Financial Markets

Highlights Portfolio Strategy Chinese reflation, the ongoing global capex upcycle, and the Fed induced cap on the greenback with the knock-on effect of higher commodity prices, all signal that it still pays to overweight S&P cyclicals at the expense of S&P defensives.  Sustained EM stock outperformance, a soft U.S. dollar, improving semi equipment operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside.   Recent Changes There are no changes in the portfolio this week. Feature The SPX consolidated the 350 point advance since the Christmas Eve trough last week, setting the stage for a durable advance in the coming months. The Fed stood pat last Wednesday, and signaled a much more dovish policy stance going forward. Chairman Powell was clearly humbled by last December’s convulsing equity market and abrupt tightening in financial conditions. On that front, in the latest FOMC statement the explicit mention of patience is significant: “the Committee will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate”. A definitively more dovish Fed, which will help restrain the greenback, remains one of the three key catalysts for a durable equity market advance as we have highlighted in recent research.1 Encouragingly, our proprietary Equity Capitulation Indicator (ECI) has bottomed at two standard deviations below the historical mean (Chart 1). Over the past two decades, such a depressed level in our ECI has marked previous equity market troughs including the early-2016, 2011, 2002 and 1998 iterations. Only the GFC episode was lower, falling to three standard deviations below the mean. Clearly the late-December selling frenzy registers as another investor capitulation point and, if history at least rhymes, more gains are in store for the broad equity market. Chart 1Capitulation Chart 2 shows some other measures of breadth that corroborate our ECI’s message: investors hit the panic button and exited equities in droves in Q4. The upshot is that with selling exhausted, stocks can now stage a durable recovery as long as profits continue to expand. As a reminder, the continuation of the earnings juggernaut is the second key catalyst we identified two weeks ago.2 Midway through earnings season, SPX EPS have held up well with growth approaching 16%. For calendar 2019 we expect mid-single digit EPS growth in line with the signal from our macro driven S&P 500 EPS growth model (please refer to Chart 4 from the mid-January Weekly Publication).3 Chart 2Selling Is Exhausted A positive resolution to the U.S./China trade spat is the third catalyst we highlighted recently in order for equities to break out to fresh all-time highs.4 Related to this, China’s reflation efforts are equally important. On that front, news of quasi QE from the PBOC suggests that the Chinese authorities remain committed to injecting liquidity into their economy.5 Already, the PBOC balance sheet, with over $5.5tn in assets, is expanding anew. Empirical evidence suggests that SPX momentum and the ebb and flow of the PBOC balance sheet are joined at the hip, and the current message is positive (second panel, Chart 3). Chart 3Heed The PBoC Message Beyond the PBOC balance sheet expansion, the Chinese six-month credit impulse is also in a sling shot recovery. This Chinese credit backdrop is enticing and moves more or less in tandem with the SPX six-month impulse (top panel, Chart 4). Chart 4Reflating Away Two forces explain these relationships. First, China’s rise to become the second largest economy in the world along with its insatiable appetite for commodities and durable goods. Second, 40% of S&P 500 sales are international and an increasing share now originates in emerging markets in general and in China in particular. Keep in mind that the S&P cyclicals/defensives ratio is not only a high beta play on the SPX itself (top panel, Chart 3), but also an S&P global versus domestic gauge. Thus, both of these Chinese indicators also enjoy a positive correlation with the cyclicals vs. defensives tilt (bottom panels, Charts 3 & 4). With that in mind, this week we are drilling deeper into why we continue to prefer S&P cyclicals over S&P defensives and also highlight a highly cyclical index we went overweight in mid-December that has gone parabolic. Double Down On Cyclicals Vs. Defensives Early-October 2017 marks the initiation of our cyclical vs. defensive preference. Initially, this tilt jumped and peaked in mid-2018 returning 18% since inception. Since then, it has given up all of those gains and then some before troughing with the market on Christmas Eve, suffering a 6% drop since inception. Currently, the ratio has moved full circle and is back to where it was when we first recommended this portfolio bent (Chart 5). Chart 5Full Circle Should investors commit capital to this tilt at this stage of the cycle and given the current global macro backdrop? The short answer is yes. Charts 3 & 4 show that China’s reflation efforts and the fate of the S&P cyclicals/defensives ratio are closely correlated. In addition to the PBOC’s expanding balance sheet and rising Chinese credit impulse, Chinese monetary easing also benefits S&P cyclicals at the expense of S&P defensives. The Chinese reserve requirement ratio (RRR) has plummeted to the lowest point since the GFC and Chinese interest rates are also plumbing multi-year lows (RRR shown inverted, top panel, Chart 6). Chart 6China Flashing Green Tack on a resurgent currency with the CNY briefly breaking 6.70 with the U.S. dollar, and factors are falling into place for a playable rally in the cyclicals/defensive ratio. Likely, the Chinese are trying to appease President Trump by underpinning the yuan, but the Fed’s recent more dovish stance on interest rate hikes is also pushing the greenback lower. Taken together, this is a boon for the commodity exposed U.S. cyclicals that also garner a significant share of their sales from abroad (bottom panel, Chart 6). Commodity prices troughed last September, staying true to their leading properties and have been in recovery mode ever since (top panel, Chart 7). Now that the Fed has capped the U.S. dollar, more gains are in store for commodities and that is a boon for commodity producers’ top line growth prospects. Chart 7Capex Remains Healthy The demand backdrop is also enticing at the current stage of the business cycle, not only domestically, but also in China. Capital outlays remain upbeat and despite some recent turbulence, U.S. capex intentions are near multi-year highs (third panel, Chart 7). In China, recent piece meal fiscal easing announcements are far from negligible; already infrastructure spending has jumped after contracting late last year (second panel, Chart 7). Were these announcements to get supplemented by a bigger and more comprehensive package, then commodity-levered equities will excel further. A look at the relative balance sheet health of cyclicals versus defensives is revealing. Cyclicals are paying down debt and their cash flow continues to improve, still recovering from the late-2015/early 2016 global manufacturing recession. On the flipside, defensives are piling on debt. All four safe haven sectors have been degrading their balance sheets (relative net debt-to-EBITDA shown inverted, middle panel, Chart 8). Interest coverage sends a similar message: cyclicals are in excellent health both in absolute terms and compared with defensives (top panel, Chart 8). Chart 8B/S Improvement Continues Sell-side analysts have not yet taken notice of the macro tide that is turning in favor of cyclicals over defensives. Relative forward profit growth has collapsed to nil and net EPS revisions are at previous nadirs (fourth & fifth panels, Chart 9). Chart 9Oversold And Unloved In sum, if our thesis pans out that China will continue to reflate, global capex will remain vibrant, the greenback will drift lower (U.S. dollar shown inverted, top panel, Chart 9) courtesy of a dovish Fed that will push the broad commodity complex higher, then a significant valuation rerating looms for the cyclicals/defensives tilt (second panel, Chart 9). Bottom Line: Continue to the prefer S&P cyclicals to S&P defensives. We also reiterate our recent long S&P materials/short S&P utilities pair trade.6 Semi Equipment: Buy Into Strength In mid-December we boosted the S&P semi equipment index to overweight from underweight and since then this niche chip subindex has outperformed the broad market by 17%.7 Semi equipment stocks are high beta (bottom panel, Chart 10) and, while we are recommending to buy into strength, from a portfolio risk management perspective, today we are also setting a trailing stop at the 10% return mark in order to protect profits in this tactical (three-to-six month time horizon) position. Chart 10Buy Into Strength... These high-octane highly-cyclical tech stocks move in lockstep with other volatile asset classes. Rebounding emerging market (EM) stocks and FX confirm the S&P semi equipment breakout, and signal additional gains in the coming months (Chart 11). Not only do they share the high-beta status, but also semi equipment stocks garner 90% of their sales outside U.S. shores and 21% of total revenues come from China (please refer to Table 3 in our December 17, 2018 Weekly Report). Thus, the tight inverse correlation with the greenback and positive correlation with the outperforming EM stocks comes as no surprise (Chart 11). Chart 11...But Expect Heightened Vol Importantly, Taiwan and Korea are chip manufacturing hubs and semi equipment stocks are levered plays on the macro backdrops of these two economies. Recent data suggests that a turn is in the making in two key indicators in these countries, respectively. Taiwanese tech capex has likely troughed at a depressed level (middle panel. Chart 12), and Korean electronic components manufacturing capacity is now contracting for the first time since late-1997 (bottom panel, Chart 12). The latter is significant as this abrupt and sizable reining in of productive capacity will soon help arrest the fall in chip prices, which serves as an excellent pricing power proxy for the semi equipment industry. Chart 12Green Shoots Historically, relative forward profit growth and DRAM price momentum are joined at the hip. Therefore, were DRAM prices to exit deflation on the back of constrained Korean capacity, that would be a boon for relative profit prospects (second panel, Chart 13). Chart 13Analysts Have Thrown In The Towel Despite these marginal positive developments, sell-side analysts’ pessimism reigns supreme. Industry revenue and profit growth expectations trail the broad market by a wide margin and net EPS revisions remain as bad as they get. The upshot is that these lowered profit and sales growth bars will be easy to surpass in 2019 (Chart 13). With regard to technicals and valuations, oversold conditions bounced, as we posited in mid-December using history as a guide, but still remain depressed (middle panel, Chart 14). Valuations are compelling with the S&P semi equipment forward P/E trading at a roughly 40% discount to the overall market (fourth panel, Chart 13). Chart 14Technicals Remain Depressed Finally, earnings season has revealed that the bifurcated semiconductor market has staying power with semi equipment stocks (we are overweight) outperforming their ailing semi producer brethren (we remain underweight). Netting it out, sustained EM stock outperformance, a soft U.S. dollar, improving industry operating metrics, along with compelling relative valuations and technicals, all suggest that there are high odds that the recent semi equipment run up has more upside. Bottom Line: Maintain the overweight stance in the S&P semi equipment index for a while longer, but set a trailing stop at the 10% relative return mark in order to protect profits in this tactical (three-to-six month time horizon) position. The ticker symbols for the stocks in this index are: BLBG: S5SEEQ – AMAT, LRCX, KLAC.   Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com Footnotes 1      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 2      Ibid. 3      Please see BCA U.S. Equity Strategy Report, “Catharsis” dated January 14, 2019, available at uses.bcaresearch.com. 4      Please see BCA U.S. Equity Strategy Weekly Report, “Dissecting 2019 Earnings” dated January 22, 2019, available at uses.bcaresearch.com. 5      Please see Bloomberg Article, “PBOC Sets Up Swap Tool to Aid Bank Capital via Perpetual Bonds” dated January 24, 2019, available at www.bloomberg.com. 6      Please see BCA U.S. Equity Strategy Report, “Trader’s Paradise” dated January 28, 2019, available at uses.bcaresearch.com. 7      Please see BCA U.S. Equity Strategy Report, “Signal Vs. Noise” dated December 17, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Highlights Our non-consensus inflation and Fed views just got even more non-consensus: Media and sell-side commentators were quick to speculate about an end to the tightening cycle following Wednesday’s FOMC meeting, but we don’t see any basis for changing our stance. December and January have been a wild couple of months, … : It’s not unusual for a swing in one direction to be following by a swing in the other, but the S&P 500 went from the 2nd percentile in December to the 96th percentile in January. … and we’re turning to our equity checklist to regain our bearings: Checklists help us maintain a healthy distance from day-to-day swings and focus on the key swing factors. For now, we don’t think anything much has changed, but the scope for a repricing of the entire Treasury curve has gotten bigger: The wider the disparity between our terminal fed funds rate expectation and the market’s, the greater the potential for yields to readjust. We continue to believe markets are being complacent about inflation pressures; their presence will force the Fed off the sidelines and ultimately spell the end of the expansion. Feature Brutal arctic cold swept the Midwest and the Northeast Corridor last week as the polar vortex clamped down on Canada and the upper U.S. The weather didn’t do anything to cool investors’ revived ardor for stocks, however. After finally taking a break from its nearly uninterrupted four-week sprint from 2,350 to 2,670 (that’s nearly 14% in just 17 sessions), the S&P 500 hung around the 2,640 level that supported it repeatedly during its October, November and early December travails (Chart 1). Then came Wednesday’s FOMC statement and press conference, and the S&P even poked its head above the 2,700 level that would seem to present a fairly stiff challenge (Chart 2). Chart 12,640 Lent Support Once Again …   Chart 2... Will The Next Round Number Offer A Little Resistance? What Goes On One minute born, one minute doomed/ One minute up, and one minute down/ What goes on in your mind?