Emerging Markets

Special Report

Highlights We update our long-range forecasts of returns from a range of asset classes – equities, bonds, alternatives, and currencies – and make some refinements to the methodologies we used in our last report in November 2017. We add coverage of U.K., Australian, and Canadian assets, and include Emerging Markets debt, gold, and global Real Estate in our analysis for the first time. Generally, our forecasts are slightly higher than 18 months ago: we expect an annual return in nominal terms over the next 10-year years of 1.7% from global bonds, and 5.9% from global equities – up from 1.5% and 4.6% respectively in the last edition. Cheaper valuations in a number of equity markets, especially Japan, the euro zone, and Emerging Markets explain the higher return assumptions. Nonetheless, a balanced global portfolio is likely to return only 4.7% a year in the long run, compared to 6.3% over the past 20 years. That is lower than many investors are banking on. Feature Since we published our first attempt at projecting long-term returns for a range of asset classes in November 2017, clients have shown enormous interest in this work. They have also made numerous suggestions on how we could improve our methodologies and asked us to include additional asset classes. This Special Report updates the data, refines some of our assumptions, and adds coverage of U.K., Australian, and Canadian assets, as well as gold, global Real Estate, and global REITs. Our basic philosophy has not changed. Many of the methodologies are carried over from the November 2017 edition, and clients interested in more detailed explanations should also refer to that report.1 Our forecast time horizon is 10-15 years. We deliberately keep this vague, and avoid trying to forecast over a 3-7 year time horizon, as is common in many capital market assumptions reports. The reason is that we want to avoid predicting the timing and gravity of the next recession, but rather aim to forecast long-term trend growth irrespective of cycles. This type of analysis is, by nature, as much art as science. We start from the basis that historical returns, at least those from the past 10 or 20 years, are not very useful. Asset allocators should not use historical returns data in mean variance optimizers and other portfolio-construction models. For example, over the past 20 years global bonds have returned 5.3% a year. With many long-term government bonds currently yielding zero or less, it is mathematically almost impossible that returns will be this high over the coming decade or so. Our analysis points to a likely annual return from global bonds of only 1.7%. Our approach is based on building-blocks. There are some factors we know with a high degree of certainly: such as the return on U.S. 10-year Treasury yields over the next 10 years (to all intents and purposes, it is the current yield). Many fundamental drivers of return (credit spreads, the small-cap premium, the shape of the yield curve, profit margins, stock price multiples etc.) are either steady on average over the cycle, or mean revert. For less certain factors, such as economic growth, inflation, or equilibrium short-term interest rates, we can make sensible assumptions. Most of the analysis in this report is based on the 20-year history of these factors. We used 20 years because data is available for almost all the asset classes we cover for this length of time (there are some exceptions, for example corporate bond data for Australia and Emerging Markets go back only to 2004-5, and global REITs start only in 2008). The period from May 1999 to April 2019 is also reasonable since it covers two recessions and two expansions, and started at a point in the cycle that is arguably similar to where we are today. Some will argue that it includes the Technology bubble of 1999-2000, when stock valuations were high, and that we should use a longer period. But the lack of data for many assets classes before the 1990s (though admittedly not for equities) makes this problematic. Also, note that the historical returns data for the 20 years starting in May 1999 are quite low – 5.8% for U.S. equities, for example. This is because the starting-point was quite late in the cycle, as we probably also are now.   We make the following additions and refinements to our analysis: Add coverage of the U.K., Australia, and Canada for both fixed income and equities. Add coverage of Emerging Markets debt: U.S. dollar and local-currency sovereign bonds, and dollar-denominated corporate credit. Among alternative assets, add coverage of gold, global Direct Real Estate, and global REITs. Improve the methodology for many alt asset classes, shifting from reliance on historical returns to an approach based on building blocks – for example, current yield plus an estimation of future capital appreciation – similar to our analysis of other asset classes. In our discussion of currencies, add for easy reference of readers a table of assumed returns for all the main asset classes expressed in USD, EUR, JPY, GBP, AUD, and CAD (using our forecasts of long-run movements in these currencies). Added Sharpe ratios to our main table of assumptions. The summary of our results is shown in Table 1. The results are all average annual nominal total returns, in local currency terms (except for global indexes, which are in U.S. dollars). Table 1BCA Assumed Returns Unsurprisingly, given the long-term nature of this exercise, our return projections have in general not moved much compared to those in November 2017. Indeed, markets look rather similar today to 18 months ago: the U.S. 10-year Treasury yield was 2.4% at end-April (our data cut-off point), compared to 2.3%, and the trailing PE for U.S. stocks 21.0, compared to 21.6. If anything, the overall assumption for a balanced portfolio (of 50% equities, 30% bonds, and 20% equal-weighted alts) has risen slightly compared to the 2017 edition: to 4.7% from 4.1% for a global portfolio, and to 4.9% from 4.6% for a purely U.S. one. That is partly because we include specific forecasts for the U.K., Australia, and Canada, where returns are expected to be slightly higher than for the markets we limited our forecasts to previously, the U.S, euro zone, Japan, and Emerging Markets (EM). Equity returns are also forecast to be higher than 18 months ago, mainly because several markets now are cheaper: trailing PE for Japan has fallen to 13.1x from 17.6x, for the euro zone to 15.5x from 18.0x, and for Emerging Markets to 13.6x from 15.4x (and more sophisticated valuation measures show the same trend). The long-term picture for global growth remains poor, based on our analysis, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. We include Sharpe ratios in Table 1 for the first time. We calculate them as expected return/expected volatility to allow for comparison between different asset classes, rather than as excess return over cash/volatility as is strictly correct, and as should be used in mean variance optimizers. Chart 1Volatility Is Easier To Forecast Than Returns For volatility assumptions, we mostly use the 20-year average volatility of each asset class. As discussed above, historical returns should not be used to forecast future returns. But volatility does not trend much over the long-term (Chart 1). We looked carefully at volatility trends for all the asset classes we cover, but did not find a strong example of a trend decline or rise in any. We do, however, adjust the historic volatility of the illiquid, appraisal-based alternative assets, such as Private Equity, Real Estate, and Farmland. The reported volatility is too low, for example 2.6% in the case of U.S. Direct Real Estate. Even using statistical techniques to desmooth the return produces a volatility of only around 7%. We choose, therefore, to be conservative, and use the historic volatility on REITs (21%) and apply this to Direct Real Estate too. For Private Equity (historic volatility 5.9%), we use the volatility on U.S. listed small-cap stocks (18.6%). Looking at the forecast Sharpe ratios, the risk-adjusted return on global bonds (0.55) is somewhat higher than that of global equities (0.33). Credit continues to look better than equities: Sharpe ratio of 0.70 for U.S. investment grade debt and 0.62 for high-yield bonds. Nonetheless, our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. Over the past 20 years a global balanced portfolio (defined as above) returned 6.3% and a similar U.S. portfolio 7.0%. We expect 4.7% and 4.9% respectively in future. Investors working on the assumption of a 7-8% nominal return – as is typical among U.S. pension funds, for example – need to become realistic. Below follow detailed descriptions of how we came up with our assumptions for each asset class (fixed income, equities, and alternatives), followed by our forecasts of long-term currency movements, and a brief discussion of correlations. 1. Fixed Income We carry over from the previous edition our building-block approach to estimating returns from fixed income. One element we know with a relatively high degree of certainty is the return over the next 10 years from 10-year government bonds in developed economies: one can safely assume that it will be the same as the current 10-year yield. It is not mathematical identical, of course, since this calculation does not take into account reinvestment of coupons, or default risk, but it is a fair assumption. We can make some reasonable assumptions for returns from cash, based on likely inflation and the real equilibrium cash rate in different countries. After this, our methodology is to assume that other historic relationships (corporate bond spreads, default and recovery rates, the shape of the yield curve etc.) hold over the long run and that, therefore, the current level reverts to its historic mean. The results of our analysis, and the assumptions we use, are shown in Table 2. Full details of the methodology follow below. Table 2Fixed Income Return Calculations Projected returns have not changed significantly from the 2017 edition of this report. In the U.S., for the current 10-year Treasury bond yield we used 2.4% (the three-month average to end-April), very similar to the 2.3% on which we based our analysis in 2017. In the euro zone and Japan, yields have fallen a little since then, with the 10-year German Bund now yielding roughly 0%, compared to 0.5% in 2017, and the Japanese Government Bond -0.1% compared to zero. Overall, we expect the Bloomberg Barclays Global Index to give an annual nominal return of 1.7% over the coming 10-15 years, slightly up from the assumption of 1.5% in the previous edition. This small rise is due to the slight increase in the U.S. long-term risk-free rate, and to the inclusion for the first time of specific estimates for returns in the U.K., Australia, and Canada. Fixed Income Methodologies Cash. We forecast the long-run rate on 3-month government bills by generating assumptions for inflation and the real equilibrium cash rate. For inflation, in most countries we use the 20-year average of CPI inflation, for example 2.2% in the U.S. and 1.7% in the euro zone. This suggests that both the Fed and the ECB will slightly miss their inflation targets on the downside over the coming decade (the Fed targets 2% PCE inflation, but the PCE measure is on average about 0.5% below CPI inflation). Of course, this assumes that the current inflation environment will continue. BCA’s view is that inflation risks are significantly higher than this, driven by structural factors such as demographics, populism, and the advent of ultra-unorthodox monetary policy.2 But we see this as an alternative scenario rather than one that we should use in our return assumptions for now. Japan’s inflation has averaged 0.1% over the past 20 years, but we used 1% on the grounds that the Bank of Japan (BoJ) should eventually see some success from its quantitative easing. For the equilibrium real rate we use the New York Fed’s calculation based on the Laubach-Williams model for the U.S., euro zone, U.K., and Canada. For Japan, we use the BoJ’s estimate, and for Australia (in the absence of an official forecast of the equilibrium rate) we take the average real cash rate over the past 20 years. Finally, we assume that the cash yield will move from its current level to the equilibrium over 10 years. Government Bonds. Using the 10-year bond yield as an anchor, we calculate the return for the government bond index by assuming that the spread between 7- and 10-year bonds, and between 3-month bills and 10-year bonds will average the same over the next 10 years as over the past 20. While the shape of the yield curve swings around significantly over the cycle, there is no sign that is has trended in either direction (Chart 2). The average maturity of government bonds included in the index varies between countries: we use the five-year historic average for each, for example, 5.8 years for the U.S., and 10.2 years for Japan. Spread Product. Like government bonds, spreads and default rates are highly cyclical, but fairly stable in the long run (Chart 3). We use the 20-year average of these to derive the returns for investment-grade bonds, high-yield (HY) bonds, government-related securities (e.g. bonds issued by state-owned entities, or provincial governments), and securitized bonds (e.g. asset-backed or mortgage-backed securities). For example, for U.S. high-yield we use the average spread of 550 basis points over Treasuries, default rate of 3.8%, and recovery rate of 45%. For many countries, default and recovery rates are not available and so we, for example, use the data from the U.S. (but local spreads) to calculate the return for high-yield bonds in the euro zone and the U.K. Inflation-Linked Bonds. We use the average yield over the past 10 years (not 20, since for many countries data does not go back that far and, moreover, TIPs and their equivalents have been widely used for only a relatively short period.) We calculate the return as the average real yield plus forecast inflation. Chart 2Yield Curves Chart 3Credit Spreads & Default Rates     Bloomberg Barclays Aggregate Bond Indexes. We use the weights of each category and country (from among those we forecast) to derive the likely return from the index. The composition of each country’s index varies widely: for example, in the euro zone (27% of the global bond index), government bonds comprise 66% of the index, but in the U.S. only 37%. Only the U.S. and Canada have significant weightings in corporate bonds: 29% and 50% respectively. This can influence the overall return for each country’s index. Table 3Emerging Market Debt Emerging Market Debt. We add coverage of EMD: sovereign bonds in both local currency and U.S. dollars, and USD-denominated EM corporate debt. Again, we take the 20-year average spread over 10-year U.S. Treasuries for each category. A detailed history of default and recovery is not available, so for EM corporate debt we assume similar rates to those for U.S. HY bonds. For sovereign bonds, we make a simple assumption of 0.5% of losses per year – although in practice this is likely to be very lumpy, with few defaults for years, followed by a rush during an EM crisis. For EM local currency debt, we assume that EM currencies will depreciate on average each year in line with the difference between U.S. inflation and EM inflation (using the IMF forecast for both – please see the Currency section below for further discussion on this). After these calculations, we conclude that EM USD sovereign bonds will produce an annual return of 4.7%, and EM USD corporate bonds 4.5% – in both cases a little below the 5.6% return assumption we have for U.S. high-yield debt (Table 3).   