worth noting that Chinese goods account for a large fraction of overall imports in many of the categories subject to the latest round of tariffs. This will limit the ability of U.S. companies to source imports from other countries, thus putting further upward pressure on U.S. consumer prices. A Headwind, Not A Game Changer Neither the U.S. nor China would gain from a prolonged trade war. This does not mean that a “World War I” scenario, where all parties end up severely worse off from their actions, can be completely excluded. However, it does mean that powerful forces will probably kick in before the trade war gets out of hand. While global equities may struggle over the coming weeks as investors try to navigate every twist and turn in the trade war saga, they will be higher 12 months from now. In such a “moderate” trade war scenario, where tariffs rise but the global supply chain continues to function, the asset market consequences are likely to be smaller than many observers believe. There are two reasons for this: First, there is the issue of magnitude. In value-added terms, U.S. exports of goods to China account for 0.5% of U.S. GDP, while Chinese exports to the U.S. represent 2.7% of Chinese GDP. These are not infinitesimal numbers, but even in the latter case, they are not particularly large either. Second, both the U.S. and China have some ability to offset the impact of a moderate trade war with stimulus. In the case of the U.S., the stimulus would come mainly in the form of more accommodative monetary policy. Indeed, since Jay Powell’s “hawkish” press conference last week, the 2-year yield has fallen by 24 basis points, while the 10-year yield has dipped by 29 basis points, largely because the market has priced in more rate cuts (Chart 3). In China’s case, the stimulus will continue to consist of credit-driven investment spending, with some tax cuts for consumers thrown in for good measure. Yes, China can stimulate its economy by further weakening its currency. However, such a strategy risks backfiring. As we saw in 2015-16, when China lost almost $1 trillion in reserves, even a small devaluation can foster expectations of a bigger one, leading to large-scale capital outflows (Chart 4). The fact that dollar-denominated debt has risen among China corporates further reduces the incentive to allow the yuan to weaken significantly. As such, we do not expect the Chinese to weaponize the yuan as a tool in the trade war. Chart 3U.S. Yields Are Lower As Markets Are Pricing In More Rate Cuts Chart 4China: A Devaluation Could Exacerbate Capital Outflows   Investment Conclusions As we discussed last week, the global manufacturing cycle tends to follow regular three-year periods – 18 months up, 18 months down (Chart 5). Given that the last downleg began in early 2018, we are due for another upturn in growth. The recent trade turbulence could delay the recovery for a bit, but ultimately, the manufacturing cycle will turn for the better. Central banks tend to be backward-looking. The weakness in both economic growth and inflation has prompted them to ease monetary policy. Just this week, central banks in Thailand, India, and New Zealand cut rates. The RBNZ shaved rates by 50 basis points, double what analysts were expecting. This brings to 16 the number of central banks which have lowered interest rates so far this year. Monetary policy affects the economy with a lag. Global growth is likely to start picking up just as the monetary stimulus is making its way through the system. Stocks will thrive in this environment. Thus, while global equities may struggle over the coming weeks as investors try to navigate every twist and turn in the trade war saga, they will be higher 12 months from now. As global growth recovers, bond yields will rise. Investors should favor stocks over bonds. We do not have a strong view on regional equity allocation for now, but intend to upgrade EM and European stocks once the trade war simmers down and leading indicators for global growth start to march higher. Chart 5The Global Manufacturing Cycle Has Likely Reached A Bottom   Peter Berezin, Chief Global Strategist Global Investment Strategy  peterb@bcaresearch.com Footnotes 1      Please see Global Investment Strategy Weekly Report, “A One-Two Punch,” dated August 2, 2019. 2      Please see Gita Gopinath, “Rebalancing the Global Economy: Some Progress but Challenges Ahead,” IMF Blogs, July 17, 2019; and “2019 External Sector Report: The Dynamics of External Adjustment,” IMF External Sector Reports, July 2019. 3      Vivian Salama and Josh Zumbrun, “Trump Ordered New Chinese Tariffs Over Objections of Advisers,” The Wall Street Journal, August 7, 2019.  Strategy & Market Trends MacroQuant Model And Current Subjective Scores   Tactical Trades Strategic Recommendations Closed Trades

Special Report

Feature Introduction Chart 1Japanese Equities: ##br##Buying Opportunity Or Value Trap? Clients have recently been asking us a lot about Japan. The reason seems clear. With the consistent outperformance of U.S. equities over the past decade, and their rather high valuations now, asset allocators are looking for an alternative. Emerging Markets and the euro zone have major structural concerns which suggest they are unlikely to outperform over any prolonged period (even if they might have a short-lived cyclical pop). Maybe Japan – whose own structural problems are well known and so surely priced in by now – could be a candidate for outperformance and a structural rerating over the next three to five years. Indeed, since the Global Financial Crisis (GFC), Japanese equities have not performed as badly as you might have imagined: they have performed in line with all their global peers – except for the U.S. (Chart 1). In this Special Report, we answer the most common questions that clients have asked us about the long-term (three to five year) outlook for Japan, and try to address the key issue: Are Japanese equities now a buying opportunity, or still a value trap? Our conclusions are as follows: The Japanese economy is still weighed down by structural problems – stubborn disinflation, and a shrinking and aging population – which means consumption growth will remain weak over the coming years. Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. We think it is unlikely, therefore, that Japanese equities will outperform in the long run. In that sense, Japan probably is a value trap, not a buying opportunity. In the past, Japanese equities benefited from bouts of Chinese reflationary stimulus – which we expect will be ramped up in the coming months – but the effect was usually short-lived and muted. The clash between accommodative monetary policy and contractionary fiscal policy, particularly October’s tax hike, is likely to dampen any revival in the Japanese economy. Global Asset Allocation downgraded Japanese equities to underweight over a six-to-12 month investment horizon in our most recent Quarterly Outlook.1 We find it hard to make a strong “rerating” case for Japan, and so, do not expect Japanese equities to outperform other major developed markets in the long run. Why Isn’t Inflation Rising? Chart 2Domestic Drivers Muted Japanese Inflation The market clearly does not believe that Bank of Japan (BoJ) Governor Haruhiko Kuroda can raise inflation to the BoJ’s target of 2%, despite negative interest rates and massive quantitative easing. The 5-year/5-year forward CPI swap rate, a proxy for inflation expectations, is currently at 0.1% (Chart 2, panel 1). Japan’s ultra-accommodative monetary policy has failed to push recorded inflation higher, with the core and core core measures2 both at 0.6% as of June (Chart 2, panel 2). In its recent outlook, the BoJ revised down its inflation forecasts in fiscal years 2019, 2020, and 2021 to 1.0%, 1.3%, and 1.6% respectively, implying that it does not expect to get even close to 2% over the forecast horizon.3  Prior to the bursting of Japan’s bubble in 1990, a big percentage of Japanese inflation came from domestic factors: housing, culture and recreation, and health care. By contrast, prices of items manufactured overseas, mainly in China, and imported goods – especially furniture and clothing – did not rise much. The same was true for other developed economies such as the U.S. and the euro area. However, since the 1990s, domestically-produced items in Japan have failed to rise in price, unlike the situation in the U.S. This kept a lid on Japanese inflation. Housing in particular, which represents about 20% of the inflation basket, now contributes only 0.02% to Japanese core core inflation (Chart 2, panels 3 & 4). Chart 3Deregulation = Low Inflation There are three main reasons for this difference: Stagnant wages Unfavorable demographics Deregulation The first two causes are discussed in detail below. Gradual deregulation of various industries has also been disinflationary. In the 1980s, Japan remained a highly regulated economy, with the government fixing many prices and limiting entry into many sectors. Although change has been slow, deregulation and the introduction of competition have caused structural downward pressure on prices in a number of industries, notably telecommunications and utilities. For example, deregulation of electric power companies in 2016 allowed increased competition and new entrants into the market.4 As a result, electricity prices in Japan dropped from an average of 11.4 JPY/Kwh prior to full deregulation to 9.3 JPY/Kwh (Chart 3). But there are still many industries which are more tightly regulated in Japan than in other advanced economies (the near-ban on car-sharing services such as Uber, and tight restrictions on AirBnB are just the most newsworthy examples). This suggests that structural disinflationary pressures are likely to persist on any further deregulation. Why Is Wage Growth Stagnant, Despite A Tight Labor Market? Chart 4Wages Have Been Beaten Down... Japan’s labor market appears very tight. The unemployment rate is 2.3%, the lowest since the early 1990s, and the jobs-to-applications ratio is 1.61, the highest since the 1970s. And yet wage growth has remained stagnant, averaging only 0.5% over the past five years. (Chart 4).5  There are a number of structural reasons why wages have failed to respond to the tight labor market situation. One major contributory factor is the social norm of “lifetime employment,” whereby many employees, especially at large companies, tend to stay with their initial employer through their careers, being rotated from one department to another, without becoming specialists in any particular field. This means they have little pricing power – and few transferable skills – when it comes to seeking a mid-career change. This social norm is also reflected in Japan’s typical salary schemes, which are based on employment length (Chart 5, panel 1). Wages tend to rise with age, while in other developed economies they peak around the age of 50. Another factor is the big increase in recent years in part-time and temporary positions, which typically pay lower wages than full-time positions. Because employment law makes it hard (if not impossible) to fire workers, companies have tended to prefer hiring non-permanent staff, who are easier to replace. Part-time workers