/ I think that I am falling down If the conditions were polar out of doors, they were bipolar on traders’ screens. As much as the clients we spoke with in January were initially skeptical about our inflation view (it’s not dead) and our corresponding Fed call (at least three or four more hikes in response to budding price pressures), several of them seemed to come around before the meeting was over. They had a lot harder time with the two-part investment conclusion that risk assets would rally while the Fed was on hold, and the economy and corporate profits were able to gain a footing, before rolling over once the data become strong enough to bring the Fed back off the sidelines. Why would investors buy into the temporary part one? We offered the view that the selloff had gone too far, and seemed to have been founded upon a premise that the Fed had either already tightened into a recession, or had gotten uncomfortably close to doing so. We expect that a Fed pause will reveal that the market’s neutral-rate estimate had been way too low. Once the economy shows signs of life, and consensus earnings estimates stop declining and begin to rise again, stocks will rise, spreads will compress, and investors will get back to chasing performance. The renewed fundamental vigor could even allow the Fed to hike rates another couple of times without inspiring a new bout of market indigestion. After this week, we are the ones scratching our heads. The committee’s post-meeting statement did change more than it has since the gradual, 25-bps-per-quarter pace of hikes took hold at the end of 2016, but early January’s procession of Fed speakers who repeated “patience” like a mantra already telegraphed an extended pause. We did not read all that much into the substitution of “will be patient as it determines … [appropriate] adjustments” for “some further gradual increases,” even if the media and the markets did. We will have more to say about the Fed’s balance sheet in subsequent research, but suffice it to say for now that we do not think it will be terribly impactful. Bottom Line: While we were surprised by the intensity of the reaction to last week’s FOMC meeting, it remains our view that the pause in the Fed’s monetary tightening campaign will give equities and corporate bonds an opportunity to rally near their late September levels. Checking And Re-Checking Our Views Among our favorite trading-desk maxims is the advice to plan your trade, and trade your plan. Checklists help us plan and help establish a repeatable process. Having a process to fall back on when rapid-fire decisions have to be made allows an investor to react to conditions as they arise without suffering from analysis paralysis, just like a seasoned trader. Checklists aren’t magic, but they can help an investor keep his/her bearings in the midst of market tides that seem to sweep all before them. Confronting the combination of December’s despondency and January’s euphoria, we return to the equity downgrade checklist we rolled out in mid-October, and last formally reviewed in mid-November. The checklist attempts to look out for threats on four fronts: a looming recession, which would bring the curtain down on the bull market; earnings pressure independent of a full-fledged recession; inflation pressures that could compel the Fed to tighten policy with a renewed sense of urgency; and unsustainably positive sentiment, which could set equities up for a fall. At the moment, only the recession category could arguably be said to be flashing yellow. Recession Watch All three factors in our simple recession indicator are moving in the wrong direction, but the yield curve is the only one at a potentially problematic level (Chart 3, top panel). It would not be a disaster for equities or the economy if the curve inverted – it is habitually early, inverting a year before a recession, on average, and six months before the S&P 500 peaks – but we don’t think it will until markets begin pricing in new rate hikes. Assuming the three-month rate won’t move until they do, the curve could only invert if the 10-year Treasury yield were to fall into the 2.40s (Chart 3, bottom panel), which would be incompatible with our constructive economic view. By the time the Fed resumes hiking, the curve should have gained some breathing room, as an economy strong enough to require further tightening merits a 10-year Treasury yield at or above 3%. Chart 3The Curve Isn’t Ready To Invert Just Yet Year-over-year growth in the leading economic indicator decelerated sharply over the last three months of 2018 (Chart 4). It is a ways away from contracting, however, and only a series of hefty month-over-month drops could make it do so this quarter. Our estimate of the equilibrium fed funds rate remains 50 bps above the 2.5% target rate and our model projects that equilibrium will rise throughout the rest of the year. If its 3.25-3.5% year-end estimate is on the money, the Fed would have to hike three or four more times by year end to provide the restrictive backdrop required for a recession. Chart 4Decelerating, But Not Contracting Checking the final item in the recession section of the checklist, a 33-basis-point rise in the three-month moving average of the unemployment rate, would require a sharp hiring slowdown and/or a significant pickup in labor force participation. The January employment report makes a drop-off in hiring appear improbable, and we are skeptical that the participation rate can keep rising in spite of the drag from retiring baby boomers. If the unemployment rate were to rise because of a rising part rate, however, it might well be more likely to extend the expansion than end it. Bottom Line: The elements of our recession indicator are deteriorating, albeit slowly. A recession may not be more than a year away, but we can’t see it occurring until the Fed turns more hawkish. Earnings Pressure We have repeatedly offered our view that the labor market is as tight as a drum in print, calls and meetings. That is good for the economy because it increases households’ ability to consume, but it will eventually squeeze profit margins and induce the Fed to remove monetary accommodation. Compensation costs shouldn’t hurt margins if they grow at or below the sum of the rate of price-level and productivity gains. If inflation grows at the Fed’s 2% target, and productivity maintains its rough 1.25% growth pace, compensation growth of 3.25% shouldn’t pose a problem, but gains exceeding 3.5% might become problematic. The total compensation series of the employment cost index ticked up to 2.9% in the fourth quarter, but an assault on 3.25-3.5% does not appear to be at hand (Chart 5). Chart 5Wages Aren’t Pressuring Margins Yet Dollar strength is a margin headwind for any company competing with multinationals, at home or abroad. After peaking in mid-November and mid-December, the DXY index has rolled over and is back to its early October level (Chart 6). The fourth-quarter blowout in spreads had us poised to check the “rising corporate yields” box, but there’s no need following last month’s reversal (Chart 7). The savings rate has recovered enough to support spending, and there’s currently no sign that consumers are about to pull back (Chart 8). We are monitoring conditions in emerging markets for spillover into the U.S., but the dollar’s decline and the broad recovery in risk assets worldwide have taken pressure off of EM corporate and sovereign borrowers. Chart 6The Dollar's Backed Off …   Chart 7... And Bond Yields Have, Too   Chart 8Ready, Willing And Able Bottom Line: None of our proxy indicators suggests that corporate earnings face meaningful near-term pressure, either from tighter margins or lower revenues. Inflation Pressures Inflation poses a threat to equities if it makes the Fed uncomfortable enough to pull the plug on the expansion to keep the economy from overheating, or if it makes investors uncomfortable enough to apply a significant haircut to earnings multiples. Given the Fed’s “symmetric” target, we don’t think it will get anxious about core PCE inflation unless it threatens to exceed 2.5% (Chart 9). The 10-year and 5-year-on-5-year TIPS inflation breakevens have slid in lockstep with oil prices, and are nowhere near the 2.3-2.5% range that is consistent with the Fed’s 2% core PCE target (Chart 10); they offer no hint that longer-run inflation expectations might become unanchored. CPI is the go-to inflation series for investors and the media, and with both headline and core hanging around 2%, it is well short of levels that would promote anxiety among the public (Chart 11). Chart 9Realized Inflation Remains Contained …   Chart 10... And Expectations Have Only Fallen   Chart 11Nothing To See Here Bottom Line: We expect that unnecessary fiscal stimulus and an extremely tight labor market will eventually produce inflation, but they’re not testing investors’ complacency yet. Overexuberance Runaway sentiment could spark a nasty correction if it sets the bar for expectations so high that stocks inevitably disappoint. BCA’s composite sentiment indicator, which aggregates the results from surveys of individual investors, professional investors and advisors, is at the lower end of its range, though not yet at levels that have often marked equity bottoms (Chart 12, bottom panel). Before falling with the S&P 500 last January, the share of consumers expecting stock prices to rise over the next twelve months had reached a level consistent with past peaks (Chart 13, bottom panel). It has since fallen to the lower end of its range, and would seem to suggest that investors had nearly given up on stocks when the January survey was taken. Chart 12Investor Sentiment Is Muted …   Chart 13... And So Is The General Public’s Bottom Line: The fourth-quarter decline pushed investor sentiment from around the higher reaches of its historical range to a position well below the mean. From a contrarian perspective, washed-out sentiment could help extend the rally. Investment Implications Our equity downgrade checklist gives U.S. equities a clean bill of health. Although potential gains are lower now with the S&P 500 trading above 2,700 than they were when it was trading below 2,500 at the beginning of the year, we do not see a fundamental reason to downgrade equities from overweight. The multiple expansion required to produce a new closing high might be a stretch, but we believe the S&P 500 can advance well into the 2,800s. We upgraded corporate credit last week, and expect that spreads will narrow as the Fed stays on the sidelines. One should not expect new tights in spreads, but there is potential for investors to augment their coupon spreads with some modest capital appreciation. We dislike Treasuries, especially at longer maturities, even more than we did before last week’s bull flattening of the yield curve. With rate hikes fully priced out, the only way the 10-year Treasury yield could fall even further would be if the Fed cut rates, and that scenario is flatly incompatible with our assessment of the economy’s strength.   Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com

Special Report

Highlights The CAD and AUD have tactical upside; however, this may well prove to be the last hurrah before some serious declines play out. This time domestic – not global – factors will drive the CAD and AUD lower. Canada and Australia are hitting the end game for their respective debt supercycles as rising U.S. rates will lift the global cost of capital. Canadian and Australian house prices and debt loads are too elevated; a reversal of these excesses is likely to push these two countries toward liquidity traps. These liquidity traps will cause the R-star in Canada and Australia to fall, lagging well behind the U.S. Canada and Australia are uncompetitive, suggesting external demand will not come to their respective rescue, at least not until after the CAD and AUD have fallen significantly. The CAD may fall first, but the AUD has more downside ultimately; not only is Australia even less competitive than Canada, but the Aussie is also more expensive than the Loonie. Feature The Canadian and Australian dollars are in the process of rebounding. This is not surprising. By the end of 2018, both these currencies were deeply oversold, and the recent easing in global financial conditions, helped by the Federal Reserve’s pause, is fueling their rebound (Chart 1). Moreover, pessimism toward China has hit an extreme, yet Sino-U.S. trade relations seem on the cusp of improving and Chinese policymakers are increasingly trying to manage the downside in the Chinese economy. This setup is normally supportive for the Canadian and Australian dollars (Chart 2). Chart 1Financial Conditions Point To A Tactical Rebound In The AUD And The CAD...   