2. Equities Our equity methodologies are largely unchanged from the previous edition. We continue to use the return forecast from six different methodologies to produce an average assumed return. Table 4 shows the results and a summary of the calculation for each methodology. The explanation for the six methodologies follows below. Table 4Equity Return Calculations The results suggest slightly higher returns than our projections in 2017. We forecast global equities to produce a nominal annual total return in USD of 5.9%, compared to 4.6% previously. The difference is partly due to the inclusion for the first time of specific forecasts for the U.K., Australia and Canada, which are projected to see 8.0%, 7.4% and 6.0% returns respectively. The projection for the U.S. is fairly similar to 2017, rising slightly to 5.6% from 5.0% (mainly due to a slightly higher assumption for productivity growth in future, which boosts the nominal GDP growth assumption). Japan, however, does come out looking significantly more attractive than previously, with an assumed return of 6.2%, compared to 3.5% previously. This is mostly due to cheaper valuations, since the growth outlook has not improved meaningfully. Japan now trades on a trailing PE of 13.1x, compared to 17.6x in 2017. This helps improve the return indicated by a number of the methodologies, including earnings yield and Shiller PE. The forecast for euro zone equities remains stable at 4.7%. EM assumptions range more widely, depending on the methodology used, than do those for DM. On valuation-based measures (Shiller PE, earnings yield etc.), EM generally shows strong return assumptions. However, on a growth-based model it looks less attractive. We continue to use two different assumptions for GDP growth in EM. Growth Model (1) is based on structural reform taking place in Emerging Markets, which would allow productivity growth to rebound from its current level of 3.2% to the 20-year average of 4.1%; Growth Model (2) assumes no reform and that productivity growth will continue to decline, converging with the DM average, 1.1%, over the next 10 years. In both cases, the return assumption is dragged down by net issuance, which we assume will continue at the 10-year average of 4.9% a year. Our composite projection for EM equity returns (in local currencies) comes out at 6.6%, a touch higher than 6.0% in 2017. Equity Methodologies Equity Risk Premium (ERP). This is the simplest methodology, based on the concept that equities in the long run outperform the long-term risk-free rate (we use the 10-year U.S. Treasury yield) by a margin that is fairly stable over time. We continue to use 3.5% as the ERP for the U.S., based on analysis by Dimson, Marsh and Staunton of the average ERP for developed markets since 1900. We have, however, tweaked the methodology this time to take into account the differing volatility of equity markets, which should translate into higher returns over time. Thus we use a beta of 1.2 for the euro zone, 0.8 for Japan, 0.9 for the U.K., 1.1 for both Australia and Canada, and 1.3 for Emerging Markets. The long-term picture for global growth remains poor, but valuation at the starting-point, as we have often argued, is a powerful indicator of future returns. Growth Model. This is based on a Gordon growth model framework that postulates that equity returns are a function of dividend yield at the starting point, plus the growth of earnings in future (we assume that the dividend payout ratio stays constant). We base earnings growth off assumptions of nominal GDP growth (see Box 1 for how we calculate these). But historically there is strong evidence that large listed company earnings underperform nominal GDP growth by around 1 percentage point a year (largely because small, unlisted companies tend to show stronger growth than the mature companies that dominate the index) and so we deduct this 1% to reach the earnings growth forecast. We also need to adjust dividend yield for share buybacks which in the U.S., for tax reasons, have added 0.5% to shareholder returns over the past 10 years (net of new share issuance). In other countries, however, equity issuance is significantly larger than buybacks; this directly impacts shareholders’ returns via dilution. For developed markets, the impact of net equity issuance deducts 0.7%-2.7% from shareholder returns annually. But the impact is much bigger in Emerging Markets, where dilution has reduced returns by an average of 4.9% over the past 10 years. Table 5 shows that China is by far the biggest culprit, especially Chinese banks. Table 5Dilution In Emerging Markets BOX 1 Estimating GDP Growth We estimate nominal GDP growth for the countries and regions in our analysis as the sum of: annual growth in the working-age population, productivity growth, and inflation (we assume that capital deepening remains stable over the period). Results are shown in Table 6. Table 6Calculations Of Trend GDP Growth For population growth, we use the United Nations’ median scenario for annual growth in the population aged 25-64 between 2015 and 2030. This shows that the euro zone and Japan will see significant declines in the working population. The U.S. and U.K. look slightly better, with the working population projected to grow by 0.3% and 0.1% respectively. There are some uncertainties in these estimates. Stricter immigration policies would reduce the growth. Conversely, greater female participation, a later retirement age, longer working hours, or a rise in the participation rate would increase it. For emerging markets we used the UN estimate for “less developed regions, excluding least developed countries”. These countries have, on average, better demographics. However, the average number hides the decline in the working-age population in a number of important EM countries, for example China (where the working-age population is set to shrink by 0.2% a year), Korea (-0.4%), and Russia (-1.1%). By contrast, working population will grow by 1.7% a year in Mexico and 1.6% in India. For productivity growth, we assume – perhaps somewhat optimistically – that the decline in productivity since the Global Financial Crisis will reverse and that each country will return to the average annual productivity growth of the past 20 years (Chart 4). Our argument is that the cyclical factors that depressed productivity since the GFC (for example, companies’ reluctance to spend on capex, and shareholders’ preference for companies to pay out profits rather than to invest) should eventually fade, and that structural and technical factors (tight labor markets, increasing automation, technological breakthroughs in fields such as artificial intelligence, big data, and robotics) should boost productivity. Based on this assumption, U.S. productivity growth would average 2.0% over the next 10-15 years, compared to 0.5% since 1999. Note that this is a little higher than the Congressional Budgetary Office’s assumption for labor productivity growth of 1.8% a year. Chart 4AProductivity Growth (I) Chart 4BProductivity Growth (II) Our assumptions for inflation are as described above in the section on Fixed Income. The overall results suggest that Japan will see the lowest nominal GDP growth, at 0.9% a year, with the U.S. growing at 4.4%. The U.K. and Australia come out only a little lower than the U.S. For emerging markets, as described in the main text, we use two scenarios: one where productivity grow continues to slow in the absence of reforms, especially in China, from the current 3.2% to converge with the average in DM (1.1%) over the next 10-15 years; and an alternative scenario where reforms boost productivity back to the 20-year average of 4.1%.   Growth Plus Reversion To Mean For Margins And Profits. There is logic in arguing that profit margins and multiples tend to revert to the mean over the long term. If margins are particularly high currently, profit growth will be significantly lower than the above methodology would suggest; multiple contraction would also lower returns. Here we add to the Growth Model above an assumption that net profit margin and trailing PE will steadily revert to the 20-year average for each country over the 10-15 years. For most countries, margins are quite high currently compared to history: 9.2% in the U.S., for example, compared to a 20-year average of 7.7%. Multiples, however, are not especially high. Even in the U.S. the trailing PE of 21.0x, compares to a 20-year average of 20.8x (although that admittedly is skewed by the ultra-high valuations in 1999-2000, and coming out of the 2007-9 recession – we would get a rather lower number if we used the 40-year average). Indeed, in all the other countries and regions, the PE is currently lower than the 20-year average. Note that for Japan, we assumed that the PE would revert to the 20-year average of the U.S. and the euro zone (19.2), rather than that of Japan itself (distorted by long periods of negative earnings, and periods of PE above 50x in the 1990s and 2000s).  Earnings Yield. This is intuitively a neat way of thinking about future returns. Investors are rewarded for owning equity, either by the company paying a dividend, or by reinvesting its earnings and paying a dividend in future. If one assumes that future return on capital will be similar to ROC today (admittedly a rash assumption in the case of fast-growing companies which might be tempted to invest too aggressively in the belief that they can continue to generate rapid growth) it should be immaterial to the investor which the company chooses. Historically, there has been a strong correlation between the earnings yield (the inverse of the trailing PE) and subsequent equity returns, although in the past two decades the return has been somewhat higher that the EY suggested, and so in future might be somewhat lower. This methodology produces an assumed return for U.S. equities of 4.8% a year. Shiller PE. BCA’s longstanding view is that valuation is not a good timing tool for equity investment, but that it is crucial to forecasting long-term returns. Chart 5 shows that there is a good correlation in most markets between the Shiller PE (current share price divided by 10-year average inflation-adjusted earnings) and subsequent 10-year equity returns. We use a regression of these two series to derive the assumptions. This points to returns ranging from 5.4% in the case of the U.S. to 12.5% for the U.K. Composite Valuation Indicator. There are some issues that make the Shiller PE problematical. It uses a fixed 10-year period, whereas cycles vary in length. It tends to make countries look cheap when they have experienced a trend decline in earnings (which may continue, and not mean revert) and vice versa. So we also use a proprietary valuation indicator comprising a range of standard parameters (including price/book, price/cash, market cap/GDP, Tobin’s Q etc.), and regress this against 10-year returns. The results are generally similar to those using the Shiller PE, except that Japan shows significantly higher assumed returns, and the U.K. and EM significantly lower ones (Chart 6). Chart 5Shiller PE Vs. 10-Year Return Chart 6Composite Valuation Vs. 10-Year Return     3. Alternative Investments We continue to forecast each illiquid alternative investment separately, but we have made a number of changes to our methodologies. Mostly these involve moving away from using historical returns as a basis for our forecasts, and shifting to an approach based on current yield plus projected future capital appreciation. In direct real estate, for example, in 2017 we relied on a regression of historical returns against U.S. nominal GDP growth. We move in this edition to an approach based on the current cap rate, plus capital appreciation (based on forecasts of nominal GDP growth), and taking into account maintenance costs (details below). We also add coverage of some additional asset classes: global ex-U.S. direct real estate, global ex-U.S. REITs, and gold. Table 7 summarizes our assumptions, and provides details of historic returns and volatility. Table 7Alternatives Return Calculations It is worth emphasizing here that manager selection is far more important for many alternative investment classes than it is for public securities (Chart 7). There is likely to be, therefore, much greater dispersion of returns around our assumptions than would be the case for, say, large-cap U.S. equities. Chart 7For Alts, Manager Selection Is Key Hedge Funds Chart 8Hedge Fund Return Over Cash Hedge fund returns have trended down over time (Chart 8). Long gone is the period when hedge funds returned over 20% per year (as they did in the early 1990s). Over the past 10 years, the Composite Hedge Fund Index has returned annually 3.3% more than 3-month U.S. Treasury bills. But that was entirely during an economic expansion and so we think it is prudent to cut last edition’s assumption of future returns of cash-plus-3.5%, to cash-plus-3% going forward. Direct Real Estate Our new methodology for real estate breaks down the return, in a similar way to equities, into the current cash yield (cap rate) plus an assumption of future capital growth. For the cap rate, we use the average, weighted by transaction volumes, of the cap rates for apartments, office buildings, retail, industrial real estate, and hotels in major cities (for example, Chicago, Los