have increased by 11 million over the past three decades, compared to an increase of two million in full-time workers (Chart 5, panel 2). A substantial part of this increase in part-time employment came from both the elderly and women joining the labor market – groups that have little wage bargaining power (Chart 5, panel 3). Part-time wage growth has also turned negative this year (Chart 5, panel 4). Bonuses are a significant portion of wages, and tend to be rather volatile, moving in line with corporate profits, which have weakened this year (Chart 5, panel 5). Japan’s structural problems will not easily be solved, and will continue to dampen the economy’s growth. Nonetheless, there are some tentative signs of a change in this social norm. The number of employees changing jobs has been rising over the past few years. This is mostly evident among employees aged over 45, signaling the need for experienced personnel (Chart 6, panel 1). The percentage of unemployed who had voluntarily quit their jobs, rather than being let go, has also reached an all-time high (Chart 6, panel 2). This evidence suggests that employees are increasingly willing to leave their jobs in search of a more interesting or a better-paid one. Given such a tight labor market, it seems only a matter of time before there is some pressure on employers to increase salaries in order to attract talent. Chart 5...Mainy Due To Part-Time Employment Chart 6Changing The Norm   Is There An Answer To Japan’s Demographic Problem? Chart 7Japanese Population: Shrinking And Aging Deteriorating demographics is a key reason why inflation has remained subdued. The Japanese population peaked in 2009 and, over the past eight years, has shrunk on average by 0.2%, or 220,000 people, a year. Furthermore, the working-age population (25-64) has shrunk by 6 million, or 10%, since its peak in 2005. With marital rates continuing to fall, and fertility rates doing no more than stabilizing, there is no sign of a quick turnaround in this situation (Chart 7, panels 1 & 2). Prime Minister Abe has eased immigration laws to try to put a stop to the population decline. Late last year, the Diet passed a law that will allow more foreign workers into the country. The law will provide long-term work visas for immigrants in various blue-collar sectors, whereas the previous regulation allowed in only highly skilled workers. It will also enable foreign workers to upgrade to a higher-tier visa category, giving them a path to permanent residency, and allowing them to bring their families along.6  However, Japan’s closed culture raises the question of how successful Prime Minister Abe’s immigration reforms will be. The number of foreign residents has risen over the past few years, reaching a cumulative 2.73 million people, but this has been insufficient to reverse the decline in the population. In addition, without implementing effective measures to integrate new immigrants and support their efforts to become long-term residents, these reforms are likely to be minor in their impact (Chart 7, panel 3). Chart 8Aging Population = Slowing Productivity Japan’s population is not just shrinking but also aging. People aged 65 and older comprise 28% of the total population (Chart 7, panel 4). That figure is projected to reach 40% within the next 40 years. The dependency ratio – those younger than 15 years and older than 64, as a ratio of the working-age population – continues to rise rapidly (Chart 7, panel 5). Moreover, older people tend to be less productive. Because of this, Japan’s productivity may continue to decline from its current level, which is already low compared to other developed countries (Chart 8). The combination of a shrinking working-age population and poor productivity growth means that Japan’s trend real GDP growth over the next decade – absent an increase in capital expenditure or improvement in technology – is unlikely to be above zero.7   Some argue that Japan’s aging population could be the trigger to overcoming its disinflation problem. They argue that, as the share of the elderly-to-total-population increases, public expenditure on health care will balloon. The United Nations projects the median age in Japan to be 53 years, 10 and 5 years older than in the U.S. and China, respectively, by 2060 (Chart 9). This implies that the Japanese government, which currently pays about 80% of total health care expenditure, will face an increasing burden from medical spending, elderly care, and public pension payments. These expenditures are projected to increase from 19% to 25% of GDP (Chart 9, panel 2). The government, therefore, may have no alternative but to resort to monetizing its debt to pay these bills, which would ultimately prove to be inflationary. Chart 9Aging Population = Higher Fiscal Burden In some countries, BCA has argued, an aging population is inflationary because retirees’ incomes fall almost to zero after retirement, but expenditure rises, particularly towards at the end of life as they spend more on health care.8 The resulting dissaving, and disparity between the demand and supply of goods, should have inflationary effects. But this rationale does not hold for Japanese households. Older people in Japan tend to maintain their level of savings (Chart 10). This phenomenon might change as a new generation, keener on leisure activities and less culturally attuned to maximizing savings, retires. But to date, at least, Japan’s aging process has been disinflationary. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Moreover, to reduce the burden on its budget, the government will continue its efforts to keep down health care costs, which have a 5% weight in the core core inflation measure. We find it unlikely, therefore, that the BoJ will achieve its 2% inflation target over the next few years. So, What Else Could The BoJ Do? Chart 11The BoJ's Ammunition Is Running Out Over the past six years, since Kuroda became governor in 2013, the Bank of Japan has rolled out aggressive monetary easing. It has cut rates to -0.1% and introduced a policy of “yield curve control,” which aims to keep the yield on 10-year JGBs at 0%, plus or minus 20 basis points. As a result, it now holds JPY479 trillion of JGBs, or 46% of the total outstanding amount (and equivalent to 89% of Japan’s GDP). It has also bought an average of JPY6 trillion of equity ETFs a year over the past three years (Chart 11, panels 1 & 2), to bring its total equity ETF holdings to JPY28 trillion, almost 5% of Japan's equity market cap. However, as noted above, these policies have had little impact on inflation, or on inflation expectations. BCA’s Central Bank Monitor indicates that Japan needs to ease monetary conditions further (Chart 11, panel 3). What alternative tools could the BoJ use to spur inflation? The BoJ could cut rates further, and indeed the futures market is discounting a 10 basis points cut over the next 12 months (Chart 11, panel 4). In its July Monetary Policy Committee meeting, the bank committed to keeping policy easy “at least through around spring 2020.” But it seems reluctant to cut rates, given that this would further damage the profitability of Japan’s banks, particularly the rather fragile regional banks. Indeed, one can argue that a small rate cut would be unlikely to have much effect, given the impotence of previous such moves. The BoJ might be inclined to emulate the ECB and extend its asset purchase program. It owns only JPY3 trillion of corporate bonds, and has bought almost no new ones since 2013 (Chart 11, panel 5), although the small size of the Japanese corporate bond market would give it limited scope to increase these purchases. It could also increase its purchases of REITs, of which it currently owns JPY26 trillion. It could even consider buying foreign assets (as does the Swiss National Bank), though this would annoy the U.S. authorities, who would consider it currency manipulation. Some economists argue in favor of a Japanese equivalent of the ECB’s Targeted Long-Term Refinancing Operations (TLTRO). In other words, the BoJ should provide funds to banks at rates significantly below zero, provided they use the proceeds to give out loans to households and corporations.9 This would not only increase credit in the economy, but also bolster banks’ declining profitability. Some academics consider Japan, which appears stuck in a liquidity trap, as the perfect setting to try out Modern Monetary Theory (MMT).10,11 However, the Ministry of Finance remains fixated on reducing Japan’s excessive pile of outstanding government debt, which is currently 238% of GDP. When MMT was debated in the Japanese Diet this June, Finance Minister Taro Aso dismissed it, saying “I’m not sure I should even call it a theory, it’s a line of argument,” and insisted that tax hikes are necessary to secure Japan’s welfare system. The Ministry’s current plan is to close the primary budget deficit by 2027.  Moreover, the Bank of Japan Law bans the central bank from underwriting government debt, due to the abuses of this in the 1930s, when it funded Japan’s militarist expansion12 – though there are no limits on how much the BoJ can buy in the secondary market.  Our conclusion is that negative rates and quantitative easing have reached the limit of their effectiveness. Even if the BoJ ramps up the measures it has taken up until now, this will have little impact on inflation. It will be only when the government finally understands that a combination of easy fiscal and monetary policy is single effective tool left that the situation can change. There is little sign of this happening soon. It will probably take a crisis before this mindset shifts. Are There Any Signs Of Improvement In Japan’s Banking Sector? Japan’s financial sector is also one of its longstanding problems. After Japan’s 1980s bubble burst, the BoJ aggressively cut rates from 6% to 0.5% over the span of eight years. Long-term rates also fell. Falling interest rates reduced Japanese banks’ net interest margins. The banks spent the 1990s cleaning up their balance sheets and recapitalizing themselves. In the end, the banks’ cumulative losses (including write-offs and increased provisioning) during the 1992-2004 period reached the equivalent of 20% of Japanese GDP.13 Japanese bank stocks have consistently underperformed the aggregate index since the late 1980s (with the exception of a short period in the mid-2000s) – and by 75% since 1995 (Chart 12, panel 1). It now seems like banks' relative performance is bound by the policy rate. It is likely, then, that a combination of subdued wage growth, decreased spending by the elderly, low demand for housing, and the ineffectiveness of an ultra-accommodative monetary policy is likely to keep inflation low. Bank loan growth throughout the period of 1995-2006 was weak or negative, as banks became more risk averse and borrowers focused on repairing their balance sheets (Chart 12, panel 2). It has picked up a little over the past decade, but remains low at around 2%-4%. This has been a drag on economic activity since both Japan’s corporate and household sectors rely much more heavily on banks for funding compared to the U.S. or the euro area (Chart 12, panels 3 & 4). As a result of stagnant loan growth at home, Japanese