Chart 2...So Does Chinese Reflation While we have been recommending that our more tactically minded clients play this rally,1  the longer-term outlook for the CAD and AUD remains poor. These countries are getting closer to the end of their respective debt supercycles. Consequently, the CAD and AUD need to trade at much larger discounts to fair value in order to be attractive. Way Too Much Debt Canada and Australia have become victims of their own success. Canada and Australia have seen real estate prices rise for more than two decades. At first, rising prices reflected solid valuations, growing populations and rising prosperity. However, things changed around the Great Financial Crisis. During this traumatic event, the Bank of Canada and the Reserve Bank of Australia both dropped interest rates by 4.25%. Since both countries’ banking sectors escaped the crisis unscathed, and households did not experience similar losses of wealth as those in the U.S., Ireland or Spain, credit growth remained strong. A real estate bubble became the natural consequence of this easy monetary policy. Banks pushed credit to households, and households – impressed by the solid performance of real estate prices, attracted by low interest rates, and enamored with the dream of easy riches – willingly took on mortgages and piled into the property market. A feedback loop ensued, whereby rising collateral values made credit even easier to access, fomenting further house price gains and even-easier credit conditions. Today, we stand at the end of this process. Vancouver and Toronto in Canada, and Sydney and Melbourne in Australia are some of the most expensive real estate markets in world in terms of price-to-income ratios, when one controls for population density (Chart 3). This has created major systemic risks for both countries. Few would care about the systemic risk created by elevated house prices if debt loads were small. However, in both countries, household indebtedness makes Americans circa 2007 look like a frugal bunch. In Canada, household debt has now reached 176% of disposable income, or 100% of GDP, while in Australia, the same ratios are 189% and 121%, respectively. This is well above the levels that prevailed in the U.S. in 2007 (Chart 4). Mortgage debt alone represents 108% and 140% of disposable income in Canada and Australia, respectively. Moreover, Canadian and Australian households also spend 14.5% and 15.6% of their incomes servicing debt, which also compares unfavorably with the U.S. in 2007. Chart 4ACanadians And Australians Make Americans Look Frugal Chart 4BCanadians And Australians Make Americans Look Frugal Canadian and Australian households thus seem close to having reached their maximum debt loads. Moreover, measures taken in Canada and Australia to limit foreign money inflows and constrain bank lending are beginning to bite. In both countries, real estate transactions are slowing, with property sales declining by 20% and 8% in Canada and Australia, respectively. House prices too are being hit. House prices in Vancouver and Toronto peaked by 2018, and in Sydney and Melbourne in 2017. Residential construction is likely to be the first victim. Real estate inventories in both these countries have been rising, courtesy of the frenetic pace of housing starts going on for decades. Today, residential investment represents 7% of GDP in Canada and 5% of GDP in Australia (Chart 5). Thus, slowing real estate activity could curtail Canadian and Australian GDP by 2% if we move back to the real estate environment that prevailed in the mid-1990s. This would also imply large hits to employment as construction, real estate and finance have created 336-thousand and 250-thousand jobs in Canada and Australia since 2009, respectively. Chart 5AA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (1) Chart 5BA Decline In Construction Activity Would Be A Vicious Hit To Canada And Australia (2) Consumption too is likely to suffer. Without a growing wealth effect and with declining equity in their houses, Canadian and Australian households are likely to curtail consumption – consumption that has contributed 60% and 30% of Canada’s and Australia’s cumulative GDP growth since 2009. Already, we are seeing slowing Canadian and Australian retail sales – right behind drops in housing activity. The biggest and most dangerous risk is that Canada and Australia teeter on the verge of falling into a liquidity trap, like the U.S. after 2007. As Chart 6 illustrates, propelled by households binging on cheap money in the form of mortgages, Canadian and Australian banks have managed to maintain higher levels of return on equity after the financial crisis. This robust profitability will decline if non-performing loans, which so far remain low, grow in response to weakening house prices and fragile household financial health (Chart 7). Chart 6Canadian And Australian Banks Remain Profitable... Chart 7...As Long As NPLs Do Not Rise Rising NPLs and declining RoEs tend to limit the willingness of banks to lend. Just as crucially, the poor health of households and falling real estate prices is likely to also limit demand for credit. This combination was behind the sharp decline in the U.S. money multiplier in 2008. No matter how much reserves the Federal Reserve would inject in commercial banks via QE programs, broader money would not respond. A similar fate is likely to ensue in Canada and Australia (Chart 8). The velocity of money is also likely to fall if households are not willing to take on debt anymore and instead focus on rebuilding their financial buffers. Chart 8Canada And Australia Have Avoided A Liquidity Trap... So Far The consequence of this monetary constipation will be much lower interest rates. When an economy enters a liquidity trap, as was the case in the U.S. after 2007, in Japan since the 1990s, or in Europe after 2010, the neutral real rate of interest, the so-called R-star, falls to zero or even lower. Essentially, no matter how low interest rates fall, they cannot equilibrate the demand and supply for savings. Everyone wants to save, no one wants to borrow, and banks are unwilling to lend. This fate looks increasingly likely for both Canada and Australia over the coming two years. Bottom Line: The Canadian and Australian real estate markets have enjoyed incredible runs for more than two decades. Now, not only are real estate prices in these two nations very expensive, households have been left with prodigious debt loads. As real estate activity slows, residential construction will suffer, but most importantly, these two countries are likely to teeter toward becoming liquidity traps as banks curtail lending and households curtail borrowing. This will result in structurally lagging interest rates. Why Now? Betting on the end of the Canadian and Australian housing bubbles has so far been mugs games. Why is the situation different now? Because the U.S. economy is stronger. Until now, very low global interest rates have kept the Canadian and Australian housing bubbles afloat, but rising U.S. interest rates are now putting upward pressure on mortgage rates in both Canada and Australia (Chart 9). This simply reflects the fact that U.S. rates represent the ultimate opportunity cost of investing outside the international reserve currency, the U.S. dollar. After years of household deleveraging, the U.S. seems to be able to handle higher rates. However, because Canadian and Australian balance sheets are much weaker, their tolerance for higher rates is substantially lower. Chart 9Higher U.S. Rates Threaten Canadian And Australian Households BCA sees further upside for U.S. rates and thus for the global cost of capital. In other words, we do not anticipate the Fed’s pause to last beyond June. The following reasons underpin this view: The U.S. labor market is increasingly inflationary. The employment-to-population ratio for prime-age workers continues to rise, which historically has boosted labor costs (Chart 10). The New York City Fed Underlying Inflation Gauge points toward higher core inflation (Chart 11). Moreover, Ryan Swift argues in BCA’s U.S. Bond Strategy that an unfavorable base effect will dissipate after February, further reinforcing the upside risk to inflation.2  Being the only component of our Fed Monitor moving toward “easy money required” territory, the tightening in U.S. financial conditions last year was the lynchpin behind the Fed’s pause. The other components of the Fed Monitor have not deteriorated significantly, and they still argue in favor of further rate hikes (Chart 12). Thus, if the recent easing in financial conditions can persist, the Fed will hike again this year.   Chart 11Budding U.S. Inflationary Pressures   Chart 12The Fed Is Pausing Because Of Tightening Financial Conditions, Not The Economy Finally, U.S. productivity is set to pick up over the coming two years. Since a rising capital stock boosts productivity, the recent strength in capex augurs well (Chart 13). Moreover, the demand deficit created by the deleveraging of U.S. households has weighed on productivity. As U.S. credit growth picks up, so will productivity. This is important as rising productivity lifts the neutral rate, and thus creates more room for the Fed to lift interest rates. Chart 13Upside For U.S. Productivity Equals Upside For U.S. Rates Ultimately, all these factors point to higher U.S. rates. As such, it suggests that Canadian mortgage rates, and to a lesser extent Australian ones as well, will experience upward pressure – exactly at the time when households in these two countries are most vulnerable to higher rates. Bottom Line: Higher U.S. rates are the main reason why we expect the Canadian and Australian housing markets and economies to buckle now, finally heeding the call of doomsayers. Higher U.S. rates lift the global cost of capital. While U.S. households are in robust shape and therefore better able to handle higher rates, the same cannot be said about Canadian and Australian households. Can the External Sector Come To The Rescue? This is unlikely. After years of commodity booms and strong domestic demand supported by rising household wealth, the Canadian and Australian manufacturing sectors have been greatly diminished. Much capacity has vanished, and it will be difficult to replace the lost output from falling domestic demand by exports of manufactured goods. The Australian and especially the Canadian corporate sectors are also already heavily indebted, and thus, it could take quite some time before capacity is expanded. Complicating the situation, Canada and Australia are not competitive exporters anymore. As the top panel of Chart 14 shows, since 1980, U.S. unit labor costs have risen by 156%, but they have risen by 183% in Canada and by a stunning 282% in Australia. Productivity trends paint a similar, albeit less dramatic picture. Since 1980, U.S. labor productivity has risen 22% versus its trading partners; in Canada it has declined by 20%, and in Australia, by 5%. Consequently, both Canadian and Australia labor will have to cheapen. Historically, the mechanism through which labor costs decline is higher unemployment, which forces a painful adjustment in wages. These adjustments are likely to force both interest rates and currencies lower. Chart 14Canada And Australia Are Uncompetitive Could China come to the rescue? Via higher commodity prices, both Canada and Australia have been major beneficiaries of the Chinese economic boom. However, while China today is trying to contain its economic deceleration, Chinese policymakers remain fixated on controlling credit growth. This means that China is unlikely to go on another debt binge similar to what transpired in 2009 or in 2015-‘16. As a result, the recent uptick in commodity prices is unlikely to last long. More fundamentally, China is not only trying to move away from its debt-led growth model: It is also trying to move away from its investment-led growth model. This means that the commodity intensiveness of the Chinese economy is likely to decline. China’s emphasis on controlling air pollution will strengthen this trend. As Chart 15 illustrates, when the share of Capex as a percentage of Chinese GDP declines, so does the labor participation rate of Canada and Australia relative to the U.S. This decline in relative participation rates is associated with falling CAD and AUD values versus the U.S. dollar, a consequence of falling growth potential and interest rates. Chart 15AChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (1) Chart 15BChanging Chinese Growth Model Points To Falling Canadian And Australian Participation Rates (2) Bottom Line: Canada’s and Australia’s lack of manufacturing capacity, poor competitiveness, and China moving away from its investment-led growth model suggest that a deflationary environment will ultimately develop in these two nations, at least relative to the U.S. Moreover, the structurally negative outlook on consumption, debt growth and employment suggests that Canadian and Australian neutral rates are likely to fall relative to the U.S. These economic forces point to deeper lows this cycle in the CAD and AUD against the USD. Investment Implications Based on this economic backdrop, both the Canadian and Australian dollar could suffer significant downside in the coming years as their fair value is likely to fall, dragged by interest rates that will lag those in the U.S. However, if an asset is cheap enough, it may nonetheless be an attractive buy. The CAD and AUD do not fall into that camp. Today, the CAD trades in line with our long-term fair-value model, implying that if its fair value falls, the CAD provides zero insulation and will therefore also have to decline. The AUD is in an even worst spot as it currently trades above its fair value (Chart 16). Additionally, the Australian current account deficit is larger than Canada’s. Chart 16The CAD And AUD Are Not Cheap Enough To Compensate For Secular Risks In terms of timing, the Loonie could start weakening before the Aussie. The Canadian housing bubble is likely to collapse first as Canadian mortgage rates are more tightly linked to U.S. ones than Australian rates are. Moreover, the Canadian economy seems even more levered to rising real estate prices than that of Australia. However, a collapse in Vancouver and Toronto housing prices will promptly catalyze similar weaknesses in Sydney and Melbourne. Thus, while the CAD may be the first to take the great plunge, the AUD will not be far behind. Ultimately, the AUD will suffer the greatest decline. Obviously, the more onerous pricing of the AUD contributes to this assessment, but so does the greater lack of competitiveness in Australia than in Canada. Australia is likely to endure deeper deflationary pressures as its labor costs need greater adjustments. Furthermore, Australia already suffers from a larger degree of underutilized labor than Canada. Since the currency – not wages – is likely to withstand the bulk of the competiveness adjustment, this implies that the AUD has more work to do than the CAD. The more expensive valuations of Australian assets also handicap the Aussie versus the Loonie. Australian real estate is pricier than Canadian property, and Australian stocks are more expensive (Chart 17). This means that Australians could end up with deeper holes in their balance sheets than Canadians, and that Australia has scope to witness greater outflows of capital than Canada. Chart 17Canadian Financial Assets Are Cheaper Than Australian Ones... Where Australia shines relative to Canada is in terms of the ability of fiscal authorities to respond to an economic slowdown. Canadian public debt stands at 90% of GDP versus 41% of GDP in Australia. Canada’s cyclically-adjusted primary deficit is already deteriorating, while Australia’s is improving (Chart 18). This means that the Australian governments have deeper pockets and a greater capacity to support domestic demand than Canada’s. This could cushion the deflationary impact in Australia relative to Canada. That being said, the Japanese, Spanish or U.S. experiences argue that once a real estate bubble bursts, fiscal spending can cushion some of the pain, but it cannot eradicate the problem – at least not until banks are recapitalized and the private sector is once again ready to borrow, something that takes years of balance-sheet rebuilding. Chart 18...But Australia Has More Fiscal Space Bottom Line: Both the CAD and AUD are likely to experience substantial downside over the coming years. The CAD and AUD are not cheap enough to compensate for a BoC and RBA that will greatly lag the Fed. While the CAD may weaken first, the AUD will suffer more long-term downside. The Aussie is more expensive, Australia is less competitive than Canada, and it could suffer greater outflows of capital. Continue to underweight Australian and Canadian assets in global portfolios as the AUD and CAD will drag their performance down. Remain short AUD/CAD on a structural basis.