Angeles, Manhattan, and San Francisco for the U.S., or Osaka and Tokyo for Japan). We assume that capital values grow in line with each’s country’s nominal GDP growth (using the IMF’s five-year forecasts for this). We deduct a 0.5% annual charge for maintenance, in line with industry practice. Results are shown in Table 8. Our assumptions point to better returns from real estate in the U.S. than in the rest of the world. Not only is the cap rate in the U.S. higher, but nominal GDP growth is projected to be higher too. Table 8Direct Real Estate Return Calculations REITs We switch to a similar approach for REITs. Previously we used a regression of REITs against U.S. equity returns (since REITs tend to be more closely correlated with equities than with direct real estate). This produced a rather high assumption for U.S. REITs of 10.1%. We now use the current dividend yield on REITs plus an assumption that capital values will grow in line with nominal GDP growth forecasts. REITs’ dividend yields range fairly narrowly from 2.9% in Japan to 4.7% in Canada. We do not exclude maintenance costs since these should already be subtracted from dividends. The result of using this methodology is that the assumed return for U.S. REITs falls to a more plausible 8.5%, and for global REITs is 6.2%. Private Equity & Venture Capital Chart 9Private Equity Premium Has Shrunk Around It makes sense that Private Equity returns are correlated with returns from listed equities. Most academic studies have shown a premium over time for PE of 5-6 percentage points (due to leverage, a tilt towards small-cap stocks, management intervention, and other factors). However, this premium has swung around dramatically over time (Chart 9). Over the past 10 years, for example, annual returns from Private Equity and listed U.S. equities have been identical: 12%. However, there appears to be no constant downtrend and so we think it advisable to use the 30-year average premium: 3.4%. This produces a return assumption for U.S. Private Equity of 8.9% per year. Over the same period, Venture Capital has returned around 0.5% more than PE (albeit with much higher volatility) and we assume the same will happen going forward.   Structured Products In the context of alternative asset classes, Structured Products refers to mortgage-backed and other asset-backed securities. We use the projected return on U.S. Treasuries plus the average 20-year spread of 60 basis points. Assumed return is 2.7%. Farmland & Timberland Chart 10Farm Prices Grow More Slowly Than GDP As with Real Estate and REITs, we move to a methodology using current cash yield (after costs) plus an assumption for capital appreciation linked to nominal GDP forecasts. The yield on U.S. Farmland is currently 4.4% and on Timberland 3.2%. Both have seen long-run prices grow significantly more slowly than nominal GDP growth. Since 1980, for example, farm prices have risen at a compound rate of 3.9% per acre, compared to U.S. nominal GDP growth of 5.2% and global GDP growth of 5.5% (Chart 10). We assume that this trend will continue, and so project farm prices to grow 1.5 percentage points a year more slowly than global GDP (using global, not U.S., economic growth makes sense since demand for food is driven by global factors). This produces a total return assumption of 6%. For timberland, we did not find a consistent relationship with nominal GDP growth and so assumed that prices would continue to grow at their historic rate over the past 20 years (the longest period for which data is available). We project timberland to produce an annual return of 4.8%. Commodities & Gold For commodities we use a very different methodology (which we also used in the previous edition): the concept that commodities prices consistently over time have gone through supercycles, lasting around 10 years, followed by bear markets that have lasted an average of 17 years (Chart 11). The most recent super-cycle was 2002-2012. In the period since the supercycle ended, the CRB Index has fallen by 42%. Comparing that to the average drop in the past three bear markets, we conclude that there is about 8% left to fall over the next nine years, implying an annual decline of about 1%. Our overall conclusion is that future returns are still likely to be below those of the past decade or two, and below many investors’ expectations. We add gold to our assumptions, since it is an asset often held by investors. However, it is not easy to project long-term returns for the metal. Since the U.S. dollar was depegged from gold in 1968, gold too has gone through supercycles, in the 1970s and 2002-11 (Chart 12). We find that change in real long-term interest rates negatively affects gold (logically since higher rates increase the opportunity cost of owning a non-income-generating asset). We use, therefore, a regression incorporating global nominal GDP growth and a projection of the annual change in real 10-year U.S. Treasury yields (based on the equilibrium cash rate plus the average spread between 10-year yields and cash). This produces an assumption of an annual return from gold of 4.7% a year. We continue to see this asset class more as a hedge in a portfolio (it has historically had a correlation of only 0.1 with global equities and 0.24 with global bonds) rather than a source of return per se.  Chart 11Commodities Still In A Bear Market Chart 12Gold Also Has Supercycles   4. Currencies Chart 13Currencies Tend To Revert To PPP All the return projections in this report are in local currency terms. That is a problem for investors who need an assumption for returns in their home currency. It is also close to impossible to hedge FX exposure over as long a period as 10-15 years. Even for investors capable of putting in place rolling currency hedges, GAA has shown previously that the optimal hedge ratio varies enormously depending on the home currency, and that dynamic hedges (i.e. using a simple currency forecasting model) produce better risk-adjust returns than a static hedge.3  Fortunately, there is an answer: it turns out that long-term currency forecasting is relatively easy due to the consistent tendency of currencies, in developed economies at least, to revert to Purchasing Power Parity (PPP) over the long-run, even though they can diverge from it for periods as long as five years or more (Chart 13). We calculate likely currency movements relative to the U.S. dollar based on: 1) the current divergence of the currency from PPP, using IMF estimates of the latter; 2) the likely change in PPP over the next 10 years, based on inflation differentials between the country and the U.S. going forward (using IMF estimates of average CPI inflation for 2019-2024 and assuming the same for the rest of the period). The results are shown in Table 9. All DM currencies, except the Australian dollar, look cheap relative to the U.S. dollar, and all of them, again excluding Australia, are forecast to run lower inflation that the U.S. implying that their PPPs will rise further. This means that both the euro and Japanese yen would be expected to appreciate by a little more than 1% a year against the U.S. dollar over the next 10 years or so. Table 9Currency Return Calculations PPP does not work, however, for EM currencies. They are all very cheap relative to PPP, but show no clear trend of moving towards it. The example of Japan in the 1970s and 1980s suggests that reversion to PPP happens only when an economy becomes fully developed (and is pressured by trading partners to allow its currency to appreciate). One could imagine that happening to China over the next 10-20 years, but the RMB is currently 48% undervalued relative to PPP, not so different from its undervaluation 15 years ago. For EM currencies, therefore, we use a different methodology: a regression of inflation relative to the U.S. against historic currency movements. This implies that EM currencies are driven by the relative inflation, but that they do not trend towards PPP. Based on IMF inflation forecasts, many Emerging Markets are expected to experience higher inflation than the U.S. (Table 10). On this basis, the Turkish lira would be expected to decline by 7% a year against the U.S. dollar and the Brazilian real by 2% a year. However, the average for EM, which we calculated based on weights in the MSCI EM equity index, is pulled down by China (29% of that index), Korea (15%) and Taiwan (12%). China’s inflation is forecast to be barely above that in the U.S, and Korean and Taiwanese inflation significantly below it. MSCI-weighted EM currencies, consequently, are forecast to move roughly in line with the USD over the forecast horizon. One warning, though: the IMF’s inflation forecasts in some Emerging Markets look rather optimistic compared to history: will Mexico, for example, see only 3.2% inflation in future, compared to an average of 5.7% over the past 20 years? Higher inflation than the IMF forecasts would translate into weaker currency performance. Table 10EM Currencies In Table 11, we have restated the main return assumptions from this report in USD, EUR, JPY, GBP, AUD, and CAD terms for the convenience of clients with different home currencies. As one would expect from covered interest-rate parity theory, the returns cluster more closely together when expressed in the individual currencies. For example, U.S. government bonds are expected to return only 0.8% a year in EUR terms (versus 2.1% in USD terms) bringing their return closer to that expected from euro zone government bonds, -0.4%. Convergence to PPP does not, however, explain all the difference between the yields in different countries. Table 11Returns In Different Base Currencies 5. Correlations Chart 14Correlations Are Hard To Forecast We have not tried to forecast correlations in this Special Report. As discussed, historical returns from different asset classes are not a reliable guide to future returns, but it is possible to come up with sensible assumptions about the likely long-run returns going forward. Volatility does not trend much over the long term, so we think it is not unreasonable to use historic volatility data in an optimizer. But correlation is a different matter. As is well known, the correlation of equities and bonds has moved from positive to negative over the past 40 years (mainly driven by a shift in the inflation environment). But the correlation between major equity markets has also swung around (Chart 14). Asset allocators should preferably use rough, conservative assumptions for correlations – for example, 0.1 or 0.2 for the equity/bond correlation, rather than the average -0.1 of the past 20 years. We plan to do further work to forecast correlations in a future edition of this report.  But for readers who would like to see – and perhaps use – historic correlation data, we publish below a simplified correlation matrix of the main asset classes that we cover in this report (Table 12). We would be happy to provide any client with the full spreadsheet of all asset classes . Table 12Correlation Matrix Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com Footnotes 1      Please see Global Asset Allocation Special Report, “What Returns Can You Expect?”, dated 15 November 2017, available at gaa.bcaresearch.com 2      Please see Global Asset Allocation Special Report, “Investors’ Guide To Inflation Hedging: How To Invest When Inflation Rises,” dated 22 May 2019, available at gaa.bcaresearch.com 3      Please see GAA Special Report, “Currency Hedging: Dynamic Or Static? A Practical Guide For Global Equity Investors,” dated 29 September 2017, available at gaa.bcaresearch.com  

Highlights So What? Geopolitical risks are not about to ease. Why? Fiscal policy becomes less accommodative next year unless politicians act. Financial conditions give President Trump room to expand his tariff onslaught. Our Iran view is confirmed by rapid escalation of tensions – war risk is high. The odds of a no-deal Brexit have risen. Feature The AUD-JPY cross and copper-to-gold ratio – two market indicators that flag global growth and risk-on sentiment – are hovering over critical points at which a further breakdown would catalyze a renewed flight to quality (Chart 1). Chart 1Risk-On Indicators Breaking Down? Global sentiment remains depressed amid a rash of negative economic surprises and bonds continue to rally despite a more dovish outlook from the Fed (Chart 2). Chart 2Global Sentiment Remains Depressed The cavalry is on the way: European Central Bank President Mario Draghi oversaw a dramatic easing of monetary policy on June 18, driving the Italian-German sovereign bond spread down to levels not seen since before the populist election outcome of March 2018 (Chart 2, bottom panel). The Federal Reserve adjusted its policy rate projections to countenance an interest rate cut in the not-too-distant future. More needs to be done, however, to sustain the optimism that has propelled the S&P 500 and global equities upward since the volatility catalyzed by President Donald Trump’s announcement of a tariff rate hike on May 6. Political and geopolitical risks are higher, not lower, since that time as market-negative scenarios are playing out with U.S. policy, Iran, and Brexit, while we take a dim view of the end-game of the U.S.-China negotiations despite recent improvements. Fiscal And Trade Uncertainties This year’s growth wobbles have occurred in the context of expansive fiscal policy in the developed markets. Next year, however, the fiscal thrust (the change in the cyclically adjusted budget balance) is projected to decline in the U.S. and Japan and nearly to do so in Europe (Chart 3). We expect President Trump and the House Democrats to raise spending caps (or at least keep spending at current levels) and thus prevent the budget deficit from contracting in FY2020 – this is their only substantial point of agreement. But this at best neutralizes what would otherwise be a negative fiscal backdrop. Meanwhile it is not at all clear that Brussels will relax its scrutiny of member states seeking to cut taxes and boost spending, such as Italy. Japanese Prime Minister Abe Shinzo would need to arrange for the Diet to pass a new law to avoid the consumption tax hike from 8% to 10% on October 1. He can pull this off, especially if the U.S. trade war escalates – or if he decides to turn next month’s upper house election into a general election and needs to boost his popularity. But as things currently stand in law, the world’s third biggest economy will face a deep fiscal pullback next year (Chart 3, bottom panel). In short, DM fiscal policy will not really become contractionary in 2020, but this is a view and not yet a reality (Chart 4). Chart 3Fiscal Pullback Likely Next Year Chart 4Only The U.S. Is Profligate Meanwhile China’s stimulus is still in question – in fact it remains the major macro question this year. The efficacy of China’s stimulus is declining ... An escalating trade war will bring greater stimulus but also greater transmission problems.  