banks have in recent years expanded their activities overseas, particularly in south-east Asia. Foreign lending for Japan’s three largest banks comprises 29.7% of total loans, 33% of which is to Asia.14 This represents a risk for future stability since these assets could easily become non-performing in the event of an Emerging Markets crisis in the next recession. Chart 12Bank Stocks Have Consistently Underperformed... Chart 13...Because Of Weak Loan Growth ##br##And Poor Profits By the mid-2000s, Japanese banks had finished cleaning up from the 1980s bubble and the non-performing loan ratio is now low. But measures of profitability such as return on assets and net interest margin remain poor by international standards (Chart 13). Japanese financial institutions’ capital adequacy ratios have also deteriorated moderately over the past five years, according to the BoJ’s Financial System Report, as risk-weighted assets have increased more quickly than profits. The core capital adequacy ratio of just above 10% is significantly lower than in other major developed economies.15 How Should Investors Be Positioned In The Short-Term? There are two factors that will determine how Japanese equities perform over the next 12 months: Chinese stimulus, and the impact of the consumption tax hike in October. Can Chinese Reflation Help Boost Japanese Economic Activity? Chart 14Chinese Stimulus Boosts Japan's Activity... Chart 15...Yet Its Impact Is Short-Lived And Muted While Japan is not a particularly open economy – exports represent only 15% of GDP – its manufacturing sector is very exposed to global trade, and the swings in this sector (which is a lofty 20% of GDP) have a disproportionately large marginal impact on the overall economy. China accounts for 20% of Japan’s exports, roughly 3% of Japan’s GDP (Chart 14). China’s economic slowdown since 2017 has clearly weighed heavily on Japanese exports and the manufacturing sector. Japanese machine tool orders have contracted for nine months, in June reaching the lowest growth since the GFC, -38% year-on-year. Vehicle production growth has also been weak, rising only 1.8% year-to-date compared to 2018, and overall industrial production growth has turned negative, falling by 4.1% YoY in June. It seems that global growth data has not yet bottomed. The German manufacturing PMI remains well below the boom/bust line at 43.2. Korean export growth is also contracting at a double-digit rate. Nevertheless, we expect the global manufacturing downturn – which typically lasts about 18 months from peak-to-trough – to bottom towards the end of this year.16 This will be supported by the Chinese authorities accelerating their monetary and fiscal stimulus, although the magnitude of this might not be as big as it was in 2012 and 2015.17 Japanese economic activity has historically been closely correlated with Chinese credit growth, with a lag of six-to-nine months (Chart 15). What Will Be The Impact Of The Consumption Tax Hike? Japanese consumer demand has been sluggish for some time, mainly as a result of low wage growth. The planned rise in the consumption tax from 8% to 10% in October is likely to dampen consumption further. With the economy currently so weak, there seems little justification for a tax rise. But, having postponed it twice, it seems highly unlikely that Prime Minister Abe will do so again, particularly after his victory in last month’s Upper House election, which was a de facto referendum on the tax hike. Chart 16Previous Tax Hikes Hurt Sales Badly The OECD, based on Japanese government data, estimates the impact on households of the tax hike will be 5.7 trillion yen (about 1% of GDP).18 Consumers did not take previous tax rate hikes well. Spending was brought forward to the two to three months immediately before the hike. However, following the hike, not only did sales fall back, they also trended down for some time (Chart 16). The risk to the economy is that the same happens again.  The government, however, is planning several measures to mitigate the tax burden (Table 1). It will not apply the tax increase to food and beverages, which will stay at 8%. The government will implement a fiscal package including free early childhood education, support for low-income earners, and tax breaks on certain consumer durable goods, such as automobiles and housing. It will also introduce a rebate program, to encourage consumer spending at small retailers using non-cash payments (partly to reduce tax avoidance by these businesses).19 Based on the government’s estimates, these measures will be enough to fully offset the impact of the tax hike. However, the IMF’s Fiscal Monitor sees fiscal policy tightening due to the tax rate hike, although by less than in 2014. Its estimate is a drag of 0.6% of potential GDP in 2020 (Chart 17). Table 1Easing The Tax Hike Burden Chart 17Clash Of Policies: Fiscal Vs. Monetary   Previous sales tax hikes caused a short-lived jump in inflation, which trended lower afterwards. Assuming a full pass-through rate of price increases to consumers, the BoJ expects the hike to raise core inflation by +0.2% and +0.1% in fiscal years 2019 and 2020 respectively.20 Consumers did not take previous tax rate hikes well. As such, over the next 12 months, Global Asset Allocation recommends an underweight on Japanese equities. While a bottoming of the global manufacturing cycle and the impact of Chinese stimulus are positive factors, there are better markets in which to play this, given the risks surrounding Japanese consumption caused by the consumption tax rise. Are Improvements In Corporate Governance Enough To Make Japanese Equities A Long-Term Buy? Chart 18Corporate Governance Not Improving Enough Many investors believe that improved corporate governance could be the catalyst the stock market needs to outperform. It is true that there have been some improvements in recent years. Japanese companies have increased the share of independent directors on their boards, although this remains low by international standards (Chart 18, panel 1). Share buybacks have increased, and are on track to hit all-time high this year (Chart 18, panel 2). However, the improvements are still somewhat superficial. Cash holdings of Japanese companies are about 50% of GDP and 100% of market capitalization. The dividend payout ratio, at 30%, is significantly lower than in other developed markets, for example 40% in the U.S. and 50% in the euro area (Chart 18, panels 3 & 4). Why haven’t Japanese corporations returned their excess cash to shareholders? The answer is that many companies simply do not believe that they hold excess cash (Chart 19). The lack of a vibrant market for corporate control, and the general failure of activist foreign investment funds in Japan, means there is also less pressure on companies to use cash efficiently, and to raise leverage to improve their return on equity. The growing presence of the BoJ in the stock market is also a concern. The BoJ now holds over 70% of outstanding ETF equity assets, and is on track to become the single largest owner of Japanese stocks within a couple of years. With the BoJ not taking an active role as a shareholder, this risks undermining corporate governance reforms.21 It also suggests that, without the BoJ’s equity purchases over the past few years, Japanese equities might have performed even worse. Foreign investors have been the main buyers of Japanese equities over the past two decades, offsetting net selling by domestic households and most types of financial institutions. But foreign purchases have recently started to roll over, a trend that could be another catalyst for downward pressures on the stock market, if it were to continue (Chart 20). Chart 20Who Will Buy If Foreigners Don't?   We conclude, therefore, that signs of improvement in corporate governance are still sporadic and not sufficient to justify a major rerating of the Japanese corporate sector.   Bottom Line GAA recommends an underweight on Japan over a 12-month time horizon, since the drag on consumption from the tax hike will override any positive impact from a rebound in global growth caused by Chinese stimulus. In the longer term, a stubborn refusal to use fiscal policy as well as monetary easing, the limited improvement in corporate governance, and Japan’s intractable structural problems such as demographics, mean it is hard to make a strong rerating case for Japanese equities.   Amr Hanafy, Research Associate amrh@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Quarterly Portfolio Outlook, “Precautionary Dovishness – Or Looming Recession?” dated July 1, 2019, available on gaa.bcaresearch.com. 2      The BoJ calculates core inflation as headline inflation less fresh food, and core core inflation as headline inflation less fresh food and energy. 3      Please see “Outlook for Economic Activity and Prices (July 2019),” Bank Of Japan, July 2019. 4      Please see “Energy transition Japan: 'We have to disrupt ourselves,' says TEPCO,” Engerati, April 24, 2017.   5      Wage growth is total cash earnings, which includes regular/scheduled earnings plus overtime pay plus special earnings/bonuses. 6      Menju Toshihiro, “Japan’s Historic Immigration Reform: A Work in Progress,” nippon.com, February 6,2019. 7      Please see Global Asset Allocation Special Report, “Return Assumptions – Refreshed And Refined,” dated June 25, 2019, available at gaa.bcaresearch.com. 8      Please see Global Asset Allocation Special Report, “Investor’s Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated May 22, 2019 available at gaa.bcaresearch.com. 9      Takuji Okubo, “Japan’s dormant central bank may have to rouse itself once more,” Financial Times, May 27, 2019. 10     The core idea of MMT is that, since governments can print as much of their own currency as they require, they do not need to raise money in order to spend money. Japan could increase its fiscal spending and, as long as the BoJ bought the increased bond issuance, this would not raise interest rates. 11     Please see Global Investment Strategy Special Report, “MMT And Me,” dated May 31 2019, available at gis.bcaresearch.com. 12     Please see Global Asset Allocation Special Report, “The Emperor’s Act Of Grace,” dated 8 June 2016, available at gaa.bcaresearch.com. 13     Mariko Fujii and Masahiro Kawai, “Lessons from Japan’s Banking Crisis 1991-2005,” ADB Institute Working Paper, No. 222, June 2010. 14     Mizuho, Mitsubishi UFJ and Sumitomo Mitsui. Data from March 2019 annual reports. 15     Please see “Financial System Report,” Bank of Japan, April 2019. 16       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com. 17       Please see GAA’s latest Monthly Portfolio Update, “Manufacturing Recession, Consumer Resilience, Dovish Central Banks,” dated 1 August 2019, available at gaa.bcaresearch.com. 18     Please see “OECD Economic Surveys: Japan,” OECDiLibrary, April 15, 2019. 19     Please see “Government plans 5% rebates for some cashless payments after 2019 tax hike,”The Japan Times, November 22, 2018. 20     Please see “Outlook For Economic Activity And Price (July 2019),” Bank Of Japan, July 30, 2019. 21     Andrew Whiffin, “BoJ’s dominance over ETFs raises concern on distorting influence,” Financial Times, March 31, 2019.