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Weekly Report, titled “Global Liquidity Trends Support The Dollar, But…”, dated January 25, 2019, 2018, available at fes.bcaresearch.com 2 Please see U.S. Bond Strategy Weekly Report, “Buy Corporate Credit”, dated January 15, 2019, available at usbs.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Feature The GAA DM Equity Country Allocation model is updated as of January 31st, 2019. The quant model slightly reduced the size of the underweight to the U.S. equities, but U.S. remains the largest underweight in the model and no directional changes among all the countries compared to last month, as shown in Table 1. Table 1Model Allocation Vs. Benchmark Weights As shown in Table 2 and Charts 1, 2 and 3, the overall model outperformed the MSCI world benchmark by 11 bp in January, with a 52 bps of outperformance from Level 2 model offset by a 17 bps of underperformance from Level 1. Since going live, the overall model has outperformed by 118 bps, with Level 2 outperforming by 192 bps and level 1 outperforming by 40 bps. Table 2Performance (Total Returns In USD %)   Chart 1GAA DM Model Vs. MSCI World   Chart 2GAA U.S. Vs. Non U.S. Model (Level 1)   Chart 3GAA Non U.S. Model (Level 2) Please see also the website http://gaa.bcaresearch.com/trades/allocation_performance. For more details on the models, please see Special Report, “Global Equity Allocation: Introducing The Developed Markets Country Allocation Model,” dated January 29, 2016, available at https://gaa.bcaresearch.com. Please note that the overall country and sector recommendations published in our Monthly Portfolio Update and Quarterly Portfolio Outlook use the results of these quantitative models as one input, but do not stick slavishly to them. We believe that models are a useful check, but structural changes and unquantifiable factors need to be considered too in making overall recommendations. GAA Equity Sector Selection Model Dear Client, As advised in our October 2018 Special Alert, we have suspended the GAA Equity Sector Selection Model due to the significant changes in the GICS sector classifications, implemented at the end of September. We will rebuild the model using the newly constituted sectors once full back data is available from MSCI, which we understood would be in December but which we have not received yet. We thank you for your understanding.   Xiaoli Tang, Associate Vice President xiaoliT@bcaresearch.com Amr Hanafy, Research Associate amrh@bcaresearch.com

Feature Half Way Back Since BCA went overweight global equities in late December, the MSCI ACWI index has rallied by 8% and the S&P 500 is back to only 8% off its September historical high. So far, this has been little more than a technical rally from the extreme oversold position in Q4. But with U.S. economic growth still resilient, earnings likely to grow healthily again this year (albeit more slowly than in 2018), and the valuation of risk assets (both equities and credit) no longer a headwind, we expect the rally to continue for some time, and so reiterate our overweight on equities. Recommendations True, there have been some disappointments in U.S. data in recent weeks. In particular, the December manufacturing ISM fell sharply to 54.3 from 59.3, raising fears that the U.S. is starting to decelerate in line with other regions (Chart 1). But the ISM may have been affected by the government shutdown and, overall, U.S. data still look solid, with the Citigroup Economic Surprise Index beginning to rebound, and stronger than in other regions (Chart 2). The residential housing market, which was exhibiting signs of stress last year, with existing home sales -6.4% YoY in December, is showing the first signs of stabilization, helped by mortgage interest rates that are now 50 BPs off their recent peak (Chart 3). Chart 1How Worrying Is The U.S. Slowdown? Chart 2U.S. Data Surprisingly Positive Chart 3Housing Market Should Stabilize In particular, the outlook for consumption looks healthy, with average hourly earnings growing at 3.3% YoY, consumer confidence close to an historic high, and the savings rate above 6%. Unsurprisingly, then, retail sales have boomed in recent months (Chart 4). Unless consumer confidence is dented by a repetition of the government shutdown or some other shock, consumption (68% of GDP, remember) should grow strongly this year. Add to this a residual positive impact of close to 0.5% of GDP coming from last year’s fiscal stimulus, and it is hard to imagine the U.S. going into recession over the next 12 months. Chart 4Consumption Booming The Fed will probably go on hold for now, however, given the market jitters in Q4. We are likely back to a situation like that in 2015-2016, where the Fed Policy Feedback Loop becomes the key factor for markets (Chart 5). When financial conditions tighten, with stock prices falling and the dollar appreciating, the Fed turns more dovish. However, this triggers a rally in risk assets and loosens financial conditions, allowing the Fed to start hiking again. With the tightening in financial conditions over the past six months, the Fed is likely to err on the side of caution for now (Chart 6). However, if our macro view is correct – and as inflation starts to pick up again after April, partly due to the base effect – the Fed will want to continue withdrawing accommodation over the course of this year. The Fed Funds Rate, at around 2.4% is still two hikes below what the FOMC sees as the neutral level of interest rates (the 2.8% terminal rate in the FOMC dots). We see the Fed, therefore, raising rates in June and perhaps hiking two or even three times this year. By contrast, the futures market assigns only a 25% probability of even one rate hike this year, and is even pricing in a small probability of a cut. Chart 6Tighter Conditions Mean More Cautious Fed Clearly, there are plenty of risks to the scenario of growth continuing. But those in the hands of President Trump, especially the trade war with China and the fight over funding of the wall on the border with Mexico, we don’t see as being serious impediments. Trump is fully aware that he is unlikely to be reelected in November 2020 if the U.S. is in recession by then. Every incumbent U.S. president since World War Two who fought for reelection during a recession failed to be reelected (Chart 7). The view of BCA’s geopolitical strategists, therefore, is that the White House and Congressional Democrats will agree to concessions to end the shutdown before the end of the current three-week stop-gap period. Less likely, Trump will declare a national emergency that will cause much controversy but have little impact on the economy. Our strategists also argue that there is a 45% probability of trade negotiations with China producing a result (at least a short-term one the president can boast about) before the March 1 deadline, and a further 25% probability of the deadline being extended without further sanctions being imposed.1 Chart 7Trump Won't Be Reelected In A Recession Equities: Analysts have become overly pessimistic about the earnings outlook for this year, cutting 2019 U.S. EPS growth to 7% (and only 2% YoY in Q1). Our top-down model (based on, admittedly optimistic, U.S. growth assumptions, but also headwinds from a stronger dollar) indicates 12% growth. If analysts are forced to revise up their numbers as better earnings come through, that should be a catalyst for further equity performance (Chart 8). We continue to prefer U.S. over European equities. The steady slowdown in European growth over the past 12 months has not yet bottomed, banks in Europe remain troubled, the earnings picture is less positive, and valuations relative to the U.S. are not especially attractive. We also remain underweight on EM equities: they may produce a positive return in a risk-on environment, but we see them underperforming DM as rising U.S. interest rates and a stronger USD put pressure on EM borrowers with excess foreign-currency debt. Chart 8Analysts Have Overdone Downward Revisions Fixed Income: The recent fall in U.S. Treasury yields was mainly caused by the inflation expectation component, itself very sensitive (if rather illogically so) to the oil price (Chart 9). As the oil price recovers (see below), inflation picks up moderately, and the Fed hikes by more than the market expects, we see the 10-year Treasury yield rising to 3.5% during the course of the year. BCA’s fixed-income strategists recently raised their recommendation on global credit to overweight, given more attractive spreads and the likelihood that the Fed will be on hold for the next six months.2 Their recommendation is for 3-6 months, and the Fed restarting the hiking cycle, say in June, might terminate the positive story. We are following their lead, by raising both high-yield and investment-grade bonds to overweight within the (underweight) fixed-income asset class. That means we are neutral credit in the overall portfolio. We would warn, though, that this is a somewhat short-term call: we still prefer equities as a way to play the continuing risk-on rally. Given the high level of U.S. corporate leverage, and the over-owned nature of the credit market, this is likely to be an asset class that performs very poorly in the next recession (Chart 10). Chart 9Inflation Expectations Should Recover Chart 10Corporate Leverage Is A Concern Currencies: Currencies will continue to be driven by relative monetary policy. With the growth desynchronization between the U.S. and other DMs set to continue (to a degree), we see modest further USD appreciation this year. The Fed (as argued above) will probably hike more than the market expects. But, given slow European growth, the ECB is unlikely to be able to hike in Q4 this year, as it currently is guiding for and the futures market implies (Chart 11). We see the ECB reopening the Targeted Long-Term Repo Facility (TLTRO), which expires soon. Italy and Spain have been big borrowers from this facility, and bank loan growth is likely to slow as it ends (Chart 12). A renewed TLRTO would be seen as a dovish move. Tighter dollar liquidity conditions also point to a stronger USD. U.S. credit growth continues to accelerate (to 12% YoY – Chart 13) in an environment where the monetary policy has tightened: credit growth is outpacing U.S. money supply growth by 7%. Historically this has been negative for global growth (mainly because the deteriorating liquidity is a problem for EM dollar borrowers) and positive for the dollar (Chart 14).3 Chart 11Can ECB Really Hike In 2019? Chart 13...U.S. Loan Growth Accelerating... Chart 14... Which Will Tighten Liquidity Further Commodities: The supply/demand situation for oil should improve over coming months. With Saudi Arabia and Russia committed to cut supply by 1.2 million barrels/day, U.S. shale production growth slowing given the low one-year forward price for WTI, Canada reducing production, and Venezuela on the verge of collapse (which alone could remove 700-800k b/d from the market), our energy strategists see the crude oil balance in deficit over the next four quarters (Chart 15). Given this, they forecast Brent crude rebounding to above $80 a barrel. Other commodity prices are mostly driven by Chinese demand. We see China continuing to slow, until the accumulated effects of its fiscal and mild monetary stimulus start to come through in H2 and stabilize growth. Our analysis suggests that China remains very disciplined about the size and nature of its stimulus: it is not turning on the liquidity taps as it did in early 2016. Bank loan growth has stabilized, but shadow banking activity continues to contract, as the authorities persist with their crackdown and their emphasis on deleveraging (Chart 16). Industrial commodities prices are therefore likely to weaken over the next six months.  Chart 15Oil Balance In Deficit This Year Chart 16China Sticking To Credit Crackdown   Garry Evans, Senior Vice President Global Asset Allocation garry@bcaresearch.com   GAA Asset Allocation Footnotes 1      Please see Geopolitical Strategy Weekly Report, “So Donald Trump Cares About Stocks, Eh?”, dated 9 January 2019, available at gps.bcaresearch.com 2      Please see Global Fixed Income Strategy Weekly Report, “Enough With The Gloom: Upgrade Global Corporates On A Tactical Basis,” dated 15 January 2019, available at gfis.bcaresearch.com 3      For a detailed explanation, please see Foreign Exchange Strategy Weekly Report, “Global Liquidity Trends Support The Dollar, But…,” dated 25 January 2019, available at fes.bcaresearch.com

The hiatus in the Fed’s rates-normalization policy in 1H19 in the wake of its capitulation to financial markets, supports our bullish view on gold prices, as it raises the risk of an inflation overshoot later this year. Per the Fed’s dual mandate, inflation and employment gauges are signaling the need for tighter policy, according to BCA’s proprietary Fed Monitor. The pause in hiking fed funds raises the likelihood the Fed will find itself behind the inflation curve, as the economy enters a late-cycle phase. Gold will outperform other commodities and equities in this phase. We remain long gold as a portfolio hedge. Highlights Energy: The U.S. imposed sanctions on state-owned Petróleos de Venezuela, S.A. (PDVSA), including a ban on the company’s Houston-based Citgo remitting earnings back to the parent company.  This raises the likelihood production and exports will fall sharply as we expect.  Separately, Saudi Energy Minister Khalid al-Falih said the country will reduce output below its recently agreed 10.3mm b/d cap in 1H19, in line with our own balances expectation.1 Base Metals/Bulks: Neutral.  Iron ore prices likely will continue to move higher, following the collapse of a wet-processing dam at Vale’s Córrego do Feijão mine.  The company suffered a similar breach at its Samarco mine in March 2016, which still has not re-opened. Output will fall, if it follows through with additional dam closures. Precious Metals: Neutral.  Gold prices will continue to move higher, as the Fed’s near-term capitulation on its rates-normalization policy raises the odds the U.S. central bank will find itself behind the inflation curve.  (See below.) Ags/Softs: Underweight.  USDA reported soybeans inspected for export to China during the week ended January 24 accounted for close to 37% of the total beans inspected.  