Since February we have argued that the Xi administration has shifted to sweeping fiscal-and-credit stimulus in the face of the unprecedented external threat posed by the Trump administration (Charts 5A and 5B). We expect China’s credit growth to continue its upturn in June and in H2. Ultimately, we think the whole package will be comparable to 2015-16 – and anything even close to that will prolong the global economic expansion. We do not see a massive 2008-style stimulus occurring unless relations with the U.S. completely collapse and a global recession occurs. Chart 5AStimulus Amid The Trade War The catch – as we have shown – is that the efficacy of China’s stimulus is declining over time because of over-indebtedness and bearish sentiment in China’s private sector. These tepid animal spirits stem from epochal changes: Xi’s reassertion of communism and America’s withdrawal of strategic support for China’s rise. An escalating trade war will bring greater stimulus but also greater transmission problems. The magnitude of the tariffs that President Trump is threatening to impose on China, Mexico, the EU, and Japan is mind-boggling. We illustrate this with a simple simulation of duties collected as a share of total imports under different scenarios (Chart 6). China and Mexico are fundamentally different from the EU and Japan and hence the threat of tariffs will continue to weigh on markets for Trump’s time in office – China because of a national security consensus and Mexico because of the Trump administration’s existential emphasis on curbing illegal immigration. But we still put the risk of auto tariffs (or other punitive measures) on Europe at 45% if Trump seals a China deal. The odds are lower for Japan but it is still at risk. Global supply chains are shifting – a new source of costs and uncertainty for companies – as a slew of recent news has highlighted. Already 40% of companies surveyed by the American Chamber of Commerce in China say they are relocating to Southeast Asia, Mexico, and elsewhere (Chart 7). If the G20 is a flop – or results in nothing more than a pause in tariffs for another three-month dialogue – relocations will gain steam, forcing companies’ bottom lines to take a hit. Even in the best case, in which the Trump-Xi summit produces a joint statement outlining a “deal in principle” accompanied by a rollback of the May 10 tariff hike, uncertainty will persist due to President Trump’s unpredictability, China’s incentive to wait until after the U.S. election, and Trump’s incentive to corner the “China hawk” platform prior to the election. We maintain that, by November 2020, there is a roughly 70% chance of further escalation. At least the U.S.-China conflict is nominally improving. The same cannot be said for other geopolitical risks discussed below: the U.S. and Iran are flirting with war; the U.S. presidential election is injecting a steady trickle of market-negative news; the chances of a no-deal Brexit are rising; and Trump may turn on Europe at a moment when it lacks leadership. This list assumes that Russia takes advantage of American distraction by improving domestic policy rather than launching into a new foreign adventure – say in Ukraine or Kaliningrad. If there is any doubt as to whether political risk can outweigh more accommodative monetary policy, remember that President Trump actually can remove Chairman Jerome Powell. Legally he is only allowed to do so “for cause” as opposed to “at will.” But the meaning of this term is a debate that would go to the Supreme Court in the event of a controversial decision. Meanwhile the stock market would dive. Now, this is precisely why Trump will not try. But the implication, as with Congress and the border wall, is that Trump is constrained on domestic policy and hence tariffs are his most effective tool to try to achieve policy victories. With an ebullient stock market and a Fed that is adjusting its position, Trump can try to kill two birds with one stone: wring concessions from trade partners while forcing the FOMC to keep responding to rising external risks. Bottom Line: Central banks are riding to the rescue, but there is only so much they can do if global leaders are tightening budgets and imposing barriers on immigration and trade. We remain tactically cautious. Oh Man, Oh Man, Oman Iran has swiftly responded to the Trump administration’s imposition of “maximum pressure” on oil exports. The shooting down of an American drone that Tehran claims violated its airspace on June 20 is the latest in a spate of incidents, including a Houthi first-ever cruise missile attack on Abha airport in Saudi Arabia. Two separate attacks on tankers near the Strait of Hormuz (Map 1) demonstrate that Iran is threatening to play its most devastating card in the renewed conflict with the U.S. Hormuz ushers through a substantial share of global oil demand and liquefied natural gas demand (Chart 8). The amount of spare pipeline capacity that the Gulf Arab states could activate in the event of a disruption is merely 3.9 million barrels per day, or 6 million if questionable pipelines like the outdated Iraqi pipeline in Saudi Arabia prove functional (Table 1). Table 1No Sufficient Alternatives To Hormuz A conflict with Iran could cause the biggest oil shock of all time. Even if this spare capacity were immediately utilized, a conflict could cause the biggest oil shock of all time – considerably bigger than that of the Iranian Revolution (Chart 9). We have shown in the past that Iran has the military capability of interrupting the flow of traffic in Hormuz for anywhere from 10 days to four months. A preemptive strike by Iran would be most effective, whereas a preemptive American attack would include targets to reduce Iran’s ability to retaliate via Hormuz. The impact on oil prices ranges from significant to devastating. Needless to say, blocking the Strait of Hormuz would initiate a war so Iran is attempting to achieve diplomatic goals with the threats themselves – it will only block the strait as a last resort, say if it is convinced that the U.S. is about to attack anyway. As the experience of President Jimmy Carter shows, Americans may rally around the flag during a crisis but they will also kick a president out of office for higher prices and an economic slowdown. President Trump cannot be unaware of this precedent. The intention of his Iran policy is to negotiate a “better deal” than the 2015 one – a deal that includes Iran’s regional power projection and ballistic missile capabilities as well as its nuclear program. The problem is that Trump has already been forced to deploy a range of forces to the region, including additional troops (albeit so far symbolic at 2,500) (Chart 10). He is also sending Special Representative for Iran, Brian Hook, to the region to rally support among Gulf Cooperation Council. The week after Hook will court Britain, Germany, and France, three of the signatories of the 2015 deal. Trump ran on a campaign of eschewing gratuitous wars in the Middle East – a popular stance among war-weary Americans (Chart 11) – but there is a substantial risk that he could get entangled in the region. First, he is adopting a more aggressive foreign policy to attempt to compensate for the lack of payoff in public opinion from the strong economy. Second, Iran is not shrinking from the fight, which could draw him deeper into conflict. Third, there is always a high risk of miscalculation when nations engage in such brinkmanship. Chart 10Is The 'Pivot To Asia' About To Reverse? The Iranian response has been, first, to reject negotiations. When Trump sent a letter to Rouhani via Japanese Prime Minister Abe Shinzo, Abe was rebuffed – and one of the tankers attacked near Oman was a Japanese flagged vessel, the Kokuka Courageous. This is a posture, not a permanent position, as the Iranian release of an American prisoner demonstrates. But the posture can and will be maintained in the near term – with escalation as the result. Second, Iran is increasing its own leverage in any future negotiation by demonstrating that it can sow instability across the region and bring the global economy grinding to a halt. Iran cannot assume that Trump means what he says about avoiding war but must focus on the United States’ actions and capabilities. Cutting off all oil exports is a recipe for extreme stress within the Iranian regime – it is an existential threat. Therefore, the Iranians have signaled that the cost of a total cutoff will be a war that will cause a global oil price shock. The Iranian leaders are also announcing that they are edging closer to walking away from the 2015 nuclear pact (Table 2). If so, they could quickly approach “breakout” capacity in the uranium enrichment – meaning that they could enrich to 20% and then in short order enrich to 90% and amass enough of this fuel to make a nuclear device one year thereafter. The Trump administration has reportedly reiterated that this one-year limit is the U.S. government’s “red line,” just as the Obama administration had done. Table 2Iran Threatens To Walk Away From 2015 Nuclear Deal This Iranian threat is a direct reaction to Trump’s decision in May not to renew the oil sanction waivers. Previously the Iranians had sought to preserve the 2015 deal, along with the Europeans, in order to wait out Trump’s first term. These developments push us to the brink of war. Iran is retaliating with both military force and a nuclear restart. This comes very close to meeting our conditions for an American (and Israeli) retaliation that is military in nature. Diagram 1 is an update of our decision tree that we have published since last year when Trump reneged on the 2015 deal. The window to de-escalate is closing rapidly. The Appendix provides a checklist for air strikes and/or the closure of Hormuz. Diagram 1Iran-U.S. Tensions Decision Tree At very least we expect to see the U.S. attempt to create a large international fleet to assert freedom of navigation in the Persian Gulf and Strait of Hormuz. While Iran may lay low during a large show of force, it will later want to demonstrate that it has not been cowed. And it has the capacity to retaliate elsewhere, including in Iraq, an area we have highlighted as a major geopolitical risk to oil supply. The U.S. government has already reacted to recent threats there from Iranian proxies by pulling non-essential personnel. Iran has several incentives to test the limits of conflict if the U.S. insists on the oil embargo. First, tactically, it seeks to deter President Trump, take advantage of American war-weariness, drive a wedge between the U.S. and Europe, and force a relaxation of the sanctions. This would also demonstrate to the region that Iran has greater resolve than the United States of America. This goal has not been achieved by the recent spate of actions, so there is likely more conflict to come. Second, President Hassan Rouhani’s government is also likely to maintain a belligerent posture – at least in the near term – to compensate for its loss of face upon the American betrayal of the 2015 nuclear deal. Rouhani negotiated the deal against the warnings of hardline revolutionaries. The 2020 majlis elections make this an important political goal for his more reform-oriented faction. Negotiations with Trump can only occur if Rouhani has resoundingly demonstrated his superiority in the clash of wills. Structurally, Iran faces tremendous regime pressures in the coming years and decades because of its large youth population, struggling economy, and impending power transition from the 80 year-old Supreme Leader Ali Khamanei. A patriotic war against America and its allies – while not desirable – is a risk that Khamenei can take, as an air war is less likely to trigger regime change than it is to galvanize a new generation in support of the Islamic revolution. For oil markets the outcome is volatility in the near term – reflecting the contrary winds of trade war and global growth fears with rising supply risks. Because we expect more Chinese stimulus, both as the trade talks extend and especially if they collapse, we ultimately share BCA’s Commodity & Energy Strategy view that the path of least resistance for oil prices is higher on a cyclical horizon, as demand exceeds supply (Chart 12). We remain long EM energy producers relative to EM ex-China. Chart 12Crude Oil Supply-Demand Balance Should Send Prices Higher Bottom Line: The risk of military conflict has risen materially. This also drastically elevates the risk of a supply shock in oil prices that would kill global demand. The U.S. Election Adds To Geopolitical Risk The 2020 U.S. election poses another political risk for the rising equity market. The Democratic Party’s first debate will be held on June 26-27. The leftward shift in the party will be on full display, portending a possible 180-degree reversal in U.S. policy if the Democrats should win the election, with the prospect of a rollback of Trump’s tax cuts and deregulation of health, finance, and energy. The uncertainty and negative impact on animal spirits will be modest if current trends persist through the debates. Former Vice President Joe Biden remains the frontrunner despite having naturally lost the bump to his polling support after announcing his official candidacy (Chart 13). Biden is a known quantity and a centrist, especially compared to the farther left candidates ranked second and third in popular support– Vermont Senator Bernie Sanders and Massachusetts Senator Elizabeth Warren. Biden is not only beating Sanders in South Carolina, which underscores the fact that he is competitive in the South and hence has a broader path to the White House, but also in New Hampshire, where the Vermont native should be ahead (Chart 14). These states hold the early primaries and caucuses and if Biden maintains his large lead then he will start to appear inevitable very early in the primary campaign next year. Hence a poor showing in the debate on June 27 is a major risk to Biden – he should be expected to be eschew the limelight and play the long game. Elizabeth Warren, by contrast, has