Analysis on India is available below. Highlights Moderate RMB depreciation is consistent with the economic as well as political objectives of Chinese authorities. Yet, this is bad news for EM currencies and risk assets. As EM currencies depreciate, driven by a weaker RMB and lower commodities prices, foreign investors will head for the exit and EM risk assets will plummet. Meanwhile, there are tell-tale signs of an incipient EM breakdown. We continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We also remain structurally short the RMB. Feature In our May 23 report titled The RMB: Depreciation Time? , we argued that the odds of an RMB depreciation were rising and that the currency would likely depreciate by some 6-8% versus the dollar. We contended that this would be bad news not only for EM currencies but also for all EM risk assets. EM fundamentals have been poor – both exports and cyclical domestic sectors have been contracting for some time. We illustrated the weak domestic demand conditions experienced by the majority of developing economies in our recent report, Domestic Demand In Individual EM Countries. Nevertheless, many investors have been ignoring the growing evidence of deteriorating growth conditions. The recent breakdown in the CNY/USD cross has reminded investors of the 2015 episode, when global risk assets – particularly in EM – tumbled following the yuan’s depreciation. We expect the RMB to depreciate by another 5-6% or so. We expect the RMB to depreciate by another 5-6% or so (Chart I-1). This will likely trigger a full-scale breakdown in EM risk assets. With respect to investor positioning, sentiment on EM was buoyant up until last week. Chart I-2 shows that asset managers’ and leveraged funds’ net long positions in EM equity index futures and high-beta liquid currencies futures was elevated as of Friday August 2. Chart I-1More Downside In RMB Chart I-2Investor Sentiment On EM Was Positive As Of Last Week With negative news proliferating on many fronts – the U.S.-China confrontation, slumping global trade, shrinking EM profits, tumbling commodities prices and RMB depreciation – the risk of a portfolio capital exodus from EM is rising, and a liquidation phase is highly probable. Implications Of RMB Depreciation It is impossible to know whether the recent RMB depreciation was market-driven or engineered by the PBoC. Our best guess is that the latest RMB depreciation was driven by both market pressures as well as the authorities’ increased tolerance of a weaker RMB.  The mainland economy requires a weaker currency to counteract accumulating deflationary pressures from deteriorating domestic and foreign demand, as well as to offset rising U.S. import tariffs. The Chinese leadership likely regards RMB depreciation as an economic and political response to U.S. import tariffs. That said, the Chinese authorities have significant latitude to control the exchange rate, not only via selling the central bank’s foreign currency reserves and tightening capital controls but also by utilizing foreign currency forward swaps. Therefore, the RMB depreciation will run further but will unlikely spiral out of control. Regardless of the cause of the depreciation, a weaker RMB will affect the rest of the world in general and EM in particular. Regardless of the cause of the depreciation, a weaker RMB will affect the rest of the world in general and EM in particular via the following two channels: Escalating competitive devaluation: The RMB is causing a breakdown in other Asian currencies, especially those exposed to manufacturing exports (Chart I-3). Critically, falling export prices herald currency depreciation not only in China but also in other Asian economies such as Korea, Singapore and Taiwan (Chart I-4). Chart I-3Breakdown In Emerging Asian Currencies Chart I-4Lower Export Prices Warrant Currency Depreciation Less Chinese imports = a drag on global trade: An RMB devaluation reduces Chinese importers’ purchasing power in U.S. dollar terms. The same amount of credit and fiscal stimulus in yuan when converted into U.S. dollars can be used to procure less goods and commodities. In brief, the gap between mainland imports in yuan and in dollars will widen (Chart I-5). Chart I-5Chinese Imports In Dollars Will Continue Shrinking Chinese imports in dollar terms will continue contracting. Many EM and some DM currencies will be negatively affected, since China is a major source of demand for these economies. Bottom Line: Moderate RMB depreciation is consistent with the economic as well as political objectives of Chinese authorities. Yet, this is bad news for EM currencies and risk assets. An EM Breakdown Is In The Making There are a number of financial markets and individual share prices that have been forewarning of potential breakdowns in EM/China plays and global pro-cyclical assets. In particular: Having failed to break above its 200-day moving average, the Risk-On vs. Safe-Haven currency ratio1 has dropped below its three-year moving average (Chart I-6, top panel). This indicator has had a very high correlation with EM stocks and global materials equities. Hence, its breakdown heralds a gap down in EM share prices as well as global materials stocks (Chart I-6, middle and bottom panels). Chart I-6Beware Of Breakdowns The rationale for using the 400-day (18-month), 800-day (three-year) and other long-term moving averages is similar to why investors utilize the 200-day (nine-month) moving average. When a market fails to punch below or above any of its long-term moving averages, odds are that it will make a new high or low, respectively. We discussed these technical indicators and have offered empirical examples of how these signals have historically worked in principal markets such as the S&P 500 and U.S. bond yields in our past reports.   Base metals (including copper) and oil prices as well as global steel stocks have broken below their three-year moving averages (Chart I-7). Commodities prices have been exhibiting a very bearish chart formation, and will likely plunge further. BCA’s Emerging Markets Strategy team remains bearish on commodities prices, even though BCA’s house view is bullish. The primary basis for this divergence in view has been and remains the Chinese growth outlook. Chart I-7Commodities Are In A Trouble Spot Chart I-8Canary In A Coal Mine For Commodities Share price of Glencore – a major player in the commodities space – has plunged below its three-year moving average, which has served as a support a couple of times in recent years2 (Chart I-8). Crucially, this stock has exhibited a head-and-shoulders formation, and has nose-dived below its neckline. Kennametal (KMT) – a high-beta U.S. industrial stock – leads the U.S. manufacturing cycles and has formed a similar configuration as Glencore’s (Chart I-9). This raises the odds that the U.S. manufacturing PMI will drop below the 50 line. Finally, the relative performance of S&P 500 global cyclical stocks versus global defensives3 has resumed its downtrend after failing to break above its 200-day moving average (Chart I-10). This foreshadows a poor global growth outlook and serves as a downbeat signal for global cyclical plays. Chart I-9Canary In A Coal Mine For U.S. Industrials Chart I-10A Message From S&P 500 Industry Groups Does all of the above imply that the global growth slowdown is already priced into global financial markets? Not necessarily. These breakdowns have occurred on the fringes of markets. As the average investor heeds to these signals and as these breakdowns move from the periphery to the center, there will be more damage to global risk assets in general and EM in particular. Importantly, there are cyclical segments of global and EM financial markets that have not adjusted and remain vulnerable. For example, global semiconductor stocks and global industrial share prices remain elevated despite the enduring global manufacturing recession (Chart I-11). Chart I-11Mind The Gaps The wide gap between share prices and revenues of these cyclical sectors implies that investors have been pricing an imminent business cycle recovery. Odds are that the current global manufacturing downturn will last longer or that a bottoming-out phase will be more extended than in 2012 and 2015. We have elaborated on the rationale for a more extended downturn in our past reports, and our conclusions still stand: A lack of aggressive stimulus in China, a lower propensity to spend among Chinese households and companies, as well as the ongoing trade war will continue to dampen business sentiment worldwide. Consequently, the current gap between share prices of these cyclical sectors and their underlying revenues will likely be closed via lower stock prices. As to non-cyclical equity sectors, they are less vulnerable to a profit downturn but their valuations are very expensive, and investor positioning is heavy. Further, EM local currency bonds as well as EM sovereign and corporate credit markets have been buoyant because of falling U.S. interest rates. Yet EM currencies are at risk from both RMB devaluation and falling commodities prices. EM currency depreciation will in turn undermine returns on EM local currency bonds and spur an investor exodus from high-yielding domestic bonds. Chart I-12Which Way These Gaps Will Close? Excess returns on EM sovereign and corporate credit have historically correlated with EM currencies and commodities prices as well as with equity returns (Chart I-12). Commodities prices, EM currencies and share prices are all poised to weaken further. It will be very surprising if sovereign and corporate spreads do not widen from their current tight levels. Bottom Line: There are a number of tell-tale signs of an incipient EM breakdown. As EM currencies depreciate driven by a weaker RMB and lower commodities prices, foreign investors will head for the exit and all EM risk assets will plummet. Investment Recommendations We are reiterating our negative stance on EM currencies and risk assets both in absolute terms and relative to their DM counterparts. Our recommended country overweights and underweights for EM equity, sovereign credit and local currency bond portfolios are always available at the end of our reports (please refer to pages 18 and 19 ). As to exchange rates, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, COP, IDR, MYR, PHP and KRW. We also remain structurally short the RMB. In a nutshell, EM currency depreciation will -- for now -- overwhelm the positive impact of lower domestic interest rates on EM equities and in some cases will prevent developing nations’ central banks from reducing rates further. Finally, we recommended a long gold / short oil and copper trade on July 11 and this has panned out nicely (Chart I-13). Gold has made a structural breakout versus the rest of commodities complex and investors should hold into this position. We recommended a long gold / short oil and copper trade on July 11 and this has panned out nicely. Chart I-13A Structural Breakout In Gold Versus Oil And Copper Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Indian Stocks: Poor Profit Outlook Amid Rich Valuation Indian stocks have failed to break out above their highs, in both local currency and U.S. dollar terms, and have rolled over decisively (Chart 1, top panel). Chart II-1Indian Stocks Failed To Break Major Resistance Levels Relative to the EM equity benchmark, Indian share prices have recently been underperforming despite collapsing oil prices and plunging U.S. interest rates. Furthermore, this bourse’s relative performance against the global equity index in common currency terms has bounced lower from a major structural technical resistance (Chart II-1, bottom panel). India’s recent underwhelming equity dynamics have transpired despite ongoing monetary policy easing by the country's central bank. In a nutshell, the roots of this poor equity performance trace back to lackluster profitability, rich equity valuations and overcrowded positioning. We recommend investors continue avoiding Indian equities for now as more downside is likely. Domestic Growth/Corporate Earnings Slump Indian domestic demand growth has been nosediving with no clear end in sight: Sales of passenger cars, two-wheelers, three-wheelers, tractors as well as medium & heavy commercial trucks are all contracting at double-digit rates (Chart II-2). Similarly, real gross fixed capital formation growth has decelerated, the number of capex projects underway are falling, capital goods imports and production are contracting and cement production growth has plummeted (Chart II-3). Chart II-2Domestic Demand Is Very Weak Chart II-3Capex And Infrastructure Are Heading South Some cracks are also appearing in India’s real estate sector. Chart II-4 shows nationwide housing price growth is decelerating in nominal terms and deflating in real (inflation-adjusted) terms. Chart II-4House Prices Are Contracting In Real Terms Typically, share prices become extremely sensitive to business cycles slowdowns when valuations are elevated. This is currently the case for the Indian