This made China the No. 1 importer of American soybeans again. Feature In February 2018, we wrote that “price risk in gold will remain skewed to the upside this year, even as our base case scenario calls for limited gains from here.” In line with this expectation, we suggested remaining long gold as a portfolio diversifier and hedge against mounting equity risks. This turned out to be an accurate call. Despite losing 8.4% between January and September 2018 because of an aggressive Fed, gold rose by 7.6% in 4Q18 amid the rising equity volatility and ended the year down a minor -1.5% compared to -6.2%, -11.2% and -7.1% for the S&P 500, global equities and the CRB commodity index. This reflects the convexity in gold returns and is the reason we favored gold in 2018. Gold returns are not simply a function of the U.S. dollar and real interest rates. As highlighted in our 2019 Key Views report last December, in mature economic cycles, gold’s ability to hedge against equity and inflation risks dominate its price formation, while its correlation with the U.S. Treasury yields diminishes (Chart of the Week).2 Chart of the WeekGold's Correlation With U.S. Rates Declines As The Cycle Matures As the current cycle extends to 2019, the skewness in gold return will prove profitable. The Fed’s retreat on its quarterly rate-hike cycle only adds to our positive view, as it increases the probability the U.S. central bank falls behind the curve. Stay long gold as a portfolio hedge. Fed’s Short-Term Capitulation Strengthens Our View The recent downward revision in the Fed’s rate-hike path reinforces our positive stance on gold prices, as risks of an overshoot in inflation rises. The dichotomy in U.S. vs. rest of the world growth puts the Fed in a difficult position. The current capitulation was mainly driven by tightening financial conditions – chiefly, the rising U.S. dollar, declining stock prices, and widening credit spreads. However, under the Fed’s dual mandate, inflation and employment still are signaling “tightening-required” per BCA Research’s Fed Monitor, a model maintained by our U.S. Bond strategists (Chart 2). Since economic growth cannot remain above-trend indefinitely, short-term productive capacity constraints (i.e. capital and labor factors of production) are already binding and will force the Fed to raise rates later this year as inflation creeps up. Chart 2Growth And Inflation Signal Tighter Money Is Required As it reaffirms its data dependence, the Fed is opening the door to falling behind the inflation curve, given inflation is a lagging indicator of the price pressures that are building up in the economy (Chart 3). As a result, we expect gold’s ability to hedge against inflation will support its price in 2H19. Chart 3Inflationary Pressure Will Rise In 2019 Short-term, a Fed pause also supports gold by readjusting investors’ expectations regarding the U.S. dollar and real interest rates lower. Our bond strategists identified two previous periods where similar conditions led to a false start in the Fed hiking cycle, 1997 and 2015. In both cases, the Fed’s capitulation led to a reversal in gold’s downward price trajectory, as the market perceived the central bank was keeping its short-term policy rate at a level that was inconsistent with the so-called R-star rate or natural rate of interest – i.e., “the real interest rate expected to prevail when the economy is at full strength” (Chart 4).3 Chart 4AGold Price's Trajectory Reversed In 1997... Chart 4B Using a conceptual four-quadrant framework developed by our colleagues at The Bank Credit Analyst to describe the Fed’s behavior, we currently believe the outcome with the highest probability of being realized by the Fed’s capitulation is Policy Mistake 2 (Table 1, lower right quadrant). If we’re right, this raises the odds of an inflation overshoot above the Fed’s 2% target later this year.4 Table 1Four Fed Policy Scenarios This is not a foregone conclusion. However, generally speaking, the higher the inflation uncertainty and the higher the perception the Fed will fall behind the curve, the higher gold is bid up. Recent price action seems to corroborate this. Chart 5 shows that the recent downward revision in the median long-term fed funds rate projection coincides with a rise in gold prices. At present, gold investors are signaling that the fed funds rate is below the neutral rate consistent with R-star. Chart 5Gold Markets Signal Monetary Policy Is Accommodative Gold And The U.S. Economic Cycle Gold prices are difficult to model and predict, given the collection of time-varying, often conflicting, components determining their evolution. Its core determinants change as we move through the economic cycle. In their current late-cycle environment, inflation and equity risks – i.e., fears of a sharp correction – usually gain in importance. In this report, we characterize the market’s late-cycle phase using two metrics: (1) the fed funds rate relative to R-star, (2) the phase of the yield curve cycle.5 We have already discussed (1) in our outlook and found that when the fed funds rate is rising yet still below the estimate of R-star, gold returns are highly skewed to the upside (Chart 6).6 For (2), we compared the yellow metal’s return to other assets returns in different phases of the U.S. Treasury yield curve’s evolution. We define these yield-curve phases as follow: Phase 1: Normal (i.e., positively sloped: 10-year rates are greater than 3-month rates). The 3-month/10-year treasury slope is above 75 bps. Phase 2: On its way to flattening and returning to normal. The 3-month/10-year Treasury slope is between 0 bps and 75 bps. We divide this in two sub-phases: (a) steepening, and (b) flattening. Phase 3: Inverted (i.e., negatively sloped). The 3-month/10-year Treasury slopes is below 0 bps (Chart 7).7 Chart 7Phases Of The Yield Curve Cycle We found that: first, DM and EM equities are the best performers in the group we looked at during Phase 1, when the slope of the yield curve is steep (above 75 bps). Second, there is wide difference between the steepening and flattening sections of Phase 2. EM equities and copper experience the largest rebound once the slope’s curve steepens from below zero. Lastly, gold performs best in the flattening section of Phase 2 and, critically, it outperforms oil, copper, broad commodity indices and equities (Table 2). Table 2Gold Returns Are Positive When The Yield Curve’s Slope Flattens Our U.S. Investment and Bond Strategists believe the Fed’s policy rate will remain in the below-r-star-and-rising range, and in Phase 2 of the yield curve cycle for most of 2019. We agree, and believe our analysis indicates gold prices will increase this year on the back of these factors. Recession Fear And Equity Risks Will Drive Gold For most of 2018, investor sentiment and positioning were primarily determined by the U.S. dollar and real rates. As these variables rose last year, investors’ sentiment and positioning turned overly bearish; this pushed our Gold Composite Indicator in the oversold territory (Chart 8).8 In our view, the other (important) drivers of gold prices were ignored during that period. The end-of-year equity selloff led to a reshuffle of the core determinants of the yellow metal’s price, pushing the equity risk factor higher on the list of variables explaining its price. Chart 8Sentiment Collapsed In 1H18 Chart 9 shows gold and the U.S. equity risk premium disconnected in 2018, until the October equity selloff. In general, these variables are positively linked. When risk aversion is elevated, investors demand higher compensations for holding risky assets, and increase their demand for safe-haven assets. This pushes up both the equity risk premium and gold prices. Chart 9Gold And Equity Risk Premium Correlation Picked Up Gold’s performance in 4Q18 supports our recommendation for holding it as a portfolio diversifier in 2018, and why we continue to do so this year (Chart 10). Separately, our U.S. dollar and rates-only model moved up recently, easing the downward pressure on gold (Chart 11). While we believe these two variables’ marginal impact diminished since 4Q18, they are included in our gold “fair-value” model, which currently indicates it is fairly valued and that its support remains intact. Chart 11Upside Pressures Are Building Bottom Line: The Fed’s near-term capitulation raises the odds the U.S. economy will experience an inflation overshoot. Our fair-value model also is supportive of gold prices. We remain long as a diversification and portfolio hedge. Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com Robert P. Ryan, Senior Vice President Commodity & Energy Strategy rryan@bcaresearch.com Footnotes 1      Please see “Saudis Pledge Deeper Oil Cuts in February Under OPEC+ Deal,” published by bloomberg.com January 29, 2019.  See also “OPEC Starts Cutting Oil Output; Demand Fears Are Overdone” published January 24, 2019, for our latest supply-demand balances and price forecasts.  It is available at ces.bcaresearch.com. 2      Please see BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 3      Please see John C. Williams’s remarks delivered to the Economic Club of Minnesota May 15, 2018, entitled “The Future Fortunes of R-Star: Are They Really Rising?”  Williams was president and CEO of the Federal Reserve Bank of San Francisco at the time, and now has the same role at the NY Fed..  We explore this further below.  See also BCA Research’s U.S. Bond Strategy Weekly Report titled “An Oasis Of Prosperity,” published August 21, 2018. It is available at usb.bcaresearch.com. 4      Please see BCA Research’s The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. It is available at bca.bcaresearch.com. 5      The San Francisco Fed defines R-star as the inflation-adjusted “natural” rate of interest consistent with a fully employed economy, with inflation close to the Fed’s target. R-star is used to guide interest-rate policy consistent with long-term macro goals set by the Fed. Please see “R-star, Uncertainty, and Monetary Policy,” by Kevin J. Lansing, published in the FRBSF Economic Letter May 30, 2017. 6      We presented this analysis in BCA Research’s Commodity & Energy Strategy Weekly Report titled “2019 Key Views: Policy-Induced Volatility Will Drive Markets,” published December 13, 2018. It is available at ces.bcaresearch.com. 7      For a similar analysis applied to different asset classes, please see BCA Research’s U.S. Bond Strategy Weekly Report titled “2019 Key Views: Implication For U.S. Fixed Income,” published December 11, 2018, and The Bank Credit Analyst January 2019 Monthly Report published December 21, 2018. These reports are available at usb.bcaresearch.com and bca.bcaresearch.com. Our approach is slightly different from our colleagues’ methodology. We used a threshold of 75 bps instead of 50 bps in order to increase the sample size of the Phase 2, flattening section. This improves the accuracy of using the average as our main descriptive statistic. Note that the yield curve can remain inverted for some time before a recession occurs, this explains why equity returns are positive in Phase 3 (curve inversion). 8      Our Gold Composite Indicator has three components: (1) Sentiment, (2) Speculative positioning and (3) Technical. It is meant to assess if there is any mismatch between our fundamental analysis and investors’ sentiment and expectations. Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades TRADE RECOMMENDATION PERFORMANCE IN 4Q18 Commodity Prices and Plays Reference Table Summary Of Trades Closed In 2018

Highlights Global equity markets have managed to recoup some of last year’s plunge since we upgraded stocks to overweight in late December. The equity rally has been tentative, however, and so far feels more like a technical bounce from oversold levels than a resumption of the bull market. One driving factor behind last year’s market swoon was that policy uncertainty spiked at a time when the last pillar of global growth, the U.S., was showing signs of cracking. Investors thus welcomed the Fed’s signal that it would pause in March. Nonetheless, shrinkage in the Fed’s balance sheet is proving to be troublesome. Quantitative tightening does not necessarily imply permanently higher risk premia, but it will be a source of volatility. There are hopeful but tentative signs that a U.S. slowdown is not the precursor to a recession. The hit to GDP from the U.S. government shutdown will be reversed next quarter. The FOMC has also signaled that policymakers are attuned to the economic risks associated with tightening financial conditions, and that the calm inflation backdrop provides room to maneuver. The FOMC will stand pat in March, but should restart rate hikes in June as the economic soft patch ends. We still see only a modest risk of a U.S. recession this year. In contrast, our outlook for growth outside the U.S. remains downbeat for at least the first half of the year. Among the advanced economies, Japan and Europe are being the most affected by the Chinese economic slowdown and global trade tensions. This means that monetary policy divergence will continue to be a tailwind for the dollar. China continues to stimulate at the margin, but efforts so far have been insufficient to put a floor under growth. The contraction in Chinese exports has just begun. It is still too early to upgrade EM assets or base metals. Despite the cloud still surrounding Brexit, sterling is beginning to look attractive as a long-term punt. Our decision to upgrade corporate bonds to overweight this month, similar to our reasoning for upgrading equities in December, is based on improved value and a sense that investor pessimism had become excessive. Just as the selloff in risk assets was overdone, so too was the rally in government bonds. It is highly unlikely that the Fed is done tightening, as is currently discounted in the money market curve. A resumption of Fed rate hikes around mid-year means that the 10-year Treasury yield will move back above 3% by year end. Feature Global equity markets have managed to recoup some of last year’s plunge since we upgraded the asset class back to overweight in the latter half of December. A decline in the VIX and high-yield bond spreads are also positive signs that global risk appetite is recovering, following an overdone investor ‘panic attack’ last quarter. The equity rally has been tentative, however, and so far feels more like a simple technical bounce from oversold levels than a resumption of the bull market. One problem is that policy uncertainty has spiked at a time when the last pillar of global growth, the U.S., is showing signs of cracking (Chart I-1). Investors are skittish while they await a clear de-escalation of U.S./China trade tensions, an end to the U.S. economic soft patch, an end to the U.S. government shutdown, and signs that global growth is bottoming (especially in China). There has only been some modestly positive news on a couple of these issues. Chart I-1Policy Uncertainty Has Spiked Another factor that appeared to play a role in last quarter’s market swoon is the fear that the end of asset purchases by the European Central Bank and the normalization of the Fed’s balance sheet necessarily imply a structural de-rating