the most to gain as she appears on the first night and does not share a stage with the other heavy hitters. If she or other progressive candidates outperform then the market will be spooked. The market could begin to trade off the polls. All of these candidates are beating Trump in current head-to-head polling – Biden is even ahead in Texas (Chart 15). This means that any weakness from Biden does not necessarily offer the promise of a Trump victory and policy continuity. The Democrats also have a powerful demographic tailwind. The just-released projections from the U.S. Census Bureau reveal how Trump’s narrow margins of victory in the swing states in 2016 are in serious jeopardy in 2020 as a result of demographics if he does not improve his polling among the general public (Chart 16). We still give Trump the benefit of the doubt as the incumbent president amid an expanding economy, but it is essential to recognize that his popular approval rating is reminiscent of a president during recession – i.e. one who is about to lose the White House for his party (Chart 17). Even if there is not a recession, an increase in unemployment is likely to cost him the election – and even a further decrease in unemployment cannot guarantee victory (Chart 18). This is why we see Trump making a bid to become a foreign policy president and seek reelection on the basis that it is unwise to change leaders amid an international crisis. We still give Trump the benefit of the doubt ... but his popular approval rating is reminiscent of a president during recession. The race for the U.S. senate is extremely important for the policy setting from 2021. If Republicans maintain control, they will be able to block sweeping Democratic legislation – which is particularly relevant if a progressive candidate should win the White House. However, if Democrats can muster enough votes to remove a sitting president with a strong economy – including a strong economy in the key senate swing races (Chart 19) – then they will likely win over the senate as well. Chart 19Hard To Win The Senate In 2020 While Key States Prosper Bottom Line: The 2020 election poses a double risk to the bull market. First, the Democratic primary campaign threatens sharp policy discontinuity, especially if and when developments cause Biden to drop in the polls (dealing a blow to centrism or the political establishment). Second, Trump’s vulnerability makes him more likely to act aggressive on the international stage, whether on trade, immigration, or national security, reinforcing the risks outlined above with regard to China, Iran, Mexico, and even Europe. Rising Odds Of A No-Deal Brexit Former Mayor of London and former foreign secretary Boris Johnson looks increasingly likely to seal the Conservative Party leadership contest in the United Kingdom. It is not yet a done deal, but the shift within the party in favor of accepting a “no deal” exit is clear. None of the remaining candidates is willing to forgo that option. The newest development advances us along our decision tree in Diagram 2, altering the conditional probabilities for this year’s events. We expect the next prime minister to try to push a deal substantially similar to outgoing Prime Minister Theresa May before attempting any kamikaze run as the October 31 deadline approaches. The attempt to leverage the EU’s economic weakness will not produce a fundamental renegotiation of the exit deal, but some element of diplomatic accommodation is possible as the EU seeks to maintain overall stability and a smooth exit if that is what the U.K. is determined to accomplish. Diagram 2Brexit Decision Tree Hence the prospect of passing a deal substantially similar to outgoing Prime Minister Theresa May’s deal is about 30%, roughly equal to the chance of a delay (28%). These options are believable as the new leader will have precious little time between taking the reins and Brexit day. The EU can accept a delay because it ultimately has an interest in keeping the U.K. bound into the union. Public opinion polling is not conducive to the new prime minister seeking a new election unless the change of face creates a massive shift in support for the Conservatives, both by swallowing the Brexit Party and outpacing Labour. If the purpose is to deliver Brexit, then the risk of a repeat of the June 2017 snap election would seem excessive. Nevertheless, the Tories’ working majority in parliament is vanishingly small, at five MPs, so a shift in polling could change the thinking on this front. The pursuit of a no-deal exit would create a backlash in parliament that we reckon has a 21% chance of ending in a no-confidence motion and new election. Bottom Line: The odds of a crash Brexit have moved up from 14% to 21% as a result of the leadership contest. The threat that the U.K. will crash out of the EU is not merely a negotiating ploy, although it will be a last resort even for the new hard-Brexit prime minister. Public opinion is against a no-deal Brexit, as is the majority of parliament, but the risk to the U.K. and EU economies will loom large over global risk assets in the coming months. Investment Conclusions Political and geopolitical risks to the late-cycle expansion are rising, not falling. U.S. foreign policy remains the dominant risk but U.S. domestic policy pre-2020 is an aggravating factor. Easing financial conditions give President Trump more ammunition to use tariffs and sanctions. Meanwhile our view that this summer will feature “fire and fury” between the U.S. and Iran has been confirmed by the tanker attacks in Oman. Tensions will likely escalate from here. Ultimately, we believe Trump is more likely to back off from the Iran conflict than the China conflict. This is part of our long-term theme that the U.S. really is pivoting to China and geopolitical risk will rotate from the Middle East to East Asia. But as highlighted above, the risk of entanglement is very high due to Trump’s approach and Iran’s incentives to raise the stakes. Oil prices will not resume their upward drift until Chinese stimulus is reconfirmed – and even then they will continue to be volatile. We remain cautious and are maintaining our safe-haven tactical trades of long gold and long JPY/USD.   Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Appendix

Supply - demand fundamentals point to higher oil prices going forward. Our expectation regarding OPEC production remains unchanged: The original cartel led by the Kingdom of Saudi Arabia (KSA) will maintain production discipline this year – likely continuing to over-comply with quotas agreed at the start of the year – to support its long-standing goal to reduce oil inventories globally. Non-OPEC member states in OPEC 2.0 led by Russia also will maintain lower output this year. The OPEC 2.0 coalition will meet July 1 - 2 in Vienna to determine whether it will extend production cuts. On the demand side, we lowered our expectation for this year and next, following the World Bank’s recent downgraded assessment of global GDP growth. Our expectation remains slightly above the EIA’s and the IEA’s. Globally, central bank easing will support demand. Following these adjustments, we are keeping our Brent forecast at $73/bbl this year and lowering our forecast for next year to $75/bbl from $77/bbl. We continue to expect WTI to trade $7/bbl and $5/bbl below those levels this year and next, respectively. The balance of risk is to the upside. The risk of hybrid warfare (see below) in the Persian Gulf -- and the wider region -- will increase, as Iranian and U.S. positions harden. Highlights Highlights Energy: Overweight. The U.S. Central Command released photos supporting an analysis claiming Iran was responsible for two attacks on commercial shipping in the Persian Gulf last week. The Pentagon deployed an additional 1,000 troops to the region, following this assessment. President Trump, meanwhile, downplayed the attacks, calling them a “very minor event.”1 Base Metals: Neutral. Copper speculators lifted their short position 6k lots to 51.7k lots on CME last week. This is a record short. But the cash market is getting tighter. Treatment and refining charges (TC/RCs) moved lower last week, as Fastmarkets MB’s TC/RC Asia – Pacific index hit $54.10/MT, $05.41/lb. This is the lowest level on record for the index, which was launched in June 2013. A low index reading means copper concentrate is in short supply, forcing refiners to lower the price of their services. We remain long the September 2019 $3.00/lb Calls vs. short the September 2019 $3.30/lb calls. Precious Metals: Neutral. Safe-haven demand continues to support gold prices, although news of a Trump – Xi meeting at the G20 in Japan to re-start trade talks reduced the urgency of buying earlier this week. We remain long gold as a portfolio hedge. Ags/Softs: Underweight. Rain continued to soak the U.S. Midwest this past week, putting a bid under grains – particularly corn – and beans. This week’s USDA Crop Progress report showed corn planting still behind schedule (at 92% vs. 100% on average in the 2014 – 18 period in the 18 states that accounted for 92% of total acres planted last year). Feature The information flows to oil markets are becoming internally contradictory. On the one hand, recent attacks on commercial oil-product tankers near the Strait of Hormuz – where close to 20% of the world’s oil supply transits daily – raised the ante in the U.S.-GCC-Iran stand-off.  The attacks follow earlier aggression against shipping and pipelines in the region, and prompted KSA’s Energy Minister Khalid al-Falih to call for a collective response to keep Gulf sea lanes open to allow oil to flow freely worldwide.2 In the post-WWII era, the U.S. has willingly taken on the responsibility of keeping the world’s sea lanes open for the free flow of commodities and finished products. However, based on remarks U.S. President Donald Trump made to Time magazine this week, it would appear the U.S. no longer is willing to shoulder the burden of defending freedom of navigation in the Persian Gulf.3 The presidential sangfroid in the wake of last week’s attacks in the Gulf – which Pentagon analysts insist were launched by Iran – might be explained by the Trump administration’s belief the global oil market is “very well-supplied,” as U.S. Deputy Energy Secretary Dan Brouillette contended in an S&P Global Platts interview this past weekend.4 Indeed, this has become part of the narrative whenever the administration discusses oil markets. Brouillette said abundant crude availability prevented oil prices from spiking to $140/bbl in the wake of the attacks on the two commercial tankers. Will The U.S. Defend Gulf Sea Lanes? The global oil market is “well supplied” as long as the Strait of Hormuz – the most critical chokepoint in the world – stays open. Freedom of navigation on the open seas is the sine qua non of a well-functioning oil market – everything from getting supplies to refiners to getting products to consumers depends on it. Oil is a globally traded, waterborne commodity: ~ 60% of all crude exports are loaded on a ship and sent to refiners, directly or via trading companies.5 A liquid crude market requires an unimpeded shipping market, so that refiners can run their operations in a routine manner. In addition, a smoothly functioning shipping market allows refiners to pick and choose among various grades that can be arbitraged against each other, so they can optimize charging stocks. The market cannot absorb the loss of close to 20mm b/d of crude and refined products, which is what would happen if the Strait shut down. It is the most important choke point in the world (Map 1). We’re sure the White House knows this. President Trump’s professed desire to leave the U.S. commitment to maintaining the free flow of oil out of the Gulf is a “question mark” that might be taken as a taunt to up the ante with Iran. Already, in response to the U.S. re-imposing sanctions on Iranian oil exports after unilaterally abrogating the Joint Comprehensive Plan of Action (JCPOA) agreement, Iran announced it will resume production of enriched uranium for its nuclear program on June 27.6 As the summer progresses, we expect a continued escalation in tensions in the Gulf, which, at the very least, will keep volatility in the oil markets elevated. The growing tension in this standoff increases the risk of hybrid warfare in the Persian Gulf, which, should it continue to escalate, increases the risk to global oil flows, as Anthony H. Cordesman at the Center For Strategic & International Studies in Washington recently noted: First, the military confrontation between Iran, the U.S., and the Arab Gulf states over everything from the JCPOA to Yemen can easily escalate to hybrid warfare that has far more serious forms of attack. And second, such attacks can impact critical aspects of the flow of energy to key industrial states and exporters that shape the success of the global economy as well as the economy of the U.S.7 There is a risk this hybrid warfare metastasizes into a full-on war in the Gulf, which would threaten the free flow of oil through the Strait of Hormuz. Should the Strait be closed, a global oil-price shock almost surely would occur, which most likely would send oil prices through $150/bbl. At that point either the warfare is contained and resolved quickly, or the world has to line up 20mm b/d of crude oil and refined products to replace the lost supply from the Gulf. As the summer progresses, we expect a continued escalation in tensions in the Gulf, which, at the very least, will keep volatility in the oil markets elevated (Chart of the Week). Chart of the WeekVolatility Will Remain High OPEC 2.0 Will Maintain Production Discipline Even as tensions in the Persian Gulf escalate, we continue to expect OPEC 2.0 to maintain its production discipline. While the producer coalition agreed to remove 1.2mm b/d of production from the market last December, we estimate year-on-year (y/y) year-to-date (ytd) production of OPEC is down ~ 1.4mm b/d in the January-to-May period. For Russia, production over that period y/y is up 310k b/d ytd. For all of OPEC 2.0, we have the group increasing production in 2H19, but we have it ending 2019 with production 480k b/d lower than last month’s forecast. The increase is mainly from Saudi Arabia, which averages ~ 10.2mm b/d of production in 2H19, roughly 130k b/d below quota. We have Russian production averaging ~ 11.5mm b/d, which is close to quota, in 2H19 (Table 1). Table 1BCA Global Oil Supply - Demand Balances (MMb/d, Base Case Balances) For the year as a whole, we are forecasting OPEC production will fall 1.6mm b/d this year versus 2018 levels, while Russia’s production grows slightly (~ 80k b/d). For next year, OPEC’s production will stay relatively flat (falling ~ 70k b/d), while we expect Russia’s production to increase 230k b/d (Table 1). Outside OPEC 2.0, the U.S. continues to dominate the production-growth story, led by increasing shale-oil output (Chart 2). We expect shale output to grow ~ 1.2mm b/d this year and just over 1mm b/d in 2020. Chart 2U.S. Shales Dominate Non-OPEC Production Growth Global Demand Is Holding Up While we do expect somewhat lower demand this year and next versus where we were earlier this year, we still expect consumption to remain fairly robust. We expect demand to grow ~ 1.35mm b/d this year and 1.55mm b/d next year, down from 1.50mm and 1.60mm b/d, respectively, in our base case. As always this is led by non-OECD demand growth, which we expect will clock in with an increase of just over 1mm b/d this year versus last year, and 1.3mm b/d next year on average. EM commodity importers will dominate growth, as usual (Chart 3). Trade-war concerns will continue to dominate headlines, but even so, demand remains reasonably stout. While it always is possible the U.S. and China will be able to resolve their trade war – perhaps in dramatic fashion following the G20 meeting in Japan – our colleagues in BCA Research’s doubt it.8 Continuing Sino – U.S. and Iranian – U.S. tension could keep the USD relatively well bid, which will present a headwind to oil demand.  