bourse. In fact, India’s latest corporate earnings season was lackluster and many companies across various sectors have warned about slowing growth. More visibility on an ameliorating profit outlook as well as lower valuation multiples are needed for share prices to reach a sustainable bottom. India Is Joining The “Kick The Can Down Road” Club Banks have been the star performers within the Indian bourse with non-financials generating underwhelming returns. This warrants particular attention to bank stocks’ fundamentals and valuations. Recent media reports have been highlighting that India’s NPL cycle has finally turned for the better – marking an end to the country’s bad asset cycle that started in 2013. Chart II-5Poor Debt Servicing Ability Among Indian Corporate Borrowers However, scratching below the surface, the recent reduction in India’s NPLs ratio has not occurred due to organic improvement in India’s corporate borrowers’ ability to service debt. For instance, the EBITDA-to-interest expense ratio for the country’s non-financial publically-listed companies has not improved at all (Chart II-5). Rather, what seems to be driving the NPLs ratio lower is a regulatory forbearance: The new Governor of the RBI – Shaktikanta Das – issued a new circular on NPL recognition in June. It essentially provides commercial banks with much more flexibility in the way they can deal with their bad assets and permits them to delay their NPL recognition. The central bank also allowed India’s manufacturing and infrastructure corporates in default to borrow via the External Commercial Borrowing route in order to pay down their domestic loans under a one-off settlement. Furthermore, the RBI permitted commercial banks to restructure loans of micro-, small-, and medium-sized businesses before they turn bad - allowing banks to delay the proper recognition of such types of loans as well. Finally, the RBI reduced the risk weight of consumer credit from 125% to 100% in its monetary policy meeting yesterday. The objective of this measure is to accelerate consumer credit growth even though the latter has been booming in the past ten years. All in all, these regulatory measures reverse banks and corporate sector restructuring efforts and thereby are negative from a structural perspective. In the past, we were positive on the Indian banking system structurally because the central bank was promoting critical reforms.   Under the new leadership of the RBI, India is now joining the “kick the can down the road” club. This warrants somewhat lower equity multiples for banks than before. Financials Stocks Are Still Expensive Despite the selloff, Indian bank stocks are not yet cheap. For Indian public banks we focused our analysis on the State Bank of India (SBI) as it is the largest and only public bank that has performed reasonably well. This bank presently trades at a price-to-book value (PBV) ratio of 1.15.  Our analysis shows that at a more realistic 12% NPL ratio4 and assuming a 30% recovery ratio, 25% of its equity would be impaired. This would move its adjusted PBV ratio to 1.5. Assuming a fair-value PBV ratio of 1.3, the SBI appears to be overvalued by 15-17%. As to private banks,5 they are also expensive. For instance, if their NPLs rise to 6% from around 3% currently, they would seem overvalued by at least 12% (Table II-1). The analysis assumes a generous recovery ratio of 50% and a very high fair-value PBV ratio of 3.3.  Finally, a comment on non-bank financial companies (NBFCs) is warranted. Their liquidity situation is extremely grim. Chart II-6 shows that our proxy for liquidity, measured as short-term investments (including cash) minus short-term borrowing for the 11 large NBFCs we assessed,6 is in a deep negative territory. In other words, these companies have a substantial maturity mismatch. Chart II-6Major Asset-Liability Mismatches In Non-Bank Finance Sector Remarkably, these non-bank organizations grew their assets at a 20% annual compounded growth rate since 2009. Odds are they have misallocated capital to a large extent and their NPL ratio is probably in the double-digits. According to the RBI, non-bank financials’ gross NPLs ratio stood at 6.6% as of March 2019. By comparison the NPLs ratio of Indian banks peaked at 11.2%. Meanwhile, their valuations are not cheap at all. For instance, the NBFCs included in the MSCI India equity index carry a PBV ratio of 3.5 for consumer finance focused companies and a PBV ratio of 3 for thrift & mortgage finance focused companies. Bottom Line: Share prices of banks and non-bank financials are far from being cheap and remain at risk of further decline. Investment Recommendations In absolute U.S. dollar terms, Indian stocks have meaningful downside. This is confirmed by some precarious technical signals: the equal-weighted stocks index has dropped by 28% from its top in January 2018 and small-cap stocks are breaking down (Chart II-7). Finally, while the RBI cut rates yesterday, share prices still closed lower. Chart II-7Ominous Signals From The Indian Broader Equity Market In terms of our relative strategy, we continue to recommend that dedicated EM equity investors keep underweighting Indian stocks for now, but our conviction level is lower than it was in May. The basis is that ongoing fiscal and monetary easing, coupled with very low U.S. bonds yields and oil prices, might help Indian equities to outpace their EM peers at some point. For now, we will wait for a better entry point to upgrade. Our strongest conviction is that Indian stocks will underperform the global equity index in common currency terms (please see Chart II-1 on page 11). As for the currency, lingering problems in the NBFC sector will force the RBI to keep liquidity in the banking system abundant. Excessive liquidity expansion amid the ongoing selloff in EM currencies will hurt the rupee. Fixed-income investors should play a yield curve steepening trade as lower short rates and rupee deprecation could generate a yield curve steepening. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes 1      Average of CAD, AUD, NZD, BRL, CLP & ZAR total return (including carry) indices relative to average of JPY & CHF total returns. 2      The drop occurred well before the latest negative profit report. 3      These indexes are based on U.S. S&P 500 industry groups and published by Goldman Sachs. The Bloomberg tickers for S&P 500's global cyclicals and global defensives indexes are GSSBGCYC and GSSBGDEF, respectively. 4      Instead of the 7.5% ratio it reported last week. 5      We analyzed the six largest private banks: HDFC Bank, ICICI Bank, Axis Bank, Yes Bank, IDFC First Bank and Kotak Mahindra Bank 6      Six of which are listed in the MSCI India equity index and account for 12% of MSCI total market cap. Equity Recommendations Fixed-Income, Credit And Currency Recommendations  

Just as it appeared the slowdown in global industrial activity had run its course, commodity markets face another test of demand resiliency brought on by exogenous political shocks (Chart Of The Week). As luck would have it, these shocks – arriving in the form of an unexpected escalation of Sino-U.S. trade tensions – came on the heels of reports of further weakness in global manufacturing activity, a less-dovish-than-expected Fed, and a breach of the 7.0 level of the RMB/USD cross. The fallout – a global risk-off event – raises the spectre of a deeper trade war damaging EM GDP growth, which would weaken commodity demand. We continue to expect global fiscal and monetary stimulus to revive commodity demand, albeit further out the curve – i.e., later this year, as opposed to earlier in 2H19. Given the trade-war escalation, we are recommending a tactical long position in spot silver to hedge portfolio risk. The metal has been tracking gold’s ups and downs post-GFC – more so than industrial demand for silver – indicating it may have some catching up to do. This will make us strategically long gold, and tactically long silver at tonight’s close. Chart Of The WeekRenewed Trade Tensions Threaten Industrial Commodities' Recovery   Highlights Energy: Overweight. U.S. President Trump informed Congress earlier this week he was imposing a total economic embargo on Venezuela, which freezes assets of the Maduro government and all business dealings with its representatives except for humanitarian aid. Venezuela’s oil production averaged ~ 750k b/d in 2Q19, and was supported by the assistance of Russian technicians, U.S.-based Chevron Corp., and four service companies that were granted 90-day waivers by the U.S. to continue to do business in the country.1 Our long Sept19 Brent vs. short Sept20 Brent position expired with a gain of 101.7%. We remain long 4Q19 Brent vs. short 4Q20 Brent. Base Metals: Neutral. Industrial metals, iron ore and steel came under renewed selling pressure this week, in the wake of heightened trade tensions between the U.S. and China. Precious Metals: Neutral. Safe-haven demand rallied gold 3% over the week ended Tuesday, following the escalation in Sino-U.S. trade tensions. We continue to favor gold as a strategic portfolio hedge, particularly if central banks are compelled to accelerate monetary accommodation as global trade tensions rise, and are adding a tactical long silver position to our recommendations. Ags/Softs: Underweight. China’s Commerce Ministry reported U.S. ag products no longer are being purchased by Chinese companies earlier this week.2 U.S. President Trump’s decision to impose tariffs on Chinese imports to the U.S. were occasioned by his claim China was not living up to an agreement to increase agricultural purchases. This broke the truce in the Sino-U.S. trade war that accompanied the resumption in negotiations last month. Feature A recovery in industrial-commodity demand – particularly for oil and base metals – could be stretched out longer than we expected just a week ago. It’s still too early to tell whether the escalation in Sino-U.S. trade tensions will throw a spanner into the revival of commodity demand we’ve been expecting, but it does give us pause. Prior to the political shocks and other disappointments hitting markets this past week, our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. EM GDP growth drives commodity demand growth globally, which is why it is so important in our analysis. Our Chart of the Week illustrates this point, showing three relationships we've developed that allow us to track the evolution of EM GDP growth in something close to real time: BCA’s Global Industrial Activity (GIA) index, which is highly sensitive to economic activity in EM generally and China in particular;3  BCA’s Global Commodity Factor (GCF), which condenses the information contained in 28 commodity price series to a common factor using principal components analysis; and BCA’s EM Import Volume model, which generates an expectation of EM import volumes using mainly FX values for countries highly exposed to global trade. To be precise, we find the output of these three models shown in the Chart of the Week and EM GDP growth are deeply entwined.4 As can be seen in the chart, these models appeared to have bottomed and were preparing to hook up. This is supported by current global activity indicators (CAIs), particularly for China and EM, which still is showing positive y/y growth, even if its rate is slowing. (Chart 2), and the recent upturn in EM Financial Conditions we track here at BCA Research (Chart 3).  Chart 2Global CAIs Support EM Growth Expectation Chart 3EM Financial Conditions Move To Easier Setting However, the escalation of Sino-U.S. trade tensions, coming off a somewhat disappointing Fed rate cut of 25bps and weak manufacturing data, was enough to erase 6% and 3% from the GSCI and Bloomberg commodity indices over the week ended Tuesday (Chart 4), and to lift volatility in industrial commodities’ prices sharply (Chart 5).5    Chart 4Policy Shock, Disappointing Rate Cut Hammer Commodity Indices Chart 5Crude Oil, Copper Vol Jump On Policy Shock   A Fraught Situation The Sino-U.S. trade standoff is fraught with risk for both sides. A full-blown trade war could devolve into domestic recessions (there is a non-trivial risk to the global economy, as well). In addition, a kinetic military confrontation between China and its allies and the U.S. and its allies cannot be ruled out, as tensions rise. The case for resolving the trade dispute is strong. Our colleague Peter Berezin notes that while an escalation in the Sino-U.S. trade war “would tip the scales towards recession, the risk of such an outcome remains low.”6 An all-out trade war could push the U.S. economy into a recession next year, just as President Trump faced re-election, which strongly suggests a goodwill gesture or two from the U.S. – e.g., the Commerce Department renewing the licenses allowing U.S. firms to deal with Huawei – could go a long way to getting trade talks back on track.  Our commodity demand gauges were indicating the slowdown in demand had – or was close to – run its course, and that EM demand, in particular, was set to revive. That said, we cannot gainsay the conclusions of our colleague Matt Gertken, who runs our Geopolitical Strategy: “The U.S.