for all risk assets. A related worry is that the de-rating might intensify the global economic slowdown, resulting in a self-reinforcing negative feedback loop. Does QT Imply Lower Multiples? The question of balance sheet normalization is a difficult one because there is widespread disagreement on how, or even whether, quantitative easing (QE) works. We have always maintained that QE was not about creating a wave of central bank liquidity that flowed into asset prices. Central banks did not “print money” – they created bank reserves. These reserves did not result in a major acceleration in broader measures of money growth, including M1 and M2, largely because there was little demand for loans and because banks tightened lending standards. In other words, the credit channel of monetary policy was broken. The implication is that investors should not worry that quantitative tightening (QT) implies a withdrawal of central bank liquidity that must mechanically come from the sale of risk assets. Rather, we believe that QE operates mostly through the portfolio balance effect. There are two ways to think about this channel. First, the central bank forced investors to move into riskier assets by purchasing large amounts of “safe” assets, such as government bonds. Investors had little choice but to redeploy the capital into other riskier areas, pushing up asset prices. The second perspective is that central bank purchases of government bonds depressed both the yield curve and bond volatility. Volatility fell because investors could forecast the policy rate with certainty – it would be glued to zero (or negative) for the foreseeable future in most of the advanced economies. This is akin to strong forward guidance that flattened the yield curve. Aggressive monetary stimulus, such as QE, also helped to reduce the perceived risk that the economy would succumb to secular stagnation or fall back into recession. Reduced bond volatility, lower bond yields, and less economic risk all increased the attractiveness of the riskier asset classes. These explanations represent two sides of the same coin. Either way, QE boosted a broad array of asset prices. If this is true, then unwinding QE must be bearish for risk assets, all else equal. In the case of the U.S., the fed funds rate is much more difficult to forecast than was the case when the Fed was buying bonds. Higher yields and bond volatility imply a lower equilibrium multiple in the equity market and wider equilibrium corporate bond spreads. Nonetheless, all else is not equal. If interest rates and bond volatility are rising in the context of healthy economic and profit growth, then it is likely that the perceived risk of secular stagnation is falling. It would be a sign that the economy has finally put the financial crisis firmly in the rear-view mirror. It could be the case that the upgrade in economic confidence overwhelms the negative impact of the reverse portfolio balance effect related to quantitative tightening, allowing risk assets to rise. No one can prove this thesis one way or the other and we are not making the case that unwinding the Fed’s balance sheet will necessarily go smoothly, especially since interest rates are rising at the same time. The problem is that both investors and the Fed are trying to figure out where the neutral fed funds rate lies. If the so-called level of R-star is still very low, then the Fed might have already made a policy mistake by raising rates too far. We discussed in last month’s Overview the market implications of four scenarios for the level of R-star and the Fed’s success in correctly guessing it. If the economy holds up and the economic soft patch ends in the coming months as we expect, then investors will revise their estimate of the neutral rate higher and risk assets will rally even as bond yields rise. The Doom Loop One risk to our base-case scenario is the so-called financial conditions “doom loop”. Irrespective of whether or not QT is playing a role, the doom loop scenario involves a shock to investor confidence that leads to a tightening in financial conditions and market liquidity as stock prices fall and credit spreads widen. More onerous financial conditions, in turn, undermine economic activity, which then feeds back into even tighter financial conditions. One could make the argument that risk assets are even more exposed to this type of negative feedback loop today than in past monetary tightening cycles because of program trading, the Fed’s balance sheet shrinkage and investors’ lingering shell shock from the Great Recession and financial crisis. Nonetheless, there are a few mitigating factors to consider. We believe that a doom loop is more likely to unfold when economic growth becomes very sensitive to changes in financial conditions. This normally happens when economic and financial imbalances are elevated. On a positive note, unlike in the lead-up to the last two recessions, the U.S. private sector is a net saver whose income outstrips spending by 2.1% of GDP (Chart I-2). The highly cyclical parts of the U.S. economy are not stretched to the upside as a share of GDP, reducing the risk that overspending in one part of the economy will required a deep contraction to correct the imbalance (Chart I-3). Chart I-2U.S. Private Sector: A New Saver Chart I-3U.S. Cyclical Spending Not Extended In terms of financial excesses, the good news is that the U.S. household sector is in its best shape in decades. Our main concern is debt accumulation in the corporate sector. We reviewed the related risks in a Special Report published in the November 2018 issue.1 We concluded that corporate leverage will not cause the next U.S. recession, because high levels of debt will only become a problem when profits begin to contract (i.e. when the economic downturn is already underway). Nonetheless, when a recession does occur, corporate spreads will widen by more than in the past for any given degree of economic contraction (see below). ‘Fed Put’ Still In Play Another factor that tempers the risk of a doom loop is that the so-called ‘Fed Put’ is still operating. The December FOMC Minutes and comments by various FOMC members communicated to investors that the Fed is attuned to the economic risks associated with tightening financial conditions, and that the calm inflation backdrop provides policymakers with room to maneuver. Chair Powell even said he was willing to adjust the Fed’s balance sheet run-off if necessary. One important reason for policymakers’ willingness to be flexible is that the fed funds rate is still not far from the zero-lower-bound, making it potentially more difficult for the FOMC to respond adequately in the event of a recession this year because the fed funds rate can only be cut by 250 basis points. Several U.S. data releases have been delayed due the government shutdown, but what has been released has been mixed. The downdraft in the January reading of the manufacturing ISM was eye-opening, highlighting that the global manufacturing slowdown has reached U.S. shores. The good news is that the non-manufacturing ISM and the small business survey, although off their peaks, remain consistent with solid underlying growth. The December U.S. payroll report revealed that wage growth continued to accelerate on the back of gangbusters job creation at the end of the year. There have also been some recent hints that the soft patch in capital spending and housing is ending (Chart I-4). Existing home sales fell sharply in December, but extremely low inventories suggest that it is more of a supply than a demand problem. The impressive bounce in home mortgage applications for purchases is a hopeful sign. U.S. commercial and industrial loan growth is also accelerating. Chart I-4Some Tentative Signs These tentative signs that the economic soft patch is close to an end will not be enough to get the FOMC to tighten in March, after so many members have gone out of their way to signal a pause in recent weeks. Nonetheless, we believe the economy will remain strong enough for the Fed to resume hiking in June. The U.S. government shutdown will complicate interpreting incoming economic data. Ultimately, while its impact on Q1 real GDP growth will be non-trivial, it will be reversed the following quarter and we do not expect any permanent damage to be done. U.S. inflation should edge higher by mid-year, supporting our view that the Fed will resume tightening in June. The decline in oil prices will continue to feed into a lower headline inflation rate in the coming months, but that does not mean that the core rate will fall. Indeed, core CPI has increased by roughly 0.2% in each of the past three months, translating into an annualized rate of approximately 2.4%. Base effects will depress annual core inflation in February but, thereafter, this effect will begin to reverse. The acceleration in wage growth according to measures such as average hourly earnings and the Employment Cost Index highlights that underlying inflationary pressures continue to percolate (Chart I-5). The implication is that the Treasury bond market is overly complacent in discounting that the fed funds rate has peaked for the cycle. Chart I-5U.S. Wage Pressure Is Percolating Looking further ahead, our base case remains that the next U.S. recession will not occur until 2020, and will be the result of tighter fiscal policy and further Fed tightening that takes short-term rates a step too far. No Bottom Yet For Global Growth Our outlook for growth outside the U.S. remains downbeat for at least the first half of the year. Our global economic indicators still show no sign of a turnaround, except for a bottoming in the diffusion index based on BCA’s Global Leading Economic Indicator (Chart I-6). The global ZEW economic sentiment index continued to fall in January, while business and consumer confidence readings in the advanced economies eroded heading into year end. Chart I-6Global Leading Indicators Still Deteriorating A better global growth dynamic awaits more serious policy stimulus in China. Real GDP growth decelerated further to 6.4% year-over-year in the last quarter of 2018. This is no disaster, but the point is that there are still no signs of stabilization. The Chinese authorities continue to tweak the policy dials at the margin, most recently providing some tax cuts and a liquidity injection into the banking system. Nonetheless, the central government has so far abstained from stimulating the property market due to existing speculative excesses. This is very different from the previous two policy easing episodes, including 2015/16 (Chart I-7). Chart I-7China: No Property Market Stimulus... The stimulus undertaken so far has been insufficient in terms of putting a floor under growth according to our 12-month Credit Impulse (Chart I-8). It is a hopeful sign that broad money growth is trying to bottom, but this does not guarantee that the credit impulse is about to turn. The latter is required to confirm that Chinese import demand will accelerate, providing a lift to EM exporters, EM asset prices and commodity prices. Without a positive credit impulse, China’s investment and construction activity will continue to moderate, leading to lower imports of machinery and raw materials. Chart I-8...And No Credit Impulse The economic situation in China is likely to get worse before it gets better. Dismal trade figures in December confirmed that the trade war is beginning to bite. The period of export ‘front-running’ related to higher U.S. tariffs is over as total exports fell by 4.4% year-over-year. Last year’s collapse in export orders indicates that the woes are just beginning. In turn, moderating production related to the Chinese export sector will bleed into domestic consumption and imports, suggesting that it is too early to expect a durable rally in EM assets or commodity prices. Lackluster Chinese demand and growing trade concerns have weighted on global business confidence, contributing to the pullback in capital goods orders, manufacturing PMIs and industrial production in the advanced economies (Chart I-9). Even the average service sector PMI and consumer confidence index in the advanced economies have fallen in recent months, although both remain at a high level. Chart I-9The Fallout From Trade Europe and Japan, in particular, are feeling the pinch. German GDP only grew 1.5% in 2018, implying that Q4 GDP growth was in the vicinity of just 0.2% QoQ. Meanwhile, European industrial production contracted by 3.3% year-over-year in December. The German Ifo and ZEW surveys do not point to any significant improvements in this trend. A few idiosyncratic factors explain some of this poor performance, including new emissions testing standards that have weighted on the German auto industry, a tightening in financial conditions in Italy, and the ‘gilets jaunes’ protests in France. Nonetheless, the euro area slowdown cannot be fully explained by one-off factors. The economy is highly sensitive to global trade fluctuations given that 18% of the euro area’s gross value added is generated in the manufacturing sector. Hence, China’s poor economic health has been painful for Europe, and the trend in Chinese credit does not bode well for the near term (Chart I-10). The European Central Bank (ECB) is likely to stay on the defensive as a result, especially as euro area core inflation, which has been stuck near 1% for three years, is unlikely to pick up if growth remains on the back foot. The ECB stuck with the view that the economic soft patch is temporary after the January policy meeting, but policymakers will consider providing more stimulus in March if the economy does not pick up (using forward guidance or a new TLTRO). This will weigh on the euro. Chart I-10China's Woes Are Infecting Europe Japan is suffering from similar ills. Exports are no longer growing, and foreign machinery and factory orders are contracting at a 4.1% and 4.3% pace, respectively. This weakness is not mimicked in domestic growth, but the disproportionate contribution of the external sector to Japan’s overall economic health means that this country is also falling victim to the malaise witnessed in China and emerging markets, the destination of 19% and 45% of Japanese shipments, respectively (Chart I-11). Collapsing oil prices and a firming trade-weighted yen have amplified this deflationary backdrop. It is therefore far too early to bet that the Bank of Japan will tighten the monetary dials. Chart I-11Japan Hit By The Chinese Cold As Well If we are correct that the U.S. economic soft patch will soon end, then the dollar will once again look to be the best of a bad lot. Interest rate expectations will move in favor of the dollar. We expect the dollar to rise by about 6% this year on a trade-weighted basis, appreciating most strongly against the AUD and SEK. As