That said, we believe central banks generally will feel compelled to remain accommodative so long as trade wars persist. This accommodation, coupled with fiscal stimulus in many of the systemically important economies, will be supportive of demand overall, EM demand in particular. Chart 3EM Oil Demand Growth Once Again Leads The World Bottom Line: Supply – demand balances indicate crude oil prices still have room to run in 2H19 and next year. We are maintaining our forecast of $73/bbl for Brent this year. We are lowering our forecast for 2020 to $75/bbl (Chart 4). We expect WTI to trade $7/bbl and $5/bbl below those levels this year and next, respectively. The combination of stout demand growth, production discipline by OPEC 2.0 and capital discipline by U.S. shale producers will allow inventories to resume drawing this year (Chart 5). Chart 4Supply - Demand Balances Point To Higher Prices Chart 5Stout Demand, Supply Discipline Will Allow Inventories To Draw   Robert P. Ryan, Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1      Please see Analyst: New Photos Are ‘Smoking Gun’ Proving Iranian Involvement in Tanker Attack published by USNI News, and Exclusive: President Trump Calls Alleged Iranian Attack on Oil Tankers 'Very Minor' published by Time magazine on June 17, 2019. 2      Please see Saudi Energy Minister calls for collective effort to secure shipping lanes published by reuters.com June 17, 2019. 3      Please see Exclusive: President Trump Calls Alleged Iranian Attack on Oil Tankers 'Very Minor' published by Time magazine on June 17, 2019. Tessa Berenson reported: “Facing twin challenges in the Persian Gulf, President Donald Trump said in an interview with TIME Monday that he might take military action to prevent Iran from getting a nuclear weapon, but cast doubt on going to war to protect international oil supplies.“I would certainly go over nuclear weapons,” the president said when asked what moves would lead him to consider going to war with Iran, “and I would keep the other a question mark.” 4      Please see Interview: Abundant oil supply prevented spike to $140/b after ship attacks - US DOE deputy published by S&P Global Platts June 16, 2019. 5      Please see World Oil Transit Chokepoints published by the U.S. EIA. 6      Please see Iran nuclear deal: Enriched uranium limit will be breached on 27 June published by bbc.co.uk June 17, 2019.  JCPOA agreement between Iran and the so-called P5+1 nations – China, France, Germany, Russia, the U.K. and the U.S. – allowed Iran to return to global markets in exchange for limiting its nuclear development.  Please see The Joint Comprehensive Plan of Action (JCPOA) at a Glance published by Arms Control Association in May 2018.    7      Please see The Strategic Threat from Iranian Hybrid Warfare in the Gulf published by CSIS June 13, 2019. 8      Please see Policy Risk Restrains Oil Prices published by BCA Research’s Commodity & Energy Strategy May 30, 2019, where we reprise the different policy risks oil markets are contending with at present, particularly the trade war.  It is available at ces.bcaresearch.com. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 2019 Q1 Commodity Prices and Plays Reference Table Trades Closed in 2019 Summary of Closed Trades Closed

Analysis on Thailand is available below. Feature Last week we were on the road meeting with some of our U.S. clients. This week’s report presents some of the key topics of our discussions in a Q&A format. Question: You have been downplaying the potentially positive impact of lower bond yields in advanced economies on EM risk assets. Why do you think lower bond yields in developed markets (DM) and potential rate cuts by DM central banks won’t suffice to lift EM markets on a sustainable basis? Answer: Falling interest rates are positive for share prices when profits are growing, even at a slower rate. When corporate profits are contracting, lower interest rates typically do not preclude equity prices from dropping. Presently, EM and Chinese corporate earnings are shrinking rapidly (Chart I-1). This is the primary reason why we believe DM monetary easing will not help EM share prices much. Furthermore, EM exchange rates follow relative EPS cycles in local currency terms (Chart I-2). In short, EM currencies are driven by relative corporate profitability between EM and the U.S. – not by interest rate differentials. Chart I-1EM & China EPS Are Contracting Chart I-2Relative EPS And Exchange Rate   The contraction in EM and China EPS has not been caused by higher interest rates and slump in DM domestic demand. Rather, the EM/China profit contraction has been due to China’s economic slowdown spilling over to the rest of EM. Crucially, there is no empirical evidence that interest rate cuts and QEs in DM preclude EM selloffs when EM/Chinese growth is slumping. Specifically: Chart I-3A and I-3B illustrate that neither the level of G4 central banks’ assets nor their annual rate of change correlates with EM share prices or EM local bonds’ total returns in U.S. dollar terms. Hence, QEs have not always guaranteed positive returns for EM financial markets. Chart I-3APace Of QE And EM Performance Chart I-3BPace Of QE And EM Performance Chart I-4U.S. Treasury Yields And EM Performance Chart I-4 demonstrates the correlation between U.S. 5-year Treasurys yields on the one hand and EM spot exchange rates, EM sovereign credit spreads and EM share prices on the other. There has been no stable relationship – at times it has been positive, and at other times negative. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. Even though DM monetary policy has not been the driving force of cyclical fluctuations in EM financial markets, it has had a structural impact. QEs and lower bond yields in DM have prompted an expanded search for yield and have produced substantial compression in risk premia worldwide. For example, Chart I-5 demonstrates that excess returns on EM corporate bonds have historically been correlated with the global manufacturing cycle, but the correlation has diminished in recent years. The widening gap between the two lines is due to investors’ search for yield. Investors have bought and continue to hold securities of “zombie” companies and countries that have low productivity and poor fundamentals. In short, QEs have undermined the efficiency of global capital allocation. This is marginally adverse for productivity in the global economy in the long run. Question: But doesn’t DM monetary policy influence DM demand, which in turn affects EM corporate profits? Answer: DM monetary policy influences DM domestic demand, but there is little correlation between DM domestic demand and EM corporate profits. For example, U.S. import volumes have been growing at a decent pace, yet EM corporate profits have shrunk (Chart I-6). Indeed, robust growth in U.S. imports did not preclude EM EPS contraction in 2012, 2014-‘15 and 2018-‘19, as shown in this chart. Chart I-5Fundamentals Have Become Less Important Due To QE Programs Chart I-6EM EPS And U.S. Imports   Chart I-7 reveals additional evidence of the diminished impact of U.S. growth on Asian exports. Korean, Taiwanese, Japanese and Singaporean exports to the U.S. are growing at 7% rate, while their shipments to China are contracting at an 11% rate from a year ago as of May. As a result, these countries’ overall exports are shrinking because they ship to China considerably more than they do to the U.S. We are not implying that DM interest rates have no bearing on EM financial markets. Our point is that lower interest rates and QEs in DM do not constitute sufficient conditions for EM financial markets to rally. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. The deceleration in global trade can be tracked to Chinese imports contraction (Chart I-8). Chart I-7Asia's Exports To China And U.S. Chart I-8Chinese Imports And Global Trade   U.S. manufacturing is the least exposed to China, which is the main reason why it was the last shoe to drop in the global manufacturing recession. Question: So, what drives EM business cycles if it is not DM growth and DM interest rates? Chart I-9China's Credit & Fiscal Impulse And EM EPS Answer: The key and dominant driver of EM risk assets – stocks, credit markets and currencies – has been the global trade and EM/China growth cycles. There is a much stronger correlation between EM financial markets and the global business cycle in general, and Chinese imports in particular than with DM interest rates. In turn, Chinese imports are driven by its capital spending cycle. 85% of the mainland’s good imports are composed of industrial goods and devices, machinery, chemicals, various commodities and autos. Only 15% are non-auto consumer goods. Meanwhile, the credit/money cycles drive capital spending. That is why China’s credit and fiscal spending impulse leads EM corporate profits (Chart I-9). This is also why we spend a significant amount of time analyzing and discussing China's credit cycle. Question: Why has the policy stimulus in China not revived growth in its economy and its suppliers around the world? Answer: Our aggregate credit and fiscal spending impulse bottomed in January of this year, but its recovery has so far been timid. In the past, this indicator led China’s business cycle and the global manufacturing PMI by an average of about nine months (Chart I-10, top panel) and EM corporate profits by 12 months (Chart I-9). According to this pattern, the bottom in global manufacturing should occur in August of this year. However, global share prices have not led global manufacturing PMI during this decade; they have instead been coincident (Chart I-10, bottom panel). Hence, there was no historical justification for global share prices to rally since early January - well ahead of a potential bottom in the global manufacturing PMI in August. The current global slowdown did not originate in the U.S. or Europe. Rather, it originated in China and has spilt across the world, affecting the economies that sell to China the most. That said, due to the U.S.-China confrontation and other structural reasons currently prevailing in China – including high levels of indebtedness and more regulatory scrutiny over shadow banking as well as local government debt – a recovery in mainland household and corporate spending is likely to be delayed. Crucially, as we have documented in previous reports, the marginal propensity to spend for consumers and companies continues to fall (Chart I-11). This is the opposite of what occurred in early 2016. Chart I-10Chinese Stimulus, Global Manufacturing And Global Stocks Chart I-11China: What Is Different From 2016   Overall, a revival in China’s growth will likely take longer to unfold and EM risk assets will likely sell off anew before bottoming. Chart I-12Global Slowdown Is Not Yet Over Chart I-13Global Semiconductor Demand Is Shrinking Question: Apart from China’s credit and fiscal spending impulse and marginal propensity to spend among households and companies, what other indicators are you monitoring to gauge a bottom in the global manufacturing cycle? Answer: Among many variables and indicators we continuously monitor, there are a few we have been paying particular attention to: The difference between global narrow (M1) and broad money growth correlates well with global corporate earnings (Chart I-12). The rationale for this indicator is that it is akin to the marginal propensity to spend: When demand deposits (M1) outpace time/savings deposits, it is indicative that households and companies are getting ready to spend on large-ticket items or kick off capital spending, and vice versa. Presently, this narrow-to-broad money growth differential continues to point to lower global growth. Last week we published a report on the global semiconductor industry, arguing that upstream demand for semiconductors is withering as sales of servers, smartphones, PCs and autos are all shrinking globally (Chart I-13). With consumption of these goods contracting, demand for semiconductors remains lackluster, and semiconductor prices are still deflating (Chart I-14). Hence, semiconductor prices can be used as an indicator of final demand dynamics in many important segments of the global economy. China’s Container Freight Index – the price to ship containers – is also currently lackluster, reflecting weak global trade dynamics (Chart I-15, top panel). Chart I-14Semiconductor Prices Are Still Deflating Chart I-15Global Shipments Are Very Weak   In the U.S., both total intermodal carloads and railroad carloads excluding petroleum and coal are tanking, reflecting subsiding growth (Chart I-15, middle and bottom panel). In turn, Chinese imports continue to contract. This is the primary channel in terms of how the Middle Kingdom affects the rest of the world economy. From the rest of the world’s perspective, China is in recession because their shipments to the mainland are shrinking. In China and Taiwan, the seasonally adjusted manufacturing PMI new orders have rolled over after the temporary pick up early this year (Chart I-16). Finally, we are monitoring our Reflation Indicator and Risk-On/Safe-Haven Currency Ratio (Chart I-17). Both are market-based indicators and are very sensitive to global growth conditions – especially to the dynamics in commodities markets – making them very pertinent to EM investors. Chart I-16Manufacturing PMI: New Orders Seasonally-Adjusted Chart I-17Market-Based Indicators   As with any marked price-based signals, both are very volatile. Even though both indicators have rebounded in recent days, only a major trend reversal matters for macro investors. Technically speaking, the profile of both indicators is consistent with a breakdown rather than a breakout. Question: You have highlighted that EM corporate EPS is contracting. How widespread is the profit contraction, and how long will it persist? Answer: EM corporate EPS contraction is widespread across almost all sectors. Chart I-18A and I-18B illustrate EPS growth in U.S. dollar terms for all sectors. EPS growth is negative for most sectors, close to zero for three (technology, financials and materials) and still positive for the energy sector. However, technology, materials and energy EPS are heading into contraction, given the drop in semiconductor, industrial metals and oil prices, respectively. Chart I-18ASynchronized EM EPS Contraction Chart I-18BSynchronized EM EPS Contraction   Consequently, all EM equity sectors will soon be experiencing synchronized profit contraction. EM corporate EPS contraction is widespread across almost all sectors. Our credit and fiscal spending impulse for China leads EM EPS growth by about 12 months, and it currently entails that the profit contraction will continue to deepen all the way through December (Chart I-9 on page 6). It would be surprising if EM share prices stage a major rally amid a hastening decline in corporate EPS (please refer to Chart I-1 on page 1). Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Thailand: A Defensive Play Within EM The Thai parliament has elected to keep the ex-military general Prayuth Chan-ocha as the country’s prime minister. This will instill political stability for now, which is positive for investor confidence. In absolute terms, Thai financial markets are leveraged to global trade and will, therefore, sell off if our negative views on the latter and EM risk assets play out. Chart II-1Thailand's Current Account Is In Surplus Relative to their EM peers, Thai equities, credit, currency and domestic bonds will continue outperforming: The Thai current account balance remains in large surplus, which provides a large cushion for the Thai baht amid the slowdown in global growth (Chart II-1). Critically, Thailand is less exposed to China and is more leveraged to the U.S. and Europe than its EM peers. Thailand’s shipments to China account for 12% of the former’s total exports, while exports to the U.S. and EU together account for 21%. Both U.S. and European imports are holding up better than those of China. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. FDOs measure the sum of short-term claims, interest payments and amortization over the next 12 months. The country’s current FDOs stand at 8% relative to its exports of goods and services and 12% relative to the central bank’s foreign exchange reserves. The rest of EM countries have much higher ratios. In addition, foreign ownership of local currency bonds is amongst the lowest in the region (18%). As a result, currency depreciation will not trigger major portfolio outflows and a self-reinforcing downtrend in Thai financial markets. Thailand also has the lowest foreign debt obligations (FDO) among EM countries. Chart II-2Thailand: Moderate Growth In Private Consumption Thailand’s private consumption is growing reasonably well (Chart II-2, top panel). Likewise, passenger and commercial vehicle sales are rising and so is household credit (Chart II-2, bottom two panels). The Thailand MSCI index carries a large weight in domestic and defensive stocks such as transportation, utilities, telecommunication, and consumer staples. These sectors will benefit from moderate consumption growth. In fact, Thai equity outperformance versus EM has been justified by its non-financial companies’ EBITDA outpacing that of EM non-financials (Chart II-3). This trend remains intact. Concerning banks, Thailand’s commercial banks suffer from credit excesses, as do many of their EM peers. However, Thai commercial banks have been responsible in terms of recognizing NPLs and have been properly provisioning for them (Chart II-4). This is contrary to many other EM banks. This means that share prices of Thai commercial banks will outperform their EM counterparts. Finally, although the Thai bourse is more expensive than its EM counterparts, relative equity valuation will likely get even more stretched before a major reversal occurs. Given our cautious view on overall EM, we continue to prefer this richly valued and defensive bourse to the more cyclical, albeit cheaper, but fundamentally vulnerable EM peers. Chart II-3Equity Outperformance Has Been Justified By Earnings Chart II-4Thai Commercial Banks Are Well Provisioned Bottom Line: Investors should keep an overweight position in Thai equities, currency, domestic bonds and credit markets. Ayman Kawtharani, Editor/Strategist ayman@bcaresearch.com Footnotes   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Following up on our May 30th Chinese apparent diesel demand and SPX momentum pictorial, the latest KOMATSU monthly demand growth rate update on Chinese excavator sales corroborates the plunging diesel demand data (as a reminder most earthmoving machinery are diesel-powered). In more detail, over the last three months ending in May, KOMATSU Chinese excavator sales have registered -10%, -16% and -27% year-over-year contraction rates, respectively.1 Such an accelerated decline is telling. Japanese construction machinery companies are not tangled up in the U.S./China trade tussle, at least not yet, so this appears to be a clean/reliable number. Moreover, it seems as though infrastructure spending is not the preferred way to stimulate the Chinese economy at the current juncture. This is important and likely serves as a near-real time indicator of Chinese reflation efforts translating into economic activity. The chart shows that in late-2015/early-2016 this economic data series went parabolic, led the U.S. stock market and clearly signaled that a Chinese reflationary push was being successful. Currently, excavator sales data suggest that Chinese reflation is either delayed or the transmission mechanism is broken, warning that U.S. stocks are in danger of disappointment. Bottom Line: Broad U.S. equity market caution is still warranted. Footnotes 1https://home.komatsu/en/ir/demand-orders/__icsFiles/afieldfile/2019/06/07/201903main_products_order_e_0607.pdf

Special Report

Highlights The report reviews our framework for predicting broad market earnings in China based on the experience of the past decade, and documents the relationship between sector earnings and broad market earnings for both the investable and domestic market. We also review the cyclicality of earnings in each sector, and highlight the sectors where relative earnings have been successful at predicting relative performance. Energy and consumer discretionary in both markets, along with real estate and financials in the domestic market, have historically been the best candidates for a classic top-down fundamental “sector rotation” strategy. Compared with these sectors, investable telecom stocks have exhibited a weaker link between sector and index earnings, but this has occurred because of relatively steady, low volatility earnings growth. As such, telecom stocks are reliably defensive, but only in the investable market. We conclude by noting the extreme nature of long-term de/re-rating trends that have occurred for several of China’s equity sectors, and argue that the strength of the relationship between earnings and stock prices for these sectors is set to rise over a secular time horizon. Over the coming few years, investors should focus nearly exclusively on the earnings outlook for high flying and beaten down sectors, as further multiple expansion/contraction is unlikely to drive future returns (without an earnings catalyst). Feature Last week’s joint report with our Geopolitical Strategy service provided investors with an update on the trade war in the lead up to the G20 meeting in Osaka.1 While a new tariff ceasefire may emerge from the meeting, the report underscored why the odds are skewed against a positive outcome over the coming 18 months. Our bet is that investors are unlikely to assume that a deal will occur merely in response to a new timetable for talks, implying that any near-term boost to stock prices will be minimal until negotiators provide market participants with evidence (rather than hope) that a deal is achievable. This means that a financial market riot point remains likely over the coming few months, and that a cyclically bullish stance towards Chinese stocks rests on the likelihood of a major policy response in China to counter the likely shock to its export sector. During times of high policy uncertainty, we often take the opportunity to review and update our framework for key asset drivers. In today’s report we review our framework for predicting broad market earnings in China based on the experience of the past decade, and then document the relationship between sector earnings and broad market earnings for both the investable and domestic market. We review the cyclicality of earnings in each sector, and highlight the sectors where relative earnings have been successful at predicting relative performance. We conclude with a summary of what our results would imply over the tactical and cyclical investment horizons given our view of China’s likely growth trajectory, and highlight why several sectors may see a stronger relationship between their earnings and stock prices over the secular horizon. The report illustrates our key conclusions in the body of the text, but reference charts for each sector/industry group in both the investable and domestic market are provided as a convenience on pages 12 - 23. Predicting Chinese Equity Index Earnings Our framework for predicting index EPS is straightforward but reliable. Chart 1Stronger Economic Activity = Stronger Investable Earnings Chart 1 presents the first element of our framework for predicting Chinese investable earnings per share (EPS) growth. The chart illustrates the strong leading relationship between our BCA China Activity Indicator and the year-over-year growth rate of investable EPS, which underscores that the fundamental performance of Chinese equities is still predominantly driven by China’s “old economy”. The leading nature of our activity index partly reflects the fact that earnings per share are measured on a trailing basis; the key point for investors is that indicators such as our Activity Index have been more successful at capturing the coincident trend in China’s economy than, for example, real GDP growth has over the past several years. Chart 2illustrates that the earnings cycle for the investable and domestic equity markets is the same, with the magnitude of a given cycle accounting for the difference between the two markets. This means that investors exposed to the Chinese equity market should be focused heavily on predicting the coincident trend in the economy, as doing so will lead investors to the same conclusion about the trend in H- and A-share EPS growth. Chart 2Same Earnings Cycle In The Investable And Domestic Markets Chart 3Our Leading Indicator Reliably Predicts Economic Activity In turn, Chart 3 presents our framework for predicting Chinese economic activity, which we originally laid out in our November 30, 2017 Special Report.2 The chart shows that our leading activity indicator has reliably predicted inflection points in actual activity over the past several years, including the slowdown of the past two years (the leading indicator peaked in Q1 2017). As detailed in the report, our indicator is based on monetary conditions and money & credit growth. Panel 2 of Chart 3 shows that monetary conditions are very easy and credit growth is picking up, though it needs to continue to improve alongside a forceful pickup in money growth in order for the economy to strengthen. The key takeaway for investors is that the overall earnings cycle in China is strongly linked to “old economy” economic activity, which in turn appears to reliably predicted by our indicator. This provides us with a stable platform from which we can examine (and ultimately predict) equity sector EPS. Sector Earnings: Predictability And Cyclicality Given the strong link between Chinese economic activity and equity market EPS that we noted above, the question for equity-oriented investors is then to identify the relationship between sector and overall index EPS. In other words, to what degree are sector EPS in China linked to the overall earnings trend (versus being driven by idiosyncratic factors), and is this relationship pro- or counter-cyclical in nature? Charts 4 and 5 present the answers to these questions, based on the 2011 – 2018 period.3 The charts present the highest R-squared value resulting from a regression of detrended sector EPS versus broad market EPS for both the investable and domestic markets, after accounting for any leading/lagging relationships. The color/shading of each bar denotes whether the beta of the relationship for each sector or industry group is above or below 1. The charts present a mix of surprising and unsurprising results. Among the latter in the investable market, the cyclicality of typically high-beta sectors such as energy, materials, industrials, consumer discretionary, and technology would be readily accepted by most investors, as would the defensive characteristics of financials, telecom services, health care, utilities, and consumer staples. Investable consumer staples, health care, and utilities EPS are driven by either bottom-up/industry-specific factors or macro factors that are not fully captured by the trend in China’s business cycle. However, there were several less-intuitive results that emerged from our analysis, related to both the investable and domestic markets: Within the investable market, the low predictability of health care, utilities, and consumer staples EPS is somewhat