-China trade negotiations are falling apart at the moment. … (B)ut with the latest round of tariffs we think it is more likely that we will get a major escalation of strategic tensions and even saber-rattling,” as U.S. and Chinese positions harden, particularly around North Korea, Hong Kong and Taiwan.7 Clearly, the outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated. Moving To A Safe Haven: Silver While we continue to expect global fiscal and monetary stimulus will revive commodity demand, the shocks and disappointments visited upon markets could incline firms, households and investors globally to scale back on risky investments and purchases until the dust settles.8  Over the near term – i.e., 3 months or so – seeking refuge in a safe haven is sensible. In particular, we believe silver offers near-term cover, and expect it will continue to follow the evolution of gold prices.9  We expect central banks generally – the Fed in particular – will err on the side of maintaining monetary accommodation while uncertainty over trade and global growth prospects remains elevated. Fed Chairman Jay Powell's description of the central bank's July rate cut of 25 bps as a mid-cycle adjustment – and not the beginning of a lengthy cutting cycle – was perceived as a hawkish surprise, but markets appear to be pricing in additional cuts this year, which will support precious metals until further guidance from the Fed arrives. An escalation of the trade war likely would increase the probability the Fed cuts rates further at its next meeting, which would push down recession fears. The outcome of this latest round of the Sino-U.S. dispute is uncertain, and the risks are elevated.   On the supply side, silver typically is mined as a secondary metal, and usually is found with gold, copper and lead deposits, according to the Silver Institute.10 On the demand side, investment and electronics account for much of the usage. Prior to the Global Financial Crisis (GFC), silver traded like a base metal, owing to the high growth rates in EM economies undergoing rapid industrialization, which led to higher consumption. This resulted in a large supply-deficit in most industrial commodities, including silver (Chart 6). Following the GFC, the evolution of silver’s price more closely tracked gold prices, following the massive injections of money and credit by central banks globally. (Chart 7).11  Chart 6Silver Is Less Industrial, More Precious Now Chart 7Post-GFC, Silver and Gold Are More Closely Aligned We expect this to continue, given our view central banks are likely to either increase or accelerate monetary accommodation to offset Sino-U.S. trade tensions, should they worsen. The U.S. dollar outlook remains important for precious metals. The dollar is a counter-cyclical currency. Thus, the escalation in trade tensions risks delaying the rebound we expect in emerging markets. This could support the USD for longer than we expected. Bottom Line: We expect commodity demand to revive on the back of global fiscal and monetary stimulus. However, exogenous political shocks along the way toward that revival likely will force households, firms and investors to re-think spending and investment decisions. This could potentially lead to reduced aggregate demand, in the event uncertainty around manufacturing, which still accounts for significant employment and output in EM economies, and global trade becomes too high. Until this is sorted, taking refuge in a safe haven is prudent. To hedge against this, we are recommending spot silver as a tactical portfolio hedge. We already are long gold as a strategic portfolio hedge, and this position is up 20% this year.   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   1      Please see U.S. sanctions waiver for Chevron signals Venezuela solution near: opposition ambassador, published by S&P Global Platts July 30, 2019. 2      Please see U.S. farmers suffer 'body blow' as China slams door on farm purchases published by reuters.com August 5, 2019. 3      Please see Expanded Sino – U.S. Trade War Could Be Bullish For Base Metals, published by BCA Research’s Commodity & Energy Strategy May 9, 2019, for a discussion of the GIA index. The index is a weighted average of selected trade, currency, manufacturing PMIs, and Chinese industrial sector variables. The article is available at ces.bcaresearch.com. 4      This is to say there is strong two-way Granger causality between EM GDP and the output of the models shown above in the Chart of the Week. Knowing the output of one of the models allows one to forecast EM GDP growth, and vice versa. We will be doing further research into using these models to estimate the change in EM GDP at a higher frequency than the stand-alone EM GDP data are reported – e.g., the World Bank’s most recent actual EM GDP data in constant 2010 USD is reported up to 1Q18, while the models shown in the chart can be updated daily (GCF and the EM Import Volume models); and monthly, as the components of the GIA index become available. 5      For a discussion of global fixed-income markets’ response to the escalation of the Sino-U.S. trade war and the outlook for more aggressive monetary policy accommodation globally, please see Trade War Worries: Once More, With Feeling, published by BCA Research’s Global Fixed Income Strategy August 6, 2019. It is available at gfis.bcaresearch.com. 6      Please see A One-Two Punch, published by BCA Research’s Global Investment Strategy August 2, 2019. It is available at gis.bcaresearch.com. 7      Please see Tariffs ... And The Last Prime Minister Of The United Kingdom?, published by BCA Research’s Geopolitical Strategy, August 2, 2019. It is available at gps.bcaresearch.com.  Almost on cue, China warned the U.S. it would view its deployment of intermediate-range missiles in Asia following Russia’s revival of its intermediate-range missile development as “offensive in nature.” Please see China warns US against deploying missiles on its ‘doorstep’, published by the Financial Times August 6, 2019.  8      Our global macro expectation can be found in Oil Markets Await Lift From Global Stimulus, published by BCA Research’s Commodity & Energy Strategy August 1, 2019. It is available at ces.bcaresearch.com. 9      Please see "The Gold Trifecta," published June 27, 2019, by BCA Research's Commodity & Energy Strategy, for our most recent analysis of the gold market and of our long-held bullish gold view. It is available at ces.bcaresearch.com. 10     The Institute’s supply-demand annual supply-demand balances showed a 29.2mm-ounce deficit in 2018. 11     When we model silver returns as a function of gold and base metals’ returns, silver’s elasticity to gold prices more than doubles – from 0.68 over the 1999 - 2010 period, to 1.67 post-GFC (2010 to now). The elasticity to changes in base-metals prices was roughly cut in half over this period, to 0.28 post-GFC.   Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q2 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades

Dear Client, In case you missed it in real time, please listen to a replay of this quarter’s webcast ‘The Investment World in 5 Charts and 18 Minutes’ available at eis.bcaresearch.com. Also please note that we will be taking a summer break, so our next report will come out on August 22. Dhaval Joshi Highlights The aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from a down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector and regional losers and winners. Economically-sensitive ‘value’ sectors will be the losers, specifically Industrials and Semiconductors. Defensive ‘growth’ sectors will be the relative winners, specifically Healthcare. Continue to overweight European equities versus Chinese equities. Feature Chart of the WeekThe Global Bond Yield Is Within A Whisker Of An All-Time Low This week the global long bond yield came within a whisker of the all-time low reached after the shock vote for Brexit in June 2016 (Chart of the Week). By definition, this means that the aggregate bond market has gone nowhere for several years. Since the autumn of 2017, the aggregate equity market has also gone nowhere, with no rally or sell-off lasting more than three months (Chart I-2).1 Chart I-2Since October 2017, No Rally Or Sell-Off Has Lasted More Than Three Months The correct strategy then has been to sell the equity market’s three month rallies and buy the three month sell-offs. In June we predicted that equities would end the year at broadly the same level as then, but that they would experience a dip of at least 4-5 percent along the way. We are now experiencing the dip. The correct strategy has been to sell the three month rallies and buy the three month sell-offs. But isn’t the global bond yield approaching an all-time low a good thing for the economy and equity market? The answer is yes, and no. Yes, the ultra-low level of yields is a boon for the valuation of risk-assets. However, when it comes to credit-sourced economic growth, what matters is not the level of the bond yield, nor its direction, so much as its rate of change.      If Bond Yields Decline At A Reduced Pace, Growth Slows Many people struggle to understand this subtle and counterintuitive point. If the bond yield declines, but at a reduced pace, it can slow credit-sourced growth. To understand why, imagine that in a certain period, a -0.5 percent decline in the bond yield added €50 billion to credit creation. This would constitute additional economic demand. If, in the following period, a further -0.5 percent yield decline added another €50 billion of credit-sourced demand, it would constitute the same amount of additional demand – which is to say, the same growth – as in the first period. By comparison, a -0.25 percent yield decline which added €25 billion to demand would result in the growth rate halving. The subtle and counterintuitive point is that the bond yield has continued to decline, yet it has caused credit-sourced growth to slow! Chart I-3In China, The Bond Yield's Peak Rate Of Decline Happened 6 Months Ago This counterintuitive dynamic has unfolded in the global economy this year. Although bond yields have been heading lower, the peak rate of decline – notably in China – happened six months ago. Meaning that credit-sourced growth has almost certainly slowed (Chart I-3). Amplifying this down-oscillation in growth, geopolitical storm clouds are now regathering over the global economy. In the early part of this year, trade tensions and currency wars between the major economic blocs seemed to dissipate, the Middle East was quiet, and the Brexit deadline was postponed. But the lull was temporary. The geopolitical headwinds to growth are now strengthening with a vengeance. That’s the bad news.  Equity Valuations Are Hyper-Sensitive To Low Bond Yields Now the good news. While the level of bond yields does not drive economic growth, it does drive the valuations of equities and other risk-assets. Moreover, it does so in a powerful non-linear way. Below a threshold level, ultra-low bond yields can give the valuation of equities an exponential boost. Geopolitical storm clouds are now regathering over the global economy. We refer readers to our other reports for the details, but in a nutshell at ultra-low bond yields the risk of owning bonds converges to the risk of owning equities. The upshot of this risk convergence is that investors price equities to deliver the same feeble nominal return as bonds, meaning that the valuation of equities soars (Chart I-4).2 Chart I-4The Valuation Of Equities Is Back To The Peak Level Of 2000 And 2007 Theoretically and empirically, this threshold level of the bond yield is in the region of 2 percent. And the bond yield that matters is the global long bond yield, defined as the simple average of the 10-year yields of the U.S., the euro area, and China. To simplify matters, we can proxy the 10-year yield of the aggregate euro area with the 10-year yield of France. So calculate the simple average of the 10-year yields of the U.S., France, and China. A value rising towards 2.5 percent equates to danger for equity valuations. A value falling below 2.0 percent equates to an underpinning for equity valuations. Today, the value stands near 1.5 percent creating a good support for equity and risk-asset valuations. The upshot is that the aggregate equity market will go nowhere for the remainder of this year – as the sell-offs from the down-oscillation in growth fight the rallies from the valuation boost given by ultra-low bond yields. But there will be sector losers and winners. Essentially, economically-sensitive ‘value’ sectors will be the losers while defensive ‘growth’ sectors will be the relative winners. Put simply, the sector trends present during the last up-oscillation in global growth are likely to unwind if they have not already done so. In which case, the sectors most likely to suffer underperformance are:   Industrials and Semiconductors (Chart I-5). Chart I-5Industrials Outperformed Strongly... But Are Now Underperforming And the sector most likely to see (continued) outperformance is: Healthcare. There will also be regional losers and winners. This is because regional equity market relative performance just follows from sector relative performance combined with each region’s sector ‘fingerprint’. Bear in mind that a fingerprint can be defined not just by overweight sectors but also by underweight sectors, such as the Shanghai Composite’s negligible weighting in Healthcare, making the Chinese index ultra-cyclical. Continue to overweight European equities versus Chinese equities (Chart I-6).  