for sterling, it is beginning to look attractive as a long-term punt. Brexit Deadlock We are a month closer to the end-March deadline and a Brexit deal seems even farther out of reach. It could play out in one of three ways: (1) a “no deal” where the U.K. leaves the EU with no alternative in place; (2) a “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; or (3) a decision to reverse the results of the original referendum and stay in the EU. There is no support for the “no deal” option in Parliament, which means that it won’t happen. We do not have a strong view on which of the latter two scenarios will occur. The odds of another referendum are rising and the polls are swinging away from any sort of Brexit, suggesting that the original referendum result may be over-turned via another referendum (Chart I-12). Nonetheless, for investors, it does not matter much whether it is scenario 2 or 3; either outcome would be welcomed by markets. Overweight sterling positions are attractive as a long-term play, although it could be some time before the final solution emerges. Chart I-12Brexit Result May Be Overturned Upgrade Corporate Bonds To Overweight Given the recent global economic dynamics, it is perhaps surprising that U.S. corporate financial health actually improved in 2018 according to our Corporate Health Monitors (CHM). We highlighted in the aforementioned Special Report the risks facing U.S. corporate bonds when the economic expansion ends. High levels of corporate leverage mean that the interest coverage ratio for the median corporation in the Barclays-Bloomberg index will plunge to near or below all-time historic lows. The potential for a large wave of fallen angels implies that downgrade activity will be particularly painful for corporate bond investors. The surge in lower-quality issuance has led to a downward trend in the average credit rating and has significantly raised the size of the BBB-rated bonds relative to the IG index and relative to the broader universe of corporate bonds. Moreover, poor market liquidity and covenant erosion will intensify pressure for corporate spreads to widen when the bear market arrives. Rapid debt accumulation is reflected in our bottom-up Corporate Health Monitors (CHM) for the U.S. investment-grade and high-yield sectors (Chart I-13). The CHMs are constructed from six financial ratios that the rating agencies use when rating individual companies. The companies in our bottom-up sample were chosen so as to mimic the sector and quality distribution in the Bloomberg-Barclay’s corporate bond index. Chart I-13U.S. Corporate Health The debt-to-book-value of equity ratio for both the U.S. IG and HY sample of companies has risen to nose-bleed levels, although the ratio appears to have flattened off for the latter. Despite rising leverage, the HY CHM has shifted into “improved health” territory and the IG CHM is on the verge of doing the same. Last year’s upturn in the profitability measures, such as the return on capital, overwhelmed the deteriorating leverage trend. In Europe, where we distinguish between domestic and foreign issuers, rising leverage has been concentrated among the latter until recently (Chart I-14). In any event, the CHM for both types of issuers is close to the neutral zone. Chart I-14Euro Area Corporate Health Improving U.S. corporate health on its own would not justify increasing exposure to corporate bonds within balanced portfolios or moving down in quality. Profit growth is likely to moderate this year, especially in Europe, such that last year’s improvement in corporate health is likely to reverse. And, as previously discussed, the economic cycle is well advanced and this sector is particularly vulnerable to a recession. Nonetheless, value has improved enough to warrant a tactical upgrade to overweight within fixed-income portfolios, at a time when the FOMC has signaled a pause and the next recession is at least a year away. Implied volatility should continue to moderate and spreads should narrow, similar to dynamics in 2016, the last time that the Fed signaled patience following a period of market turmoil (Chart I-15). Chart I-15Fed Patience To Narrow Spreads Spreads have already narrowed from the peak in late December, but 12-month breakeven spreads for most credit tiers are all still close to or above their historical means, except for AA-rated issues (Chart I-16). For example, the 12-month breakeven spread2 for the Baa credit tier is 46%. This means that the spread has been tighter than its current level 46% of the time since 1988 and wider than its current level 54% of the time. Historically, spreads tend to hover within the tight-end of their historical range during this phase of the credit cycle, and only cheapen significantly when the yield curve inverts and the default rate moves higher. Chart I-16Value Restored In IG Corporates... For U.S. high yield, our estimate of the spread adjusted for expected defaults has risen to 237 bps (Chart I-17). This implies that investors are discounting a 2019 default rate of 3.2%, in line with Moody's forecast. Since we do not foresee recession this year, high-yield bonds are not expensive enough to be avoided within a portfolio. Chart I-17...And In HY Too Value has also improved in the European corporate bond market, but our global fixed-income team still recommends favoring the U.S. market for global credit investors. Leverage is higher in the U.S., especially relative to domestic issuers in Europe, but the U.S. economic and profit outlook for 2019 is better. Conclusions Our decision to upgrade corporate bonds this month, similar to our reasoning for upgrading equities to overweight in December, is based on improved value and a sense that investor pessimism had become excessive. For the equity market, the S&P 12-month forward P/E is an attractive 15.4 as we go to press, and bottom-up estimates for 2019 EPS have been slashed to a very reasonable 8%. Just as the selloff in risk assets late last year was overdone, so too was the rally in government bonds. It is highly unlikely that the Fed is done tightening. A resumption of Fed rate hikes, probably in June, means that the 10-year Treasury yield will move back above 3% by year end. Across the major countries, market expectations for yields 5-10 years from now are close to current levels, which is extremely complacent (Chart I-18). Investors should keep duration short of benchmark. Chart I-18Forward Rates Far Too Low Our shift to overweight in both equities and corporate bonds is tactical in nature. We fully expect to move back to neutral and then to underweight later this year or into 2020, as the peak in U.S. GDP draws nearer. Timing will be difficult as always, which means that investors should be prepared to trim risk exposure earlier than implied by our base-case economic timeline.  The tactical upgrade does not imply that we have become more sanguine on the economic and geopolitical risks for 2019. We do not believe that quantitative tightening or U.S. corporate leverage will truncate the U.S. expansion prematurely. Nonetheless, there is a plethora of other risks to keep us up at night. These include a Fed policy mistake, a hard economic landing in China, a full-blown financial crisis in Italy and an escalation in U.S./China trade tensions. The last one has diminished marginally in probability. We have a sense that the recent equity market downdraft unnerved President Trump, such that he now has a diminished appetite for upsetting investors with talk of an escalating trade war ahead of next year’s election. Outside of these well-known risks, our geopolitical team has recently published its “Black Swans” report for 2019. These are deemed to be risks that are off of most investors’ radar screens, but that would have profound implications if they were to occur: It is premature to expect armed conflict over Taiwan, but an outbreak of serious tensions between China and Taiwan is possible as Sino-American strategic distrust continues to build. Russia and Ukraine may have a shared incentive to renew hostilities this year. Saudi Arabia has received a “blank cheque” from Donald Trump, and thus it may continue to be provocative. This could boost the geopolitical risk premium in oil prices. Tensions are building in the Balkans. A renewed conflict on Europe’s doorstep could be the next great geopolitical crisis. A “Lame Duck” Trump could stage a military intervention in Venezuela. We encourage interested readers to see our Special Report for details.3 As for emerging market assets and base metals, we continue to shy away until we receive confirmation that China is aggressively stimulating. We expect better news on this front by mid-year, but watch our China Credit Impulse indicator for timing. In contrast, investors should be overweight oil and related assets now because our commodity specialists still see the price of Brent rising above US$80/bbl sometime this year. Recent political turmoil in Venezuela buttresses our bullish oil view. Finally, this month’s fascinating Special Report, penned by BCA’s Chief Global Strategist, Peter Berezin, examines the long-term implications of the peaking in the average IQ in the advanced economies. Average intelligence is falling for both demographic and environment reasons. The impact will be far from benign, potentially leading to lower productivity growth, lower equity multiples, larger budget deficits and higher equilibrium bond yields. The report begins on page 20. Mark McClellan Senior Vice President The Bank Credit Analyst Mathieu Savary Vice President Foreign Exchange Strategy January 31, 2019 Next Report: February 28, 2019   II. The Most Important Trend In The World Has Reversed And Nobody Knows Why After rising for thousands of years, human intelligence has begun to decline in developed economies. This can be seen in falling IQ scores and a decline in math and science test scores. Environmental factors appear to account for the bulk of this decline, but no one knows what these factors are. If left unchecked, falling intelligence will severely undermine productivity growth. This could lead to lower equity multiples, larger budget deficits, and ultimately, much higher government bond yields. Technological advances, particularly in the genetic realm, promise to radically raise IQs. In a complete abandonment of its one-child policy, China will combine these controversial technologies with pro-natal measures in order to boost sagging birth rates. The coming Eugenic Wars will be one of the most important economic and geopolitical developments of the 21st century. Part 1: What The Tame Fox Says In 1959, a Soviet scientist named Dmitry Belyaev embarked on an ambitious experiment: to domesticate the silver fox. A geneticist by training, Belyaev wanted to replicate the process by which animals such as cats and dogs came to live side-by-side with humans. It was a risky endeavor. The Soviets had essentially banned the study of Mendelian genetics in favor of the blank slate ideology that is popular in progressive circles today. Belyaev persevered. Working under the guise of studying vulpine physiology, he selected foxes based on only one trait – tamability. Less than 10% of foxes made it to the subsequent generation, with the other 90% being sent off to fur farms. By the fourth generation, the changes were undeniable. Rather than fleeing humans, the foxes sought out their attention with no prompting whatsoever. They even wagged their tails and whined and whimpered like dogs do. The tame foxes also displayed physical changes. Their ears flopped over. Their snouts became shorter and their tails stood upright. "By intense selective breeding, we have compressed into a few decades an ancient process that originally unfolded over thousands of years," wrote Lyudmila Trut, who began as Belyaev’s assistant and took over the project when her boss died in 1985.  Genetically Capitalist? Evolution can broadly proceed in two ways. The first way is through random mutations. This form of evolution, which scientists sometimes refer to as genetic drift, can take thousands of years to yield any discernable changes. The second way is through natural selection, a process that exploits existing variations in genetic traits. As the Russian fox experiment illustrates, evolution driven by selective pressures (either natural or artificial) can occur fairly quickly. Did selective pressures manifest themselves in human evolution in the lead up to the Industrial Revolution? Did humans, in some sense, domesticate themselves? In his book, A Farewell To Alms, economic historian Gregory Clark argued in the affirmative. Clark documented that members of skilled professions in Medieval England had twice as many surviving children as unskilled workers (Chart II-1). Indeed, the fledgling middle class of the time had even more surviving children than the aristocracy, who were often out fighting wars. As a result, the wages of craftsmen declined by a third relative to laborers between 1200 and 1800, implying that the supply of skilled labor was growing more quickly than the demand for skilled workers over this period. In subsequent work, Clark and Neil Cummins argued that the spread of bourgeois values across pre-industrial England was more consistent with a model of genetic transmission than a cultural one (see Box II-1 for details). Similar developments occurred in other parts of the world. For example, in China, the gateway into the bureaucracy for a thousand years was the highly competitive imperial exam. Xi Song, Cameron Campbell, and James Lee showed that high-status men had more surviving children during the eighteenth- and nineteenth-centuries (Chart II-2).4 The 10,000 Year Explosion Stephen Jay Gould famously said that “There’s been no biological change in humans in 40,000 or 50,000 years. Everything we call culture and civilization we’ve built with the same body and brain.” Gould was wrong. Data from the International HapMap Project show that human evolution accelerated by 100-fold starting around 10,000 years ago (Chart II-3). In their book The 10,000 Year Explosion: How Civilization Accelerated Human Evolution, Gregory Cochran and the late Henry Harpending explained why evolution sped up so rapidly.5 The advent of agriculture led to a surge in population levels. This, in turn, increased the absolute number of potentially beneficial genetic mutations that could be subject to selection effects. Farming and the rise of city states also completely reshaped the environment in which people lived. Basic biology teaches us that environmental dislocations of this kind tend to generate selective pressures that cause evolution to accelerate. John Hawks, professor of anthropology and genetics at the University of Wisconsin-Madison, put it best: “We are more different genetically from people living 5,000 years