difficult to explain. A weak relationship would easily be explained if EPS growth for these sectors were somewhat constant in the face of fluctuations in overall index EPS, but Chart 6 shows that the volatility in EPS growth for these sectors are not bottom-ranked (see also pages 16, 17 and 22). In fact, utilities EPS growth vol has been relatively high, and it is higher for health care and consumer staples than it is for financials and banks, whose EPS growth are highly linked to the overall earnings cycle. This result suggests that the determinants of earnings for these sectors are driven by either bottom-up/industry-specific factors or macro factors that are not fully captured by the trend in China’s business cycle. The low predictability of consumer staples and utilities EPS observed in the investable market is also evident in the domestic market, suggesting that this finding is not the result of quirky data. We noted earlier that overall index earnings are highly correlated with our BCA China Activity Index, and we have noted in past reports that China’s business cycle continues to be subject to its “old” growth model centered on investment and exports rather than the services and consumer sectors.4 This may explain the relatively idiosyncratic EPS profile for consumer staples, although it still fails to explain the low predictability and relatively high volatility of utilities earnings. Telecom services and technology earnings also have a very low correlation with overall earnings in the domestic market, which is similar to the investable market but more extreme. On the tech front, this is explained by the fact that Alibaba and Tencent, China’s tech giants, are not listed in the domestic market, underscoring that investable tech and domestic tech should be considered by investors to be distinctly separate sectors. In the investable market the low predictability and defensive characteristic of telecom services EPS can be explained by stable, low-volatility growth, but this is not true in the domestic market. In fact, over the past several years the volatility of domestic telecom EPS growth has been among the highest of any of China’s domestic equity sectors, and it has been cyclical rather than defensive in nature. These findings are difficult to explain from a top-down perspective. Finally, while Charts 4 and 5 show a difference in the cyclicality of real estate earnings between the investable and domestic markets, the difference is not substantial: the beta of the former is 1.03 versus 0.94 for the latter. The truly surprising result from real estate stocks is that their EPS growth is not considerably high-beta, given the boom & bust nature of Chinese property prices and the enormous amount of activity that has occurred in Chinese real estate over the past decade. Given that beta is determined relative to the overall index, this is emblematic (and an important reminder) of the underlying cyclicality of China’s economy and its financial markets relative to its global counterparts. Sector Earnings: Relevance For Stock Prices Following our review of the predictability and cyclicality of Chinese sector EPS, Charts 7 and 8 illustrate the relationship between relative EPS and relative stock price performance for these sectors. The charts highlight several notable points: In both the investable and domestic markets, the relative performance of energy and consumer discretionary stocks have been highly explained by the trend in relative EPS. Both of these sectors have also shown reasonably high EPS predictability (based on overall index EPS), suggesting that these two sectors have historically been the best candidates for a classic top-down fundamental “sector rotation” strategy. The relative re-rating of consumer staples and de-rating of banks reflects the existence of a long consumer economy / short industrial economy trade. Chart 9Multiples Have Been More Important In Driving The Returns Of These Sectors Within the investable market, relative EPS has not been successful at predicting relative stock price performance for financials/banks, health care, consumer staples, and industrials. This means that multiple expansion/contraction has been a relatively more important factor in driving returns, which can clearly be seen in Chart 9. The chart shows that investable banks, health care, and industrials have been meaningfully de-rated over the past several years, whereas the relative P/E ratio for consumer staples stocks has risen (albeit in a choppy fashion). Domestic consumer staples have also benefited from re-rating, although it has occurred entirely within the past three years and has merely made up for the substantial de-rating that took place in 2012 (Chart 9, panel 2). Taken together, the relative re-rating of consumer staples and de-rating of banks and industrials reflects, at least in part, the existence of a long consumer economy / short industrial economy trade. The relative EPS trend of utilities in both markets and that of telecom services stocks in the investable market have done a decent-to-good job of predicting relative stock price performance. We noted earlier that investable telecom services earnings appear to have a weak relationship with overall index earnings because of their low variability, meaning that they have also been a good top-down rotation candidate on the defensive side of the spectrum. The high responsiveness of the relative equity performance of Chinese utilities to relative EPS raises the importance of predicting the latter, which is likely to be a topic of future reports for BCA’s China Investment Strategy service. Finally, Chart 7 shows that the most important sector trend in the investable market over the past several years, the outperformance of information technology, has been strongly explained by the trend in relative EPS. This is good news for investors, as it suggests that relative tech returns can be reasonably predicted by accurate earnings analysis. From a top-down perspective, we noted earlier that the relationship between tech and overall index EPS has not been extremely high, which raises the bar for investors to understand the idiosyncratic drivers of earnings for the BAT (Baidu, Alibaba, and Tencent) stocks. Chinese consumer spending remains the most important macro factor for these stocks, but our understanding of this relationship is not complete and is an area of ongoing research at BCA. Investment Conclusions Chart 10 summarizes the results of Charts 4-5 and 7-8, by grouping investable and domestic equity sectors into four quadrants based on top-down EPS predictability (x-axis) and the impact of the trend in relative EPS on relative stock price performance (y-axis): Over a multi-year time horizon, the relationship between relative earnings and relative stock prices is likely to rise for several sectors. As we noted above, energy and consumer discretionary in both markets along with real estate and financials in the domestic market have had the strongest relationship across both dimensions (top-right quadrant). The EPS relationship is cyclical in both markets in the case of energy and consumer discretionary, whereas it is modestly cyclical for domestic real estate and defensive for domestic financials. Sectors in the top-left quadrant have shown a strong link between earnings and stock price performance, but a weaker link between sector and index earnings. This is the case for telecom services because of relatively steady, low volatility earnings growth, meaning that telecom stocks are reliably defensive. Fluctuations in the growth of index EPS do not explain the majority of changes in investable tech EPS, but it is an important driver in a cyclical relationship. Sectors in the bottom-right quadrant have a predominantly strong and defensive relationship with index earnings growth (with the exception of domestic industrials), but have experienced significant changes in multiples over the past several years that have materially impacted their relative stock price performance. We showed in Chart 9 that banks have been meaningfully de-rated over the past several years; this process appears to have halted at the end of 2017, suggesting that the relationship between relative earnings and relative stock prices may be stronger going forward. Chart 11Investable Real Estate And Materials Stocks Trade At A Huge Discount Finally, sectors in the bottom left quadrant have had relatively idiosyncratic earnings trends, and relative EPS have not explained a majority of the trend in relative performance. We would draw a distinction between investable industrials, real estate, and materials and the rest of the sectors shown, as they are on the cusp of being in the top-right or bottom-right quadrants, and all three appear to have suffered from meaningful de-rating. Investable real estate and materials now trade at over a 40% discount to the overall index (Chart 11), raising a serious question as to whether relative P/Es can continue to compress and explain the majority of relative equity performance. However, investable consumer staples and health care, along with domestic technology and telecom services stocks, do appear to be legitimately idiosyncratic, suggesting that an equity beta approach (regressing sector returns against index returns) is the best top-down method available to investors when allocating to these sectors. For investable staples and health care their equity return betas are clearly defensive, whereas domestic tech and telecom services stocks are market neutral. What does this all mean for investors? Our findings above lead us to some specific conclusions over the tactical (0-3 months), cyclical (6-12 months), and secular (multi-year) horizons: Over the cyclical horizon, we expect Chinese co-incident economic activity to pick up and for overall index EPS to improve, suggesting that global investors have a fundamental basis to be overweight investable energy, consumer discretionary, materials, media & entertainment (within the new communication services sector) and industrial stocks, at the expense of telecom services and financials.5 Investable health care, consumer staples, and utilities stocks are also likely to underperform, although this view is based on a statistical/empirical relationship rather than a fundamental one. In the domestic market, our findings support substituting real estate for technology in comparison to the investable sectors we listed above, but we are concerned that policymakers may crack down more heavily on the property sector if they allow overall credit growth to rise meaningfully as part of a stimulative response. For now, we would not recommend aggressive bets in favor of the domestic real estate sector. Chart 12Flagging Earnings Growth Heightens Tactical Risks To Chinese Stocks Over the tactical horizon, however, we would advise either the opposite stance, or a benchmark sector allocation. In addition to our view that a financial market riot point remains likely over the coming few months to force policymakers to address the economic weakness that an escalated tariff scenario would entail, broad-market Chinese EPS growth continues to decelerate (Chart 12). We see this continued slowdown as a lagged response to past economic weakness, which we expect will be reversed over the coming year due to stronger money & credit growth. However, sectors with pro-cyclical earnings growth may fare poorly in the near term until investors gain confidence that the (inevitable) policy response will stabilize the earnings outlook. Over the secular horizon, the most important conclusion is that there have been several long-term sectoral de/re-rating trends within China’s equity market. In the investable market, health care, consumer staples, and consumer discretionary (of which Alibaba is heavily represented) trade at 100-200% of a premium relative to the broad equity market on a trailing earnings basis, whereas financials, materials, and real estate stocks trade at a 40-60% discount. These divergences also exist in the domestic market, although the range is somewhat less extreme. A simple contrarian instinct might be to strategically overweight/underweight expensive/cheap sectors, but to us the simpler conclusion is that the extreme nature of these trends means that the strength of the relationship between EPS and stock prices for these sectors is set to rise. Over the coming few years, investors should focus nearly exclusively on the earnings outlook for high flying and beaten down sectors, a question that is very likely to be the topic of additional China Investment Strategy reports this year. Stay tuned!   Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com     Reference Charts Energy Chart 13 Chart 14 Materials Chart 15 Chart 16   Industrials Chart 17 Chart 18   Consumer Discretionary Chart 19 Chart 20   Consumer Staples Chart 21 Chart 22   Health Care Chart 23 Chart 24   Financials Chart 25 Chart 26   Banking Chart 27 Chart 28   Information Technology Chart 29 Chart 30   Telecom Services Chart 31 Chart 32   Utilities Chart 33 Chart 34   Real Estate Chart 35 Chart 36   Footnotes 1      Please see Geopolitical Strategy and China Investment Strategy Special Report, “Another Phony G20? And A Word On Hong Kong”, dated June 14, 2019, available at cis.bcaresearch.com. 2      Please see China Investment Strategy Special Report, “The Data Lab: Testing The Predictability Of China’s Business Cycle”, dated November 30, 2017, available at cis.bcaresearch.com. 3      S&P Dow Jones and MSCI Inc. implemented major structural changes to the Global Industry Classification Standard (GICS) in Q4 2018 that substantially altered the sector composition of the MSCI China Investable index. The weight of the information technology sector in the investable index dropped dramatically after the GICS changes occurred. Investors should note that we used Q3 2018 as the end date of our analysis in order to remove any impact from the GICS sector change; the reference charts shown on pages 12 – 23 provide all data since 2011. 4     Please see China Investment Strategy Weekly Report, “The Three Pillars Of China’s Economy”, dated May 16, 2018, available at cis.bcaresearch.com. 5      Due to the changes to the GICS classification structure noted in footnote 3, the tech sector relationships that we highlighted above now apply to the consumer discretionary sector (level 1) and media & entertainment industry-group (level 2, within the new level 1 communication services sector. Cyclical Investment Stance Equity Sector Recommendations