Chart I-6Overweight Europe Versus China Market Dislocations And Recessions: Cause And Effect As investment strategists, our primary focus should be the financial markets rather than the economy. On this basis, we define a major dislocation in terms of the markets: an episode in which equities underperform bonds by more than 20 percent over a period of more than six months. There have been three such episodes in the twenty-first century.3 Yet our market based definition of a major dislocation also perfectly captures the three last times that the European economy went into recession or near-recession. Does this mean that the recessions caused the financial market dislocations? No. Quite the reverse. The twenty-first century’s recessions have all resulted from financial market dislocations. The twenty-first century’s recessions have all resulted from the financial market dislocations that followed market distortion or mispricing: the bubble valuations of the technology, media and telecom sectors in 2000 (Chart I-7); the mispricing of U.S. mortgages and credit in 2007 (Chart I-8); and the mispricing of euro area sovereign credit risk in 2011 (Chart I-9). Therefore, the major dislocations in the financial markets have always preceded the recessions and near-recessions, sometimes by several quarters, even when both are measured in real time. Chart I-7The Twenty First Century Recessions Stemmed From Financial Market Distortions: The Dot Com Bubble In 1999/2000... Chart I-8...The Mispricing Of U.S.##br## Mortgages And Credit In##br## 2007/2008...   Chart I-9...And The Mispricing Of Euro Area Sovereign Credit Risk In 2010/2011 Today, the consensus overwhelmingly believes that a recession will cause the next major dislocation in financial markets. But history has taught us time and time again that the causality is much more likely to run the other way. Hence, a major dislocation in the financial markets – should one occur – will cause the next recession. And not the other way round! Fractal Trading System* The nickel price has surged on continued fears over Indonesian exports bans. But from a technical perspective the recent surge is excessive and susceptible to a reversal on any easing of the fears. Accordingly, this week’s trade is short nickel versus copper, setting a profit target of 10 percent with a symmetrical stop-loss. In other trades, short ASX200 versus FTSE100 hit its 2 percent stop-loss, but short MSCI All-Country World has moved well into profit. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-10Short Nickel, Long Copper The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Dhaval Joshi,  Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 We define the global long bond yield as the simple average of the 10-year yields in the U.S., euro area, and China. And to make things simple, France provides a good proxy for the euro area long bond yield. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25, 2018 available at eis.bcaresearch.com. 3 Based on the relative performance of the MSCI All Country World Index versus the JP Morgan Global Government Bond Index, both in local currency terms. Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Highlights Chinese economic growth slowed in June & July, but at a more moderate pace than had been the case earlier this year. The housing market is a notable exception, which appeared in June to slow in a broad-based fashion. The near-term (0-3 month) outlook is bearish for China-related assets, and investors should bet on further weakness in the RMB. However, investors should remain cyclically bullish (i.e., over a 6-12 month time horizon) in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the intensifying drag from weak external demand. Feature Tables 1 and 2 on pages 2 and 3 highlight key developments in China’s economy and its financial markets over the past month. On the growth front, coincident measures of economic activity suggest that China’s economy experienced “controlled weakness” in June and July: growth continued to slow, but at a more moderate pace than had been the case in late-2018 and early-2019. The housing market appeared to be the exception to this relative stability; all 10 of the core housing indicators that we track decelerated in June, suggesting that a moderation in housing-related activity was broad-based. This implies that a further slowdown in construction is likely over the coming months, barring a meaningful pickup in sales. Table 1China Macro Data Summary Table 2China Financial Market Performance Summary Within financial markets, all of the key developments have occurred over the past several trading days, in response to President Trump’s threat last week to further hike U.S. import tariffs at the beginning of September. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark, as have Hong Kong stocks in response to intensifying protests in the city. A sharp decline in the RMB and the U.S. designation of China as a currency manipulator have unnerved Chinese and global investors, and our bias is to expect even further weakness in the yuan. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. The near-term outlook remains bearish for China-related assets, as we see the selloff over the past week as the beginning of a financial market riot point that will force policymakers, both in China and the U.S., to address the economic weakness that a full-tariff scenario will entail. Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Otherwise stated, we expect Chinese relative performance to trend lower in the near-term, but to be higher 12-months from today. Investors should also continue to hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks with a long USD-CNH position. In reference to Tables 1 and 2, we provide below several detailed observations concerning developments in China’s macro and financial market data: Our leading indicator for the Li Keqiang Index is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth. Chart 1Our Leading Indicator Is Now In A (Moderate-Strength) Uptrend Chart 2Money, And Still-Modest Credit Growth, Are Holding Back Our Leading Indicator The Li Keqiang index (LKI) rose moderately in June after a significant decline in May, but remains in a downtrend (Chart 1). The June increase was driven entirely by a pickup in electricity production (which had nearly contracted in May); bank loan growth and rail cargo volume both decelerated. The takeaway for investors is that while the Chinese economy did not slow meaningfully further in June, the pace of growth remained tepid, suggesting the economic activity remains vulnerable to a further increase in U.S. import tariffs. Our leading indicator for the LKI is now in a clear uptrend, most recently led by a meaningful improvement in monetary conditions and credit growth (Chart 2). However, the magnitude of the rise in the indicator is being held back by growth in the money supply, which has only slightly accelerated over the past few months, as well as a “half strength” recovery in credit. Our view is that Chinese policymakers are likely to wait for further economic weakness before allowing money & credit growth to significantly overshoot, which increases the odds of a continued market riot in the short-term. Chart 3Decelerating House Price Appreciation Is Coming All 10 of the housing indicators shown in Table 1 decelerated in June, suggesting that a moderation in housing-related activity was broad-based. Our BCA 70-city diffusion index for (YoY) house prices has an excellent track record at leading inflection points in overall price growth (Chart 3), and is currently suggesting that house price appreciation is at risk of falling back to mid-2018 levels (which would imply a 5-6 percentage point deceleration). Continued weakness in floor space sold continues to suggest that the ongoing pace of housing construction is unsustainable; we expect a further moderation in floor space started over the coming several months barring a meaningful pickup in sales. Both the Caixin and official manufacturing PMI for China rose in July, including the official new export orders component (which we have been closely following). However, the survey was taken prior to President Trump’s renewed tariff threat last week, and we expect the July gains to reverse in August barring a major de-escalation in the conflict. Both investable and domestically-listed Chinese stocks have significantly underperformed the global benchmark over the past week due to President Trump’s threat to impose tariffs on all remaining imports from China. We noted in our May 29 weekly report that a financial market riot point remained likely over the coming few months,1 and we explicitly recommend an underweight position in Chinese stocks for the remainder of 2019 in last week’s report.2 Still, investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Investors who are already positioned in favor of Chinese stocks should stay long, despite the likelihood of further near-term losses. ​​​​​​​Investors should remain cyclically bullish in anticipation of an eventual reflationary response from Chinese policymakers that will boost domestic demand enough to offset the drag from weak external demand. Chart 4Intensifying Protests Have Weighed On Hong Kong's Relative Equity Performance The MSCI Hong Kong index has also significantly underperformed the global benchmark since late-July, in response to intensifying protests in the city (Chart 4). The protests have been driven by underlying socio-economic factors as well as Beijing’s encroachment on traditional political liberties. However, Hong Kong has no real alternative to Beijing’s sovereignty, and the unrest should gradually die down as long as the imposition of martial law is avoided. Nonetheless, Hong Kong’s stock market is likely to remain under pressure in the interim; for now, we recommend that investors stay underweight versus China and Taiwan.​​​​​​​ The sector performance within China’s investable and domestically-listed equity markets over the past month has largely been along cyclical / defensive lines. In the investable market, consumer staples, health care, financials, information technology, communication services, and utilities have all outperformed, in contrast to energy, materials, industrials, consumer discretionary, and real estate stocks. The pattern has been similar in the domestic market, with two exceptions: modest staples underperformance, and material underperformance of comm services. Real estate stocks have been among the worst performers in both markets over the past month, possibly in response to the deteriorating housing market data that we highlighted above. China’s 3-month repo rate has fallen approximately 20 bps over the past month, and is now back close to its one-year low. We continue to believe that a cut to the benchmark lending rate is unlikely in the near-term, but could occur in Q4 if economic conditions in China weaken materially further.​​​​​​​ Chinese onshore corporate spreads increased modestly over the past month, but have not yet risen to a new high for the year. The uptrend in spreads that began in late-May does reflect renewed risks to the Chinese economy from a further increase in U.S. import tariffs, but annualizing the most recent pace of onshore corporate defaults suggests that onshore bond spreads are still much too high. Our long China onshore corporate bond trade continues to register gains in local currency terms (Chart 5), and we recommend that investors stick with a long/overweight currency-hedged stance. ​​​​​​​Our bias is to bet on further RMB weakness until policymakers aggressively ramp up their reflationary efforts. The yuan weakened sharply this week, with the U.S. dollar breaking above 7 versus both the onshore and offshore RMB (Chart 6). This is the weakest level for the currency since the global financial crisis, and the decline has clearly occurred in response to last week’s tariff threat. We noted in our May 15 report that a meaningful decline in the exchange rate would likely be required in order to stabilize the outlook for earnings & the economy,3 and we recommended at that time that investors should hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. It is difficult to forecast how much further the RMB is likely to fall, but our bias is to bet on further weakness until policymakers aggressively ramp up their reflationary efforts. Stay tuned. Chart 5Despite Ongoing Default Concerns, Onshore Corporate Bonds Are Winners Chart 6Weakest RMB In A Decade, And Further Declines Are Likely   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com   Jing Sima China Strategist jings@bcaresearch.com 1      Please see China Investment Strategy Weekly Report, “Waiting For The Pain,” dated May 29, 2019. 2      Please see China Investment Strategy Weekly Report, “Threading A Stimulus Needle (Part 2): Will Proactive Fiscal Policy Lose Steam?” dated July 24, 2019. 3      Please see China Investment Strategy Weekly Report, “Simple Arithmetic,” dated May 15, 2019.   Cyclical Investment Stance Equity Sector Recommendations

Highlights U.S.-China: The escalation of the trade war has renewed investor fears that uncertainty could create an even deeper drag on global growth, requiring a more aggressive easing of global monetary policy. Fed: The Fed had an opportunity last week to regain control of monetary policy from the markets, but opted for only a cautious rate cut that came off as too hawkish. The FOMC will be forced to play defense in the next 3-6 months, likely by cutting rates more than originally envisioned given the market turbulence stemming from the trade war escalation. Fixed Income Asset Allocation: Raise overall global portfolio duration to neutral on a tactical (0-3 months) basis, at least until equity markets stabilize. Maintain strategic (6-12 months) overweights to global corporate bonds, however, as global leading economic indicators are bottoming. Feature A Painful Repricing Chart of the WeekNot A Pretty Picture A long-overdue correction in risk assets, or the start of something more sinister? That is the question investors must now consider. Another Twitter blast from @realDonaldTrump has triggered chaos in global financial markets, with the imposition of fresh U.S. tariffs on Chinese imports. This shattered the market calm since the June G20 meeting, when an announced truce on the U.S.-China trade dispute led to optimism that a real deal could be reached. China retaliated to the new tariffs by allowing the USD/CNY exchange rate to depreciate beyond the perceived line in the sand at 7.0. The trade news came at a bad time for financial markets, a few days after the release of soft global manufacturing PMI data for July that highlighted how global growth remains highly vulnerable to trade war developments (Chart of the Week). The Fed did not help matters by delivering an interest rate cut last week but somehow coming across as hawkish (or, at least, not dovish enough). The market response to the renewed trade tensions and yuan weakness has been classic “macro risk-off” – sharply lower government bond yields, alongside big declines in global equity markets and commodity prices (Chart 2) and increases in the value of typical safe-havens like gold and the Japanese yen (Chart 3). Chart 2Growth-Sensitive Assets Not Doing Well Chart 3Safe Havens In Demand The nature of the fall in global bond yields has been consistent with what has been seen so far in 2019 – fairly coordinated moves in terms of size, with much smaller changes seen in cross-country yield spreads. This suggests that the unobservable “global” bond yield is falling in response to deteriorating global growth expectations, rather than country-specific factors driving local bond yields. Global trade uncertainty – and what that implies for future weakness in corporate profits, investment and employment – is indeed an “external shock” for every nation. We admit that our current duration recommendations have not been aligned to benefit from these moves. Our forecasting philosophy for government bond yields is based on what our colleagues at our sister service, BCA U.S. Bond Strategy, have dubbed “The Golden Rule of Bond Investing”.1 In that framework, the primary driver of government bond market returns (excess returns over cash, to be precise) is the outcome of central bank policy moves versus what is discounted in interest rate markets. In the U.S., we have been steadfast in our expectation that the Fed would disappoint market pricing that was calling for as much as 90bps of rate cuts over the next 12 months. Global trade uncertainty – and what that implies for future weakness in corporate profits, investment and employment – is indeed an “external shock” for every nation. Chart 4Rate Cuts Required - And Discounted - Everywhere Now, with the President giving markets the unpleasant news that a trade deal with China is not imminent, and new tariffs about to be imposed, the pressure is on the Fed to provide an offset through easier monetary policy. Some are even interpreting the timing of Trump’s latest Tariff Tweet in a Machiavellian fashion, as if he wanted to create more uncertainty to get to Fed to cut rates (and, by association, help deliver Trump’s goal of weakening the U.S. dollar). On the surface, Trump ratcheting up the trade tensions sounds like a risky economic game to play leading up to the 2020 Presidential election. Our colleagues at BCA Geopolitical Strategy, however, note that many of the leading Democratic presidential nominee contenders have themselves been pushing for a more hawkish stance on China. Trump may now feel politically emboldened to become even harder on China himself, to avoid being outflanked by the Democrats – even if it means the U.S. stock market suffers a nasty selloff as a result. Although, again, if the Fed cuts rates as a result, Trump will likely view that as a victory given his constant haranguing of Fed Chair Jay Powell over the past year. With Powell tipping his hand last week that trade uncertainty was something that could trigger additional Fed interest rate cuts, and with Trump now highly incentivized to create that uncertainty, the case for betting against the rate cuts discounted in U.S. interest rate markets has weakened – even though it is still debatable whether the U.S. economy has softened enough to justify a full-blown easing cycle. With Powell tipping his hand last week that trade uncertainty was something that could trigger additional Fed interest rate cuts, and with Trump now highly incentivized to create that uncertainty, the case for betting against the rate cuts discounted in U.S. interest rate markets has weakened Our Central Bank Monitors are now signaling a need for some easing of monetary policy in all the major developed economies, including the U.S. (Chart 4). Even though our 12-month Discounters also show that a lot of easing is already priced into Overnight Index Swap (OIS) curves in those same countries, the amount of cuts discounted is consistent with the dovish message from our Central Bank Monitors. Given the renewed trade tensions, alongside no signs of much improvement in overall global growth momentum, we are less certain at the moment that the amount of cuts discounted by markets will not be delivered. Thus, under our Golden Rule framework, a below-benchmark overall global duration stance is not warranted at this time. Therefore, this week, we are increasing our overall duration stance to neutral from below-benchmark, on a tactical basis. In our model bond portfolio on Page 10, we are implementing this view by “neutralizing” the duration exposures within each country. This is done by keeping the same total country weightings versus the benchmark index, but allocating across all maturities in line with the index weightings within each country. This adds about one-half of year of duration to the model portfolio to bring it up the same level as the benchmark index, but without altering the overall allocations to countries or spread product sectors. What To Do Beyond The Short-Term? Chart 5A Lot Of Bad News Discounted In Bond Yields Despite the near-term concerns and volatility stemming from the increased trade tensions, we do not advocate moving to a more defensive portfolio allocation (above-benchmark duration, underweight corporate bonds) to position for a deeper global growth slowdown, for the following reasons: A lot of bad news is already discounted in global bond yields. The rally in government bond markets this year has pushed bond yields down to stretched levels using typical valuation metrics (Chart 5) like the 5-year OIS rate, 5-years forward; the term premium on 10-year yields, and market-implied inflation expectations from CPI swaps or inflation-linked bonds. Additional sustainable declines will be harder to achieve from current levels. The U.S. economy is still holding up relatively well, especially compared to other major economies. Although the U.S. manufacturing sector data has slowed, U.S. Treasury yields already are in line with the diminished readings of the ISM Manufacturing index, which is still above the 50 level signifying expanding activity (Chart 6). The non-manufacturing (services) side of the economy has not seen the same degree of slowing, while consumer confidence and retail sales have both picked up of late. Also, the mean-reverting U.S. data surprise index – which is correlated to the momentum of bond yields – is very stretched to the downside, suggesting less downside potential for Treasury yields from weak U.S. data (Chart 7). Chart 6UST Yields Consistent With Slower Manufacturing In addition, the easing of U.S. financial conditions from the 2019 rally in U.S. equity and credit markets before the past few days does suggest a rebound in U.S. growth is likely beyond the next few months. It will take much bigger market declines than seen so far, something beyond a mere “garden-variety” correction in U.S. equities, to tighten financial conditions enough to offset the prior loosening. Chart 7Treasuries Are Vulnerable To Better Data Early leading indicators are flashing a future bottoming of global growth. Several of the more reliable leading economic signals, like our global LEI diffusion index and the China credit impulse, are both flashing the potential for a rebound in global growth to begin around the end of the year (Chart 8). If Chinese policymakers choose to offset the negative domestic economic impact of the new Trump tariffs with even more stimulus measures, as seems likely, then the odds of an eventual growth rebound would improve – especially if there is also a healthy dose of monetary easing from the Fed, ECB (both rate cuts and renewed asset purchases) and other major central banks. Early leading indicators are flashing a future bottoming of global growth. Summing it all up, we see the best way to protect against the risks of an even deeper near-term selloff in risk assets is to increase duration by buying liquid government bonds, rather than reduce credit exposure by selling less liquid corporate bonds. It would take signs that the improvement in leading economic indicators is reversing to justify downgrading global corporate bond exposure. We think it more likely that we’ll be reducing our recommended duration exposure back to below-benchmark sometime in the next few months. We will be watching news on global trade, China stimulus and U.S. non-manufacturing growth before making the next change to our duration call. We see the best way to protect against the risks of an even deeper near-term selloff in risk assets is to increase duration by buying liquid government bonds, rather than reduce credit exposure by selling less liquid corporate bonds. With regards to country allocation within developed market government bonds, we are choosing to stick with our current recommendations: overweight core Europe, the U.K., Japan, Australia and Spain; underweight the U.S. and Italy; and neutral Canada (Chart 9). Those allocations have served us reasonably throughout 2019, with the bulk of the overweights outperforming the Bloomberg Barclays Global Treasury index in hedged USD terms, and the U.S. actually only just matching the global hedged benchmark (thanks to the yield pickup for non-U.S. debt from hedging currency exposure back to higher-yielding U.S. dollars). Chart 8A Light At The End Of The Tunnel? Chart 9We're Sticking With Our Country Allocations Only in the case of Italy, were we have maintained an underweight stance given our concerns about weak Italian growth and the implications for debt sustainability, have we seen a significant underperformance of our recommendation. At current yield/spread levels, however, we remain reluctant to simply chase higher-yielding Italian bond yields in the absence of any sign of improving Italian growth that would justify lower Italian risk premia. Bottom Line: The escalation of the trade war has renewed investor fears that trade could create an even deeper drag on global growth, requiring a more aggressive easing of global monetary policy. Raise overall global portfolio duration to neutral on a tactical (0-3 months) basis, at least until equity markets stabilize. Maintain strategic (6-12 months) overweights to global corporate bonds, however, as global leading economic indicators are bottoming.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Footnotes 1 Please see BCA U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.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