ago than they were different from Neanderthals.” Many of the changes to our genomes relate to diet and diseases. The various genetic resistances that people have built up to malaria are all less than 10,000 years old. Mutations to the LCT gene, which confers lactose tolerance into adulthood, occurred independently in three different geographical locations: one in East Asia, one in the Middle East, and one in Africa. The Middle Eastern variant was probably responsible for the rapid enlargement of the Indo-European language group, which now stretches from India to Ireland. The African variant likely facilitated the Bantu expansion, which started near the present-day border of Nigeria and Cameroon, and then spread out across almost all of sub-Saharan Africa. Evolution Of The Human Brain About half of the genes in the human genome regulate some aspect of brain function. Given the rapid acceleration in evolution, it would be rather surprising if our own brains had not been affected. And indeed, there is plenty of evidence that they were. The frontal lobe of the brain has increased in size over the past 10,000 years. This is the part of the brain that regulates such things as language, memory, and long-term planning. Testosterone levels have also declined. That may explain the steady reduction in violent crime rates (Chart II-4). We know that certain genes that are associated with higher intelligence have been under recent selective pressure. For example, the gene that leads to torsion dystonia – a debilitating movement disorder – appears to have increased in frequency. Why would a gene that causes a known disease become more widespread? The answer is that individuals who have this particular mutation tend to have IQs that are around 10-to 20-points above the population average. Why IQ Matters IQ has a long and contentious history. Yet, despite numerous efforts to jettison the concept, it has endured for one simple reason: It has more predictive power than virtually anything else in the psychological realm. A simple 30-minute IQ test can help predict future educational attainment, job performance, income, health, criminality, and fertility choices (Table II-1 and Chart II-5). IQ even predicts trader performance!6   Like most physiological traits, IQ is highly heritable.7 The genetic contribution to IQ increases from 20% in early childhood to as high as 80% by one’s late teens and remains at that level well into adulthood.8 This makes IQ almost as heritable as height (Chart II-6). Although there is a great deal of variation among individuals, on average, more intelligent people earn higher incomes (Chart II-7). If the same relationship existed in the pre-industrial era, as seems likely, then human intelligence probably increased in a way that facilitated the economic explosion that we associate with the Industrial Revolution. The stunning implication is that the emergence of the modern era was a question of “when, not if.” Part 2: The Flynn Effect By the late-19th century, it had become clear that the rich were no longer having as many children as the poor. This realization, together with the growing popularity of Darwin’s theories, helped galvanize the eugenics movement. Contrary to popular belief, this movement was not a product of the far-right. In fact, the most vocal proponents of eugenics were among the progressive left. John Maynard Keynes, for example, served as the Director of the British Eugenics Society between 1937 and 1944. Yet, a funny thing happened on the road to idiocracy: The concerns of eugenicists did not come to pass. Rather than becoming dimmer, people became smarter. This phenomenon is now known as the Flynn Effect, named after James Flynn, a psychologist who was among the first to document it. Chart II-8 shows the evolution of IQ scores in a sample of countries between 1940 and 1990. The average country recorded IQ gains of three points per decade over this period, a remarkably large increase over such a relatively short period of time. Explaining The Flynn Effect The Flynn Effect must have been entirely driven by environmental factors since genetic factors – namely the tendency of less-educated people to have more children, and to have them at an earlier age – would have reduced average IQs over the past two hundred years. But how could environmental factors have played the dominant role in light of the strong role of genes discussed above? The answer was proposed by geneticist Richard Lewontin in the 1970s. Lewontin suggested imagining a genetically-diverse sack of seed corn randomly distributed between two large identical fields. One field had fertilizer added to it while the other did not. Genetic variation would explain all of the differences in the height of corn stalks within each field, while environmental factors (the addition of fertilizer) would explain all of the difference in the average height of corn stalks between the two fields. This logic explains why genes can account for the bulk of the variation in IQs within any demographic group, while environmental effects may explain most of the variation across groups, as well as why average scores have changed over time. And what environmental effects are these? The truth is that no one really knows. Plenty of theories have been advanced, but so far there is still little consensus on the matter. Bigger, Healthier Brains It has long been known that learning increases the amount of grey matter in the brain. For example, a recent study showed that the hippocampi of London taxi drivers tend to be larger due to the need for drivers to memorize and navigate complex routes.9 The emergence of modern societies likely kicked off a virtuous circle where the need to solve increasingly complex tasks forced people to hone their learning skills, leading to higher IQs and further technological progress. The introduction of universal primary education amplified this virtuous circle. Better health undoubtedly helped as well. Early childhood diseases reduce IQ by diverting the body’s resources away from mental development towards fighting off infections. There is a strong correlation between measured IQ and disease burden across countries (Chart II-9). A number of studies have documented a strong relationship between the timing of malaria eradication in the U.S. and other parts of the world and subsequent observed gains in childhood IQs.10 Brain size and IQ are positively correlated. Forensic evidence from the U.S. suggests that the average volume of adult human skulls has increased by 7% since the late 1800s, or roughly the size of a tennis ball.11 Part 3: The End Of A 10,000 Year Trend The problem with environmental effects is that they eventually run into diminishing returns. This appears to have happened with the Flynn Effect. In fact, not only does the recent evidence suggest that the Flynn Effect has ended, but the data suggest that IQs are starting to decline. Chart II-10 shows that average math and science test scores fell in the OECD’s Program For International Scholastic Achievement (PISA) between 2009 and 2015, the latest year of the examination. The drop in math and science test scores has been mirrored in falling IQ scores. Flynn observed a decade ago that IQs of British teenagers were slipping.12 Similar results have been documented in France, the Netherlands, Germany, Denmark, and most recently, Norway. The Norwegian results, published last year, are particularly noteworthy.13 Bernt Bratsberg and Ole Rogeberg examined three-decades worth of data on IQ tests of Norwegian military conscripts. Military duty has been mandatory for almost all men in Norway since 1814, which means that the study’s authors were able to collect comprehensive data on most Norwegian men and their fathers.  Their paper clearly shows that IQ peaked with the generation born in the mid-1970s and declined by about five points, or one-third of a standard deviation, for the one born in 1990 (Chart II-11). For the first time in recorded history, Norwegian kids today are not scoring as well as their parents. A Mystery What caused the sudden reversal of the Flynn Effect in Norway and most other developed economies? Nobody knows. We can, however, offer three possible theories: New Technologies For much of human history, rising intelligence and technological innovation were complementary processes, meaning that the smartest people were the ones who could best exploit the new technologies that were coming their way. Moreover, as noted above, even those who were less gifted benefited from the mental stimulation that a technologically advanced society provided. It remains to be seen how future technological advances such as generalized AI will affect human intelligence, but recent technological advances seem to have had a dumbing down effect.14 For example, the GPS has obviated the need for people to navigate unfamiliar locations, thus blunting the development of their visuospatial skills. Modern word processors have made spelling skills less important. Having all the information in the world just a click away is a wonderful thing, but it has reduced the need for our brains to retain and codify what we learn. Meanwhile, the constant bombardment of information to which we are subject has made it difficult to concentrate on anything for long. How many youth today can read a report of this length without checking their Facebook feed multiple times? My guess is not many. Diminishing Returns To Education The ability to take young bright minds, who would have otherwise spent their lives doing menial labor, and provide them with an education was probably the greatest tailwind to growth that the 20th century enjoyed. There is undoubtedly still scope to continue this process, but the low-hanging fruits have been picked. Educational attainment has slowed dramatically in most of the world (Chart II-12). Economist James Heckman estimates that U.S. high-school graduation rates, properly measured, peaked over 40 years ago.15 Despite billions of dollars spent, efforts to improve school performance have generally fallen flat. A recent high-level report by the U.S. Department of Education concluded that “The panel did not find any empirical studies that reached the rigor necessary to determine that specific turnaround practices produce significantly better academic outcomes.”16 This gets to a point that most parents already know, which is that when people talk about “bad schools," they are really talking about “bad students.” Deteriorating Health Better health probably contributed to the Flynn Effect. But is it possible to have too much of a good thing? More calories are welcome when people are starving, but today’s calorie-rich, nutrient-poor diets have led to a surge in obesity rates. A clean environment reduces the spread of germs, but it also makes children hypersensitive to foreign substances. Following German reunification, researchers observed that allergies were much more common among West German children than their Eastern peers, presumably because of the West’s more salubrious environment.17 All sorts of weird and concerning physiological changes are occurring. Sperm counts have fallen by nearly 60% since the early 1970s.18 Testosterone levels in young men are dropping. Among girls, the age of first menarche has declined by two years over the past century.19 Are chemical agents in the environment responsible? If they are, what impact are they having on cognitive development? Nobody knows. Reported mental illness is also on the rise. The share of U.S. teenagers with a reported major depressive episode over the prior year surged by over 60% between 2010 and 2017 (Chart II-13). The fraction of young adults that made suicide plans nearly doubled.20 More than 20% of U.S. women over the age of 40 are on antidepressants.21 Five percent of U.S. children are receiving ADHD medication.22 Implications For Economic Growth And Asset Markets So far, the reversal of the Flynn Effect has been largely confined to the developed economies. Test scores are still rising in the developing world, albeit from fairly low levels. For example, two recent studies have documented significant IQ gains in Kenya and Brazil.23 In the poorest countries, opportunities for improving health abound. Even small steps such as fortifying salt with iodine (which costs about five cents per person per year) have been shown to boost IQ by nearly one standard deviation.24 Measures to reduce inbreeding are also likely to boost IQ scores.25 Yet, we should not underestimate the importance of falling cognitive skills in developed economies. Chart II-14 shows that there is a clear positive correlation between student score on math and science and per capita incomes. Most technological innovation still takes place in developed economies. There is an extremely tight relationship between visuospatial IQ and the likelihood of becoming an inventor (Chart II-15). Since IQ is distributed along a bell curve, a 0.1 standard deviation drop in IQs across the entire distribution will result in an 8% decline in the share of people with IQs over 100, a 14% decline in those with IQs over 115, and a 21% decline in those with an IQ over 130 (by convention, each standard deviation on an IQ test is worth 15 points). Falling IQs could result in slower productivity growth, which could further strain fiscal balances. Lower IQs are also associated with decreased future orientation.26 People who live for the moment tend to save less. A decline in savings would push up real rates, leading to less capital accumulation. History suggests that a deceleration in productivity growth and higher real rates will put downward pressure on equity multiples (Chart II-16). Part 4: Generation E For 200 years, the environmentally-driven Flynn Effect disguised the underlying genetically-driven decline in IQs that began not long after the dawn of the Industrial Revolution. Flynn has acknowledged this himself, noting at the 2017 International Society For Intelligence Research Conference that “I have no doubt that there has been some deterioration of genetic quality for intelligence since the late Victorian times.”27 Now that the Flynn Effect has reversed, both genes and the environment are working together to reduce cognitive abilities in developed economies. This means that the most important trend in the world – a trend that allowed the human population to increase during the Malthusian era and later allowed output-per-worker to soar following the Industrial Revolution – has broken down. Yet, there may be another twist in the story – one that began just a few months ago: the first members of Generation E were born. E Is For Edited ... Or Eugenics Lulu and Nana will be like most other children, but with one key difference: They will be the first humans ever to have their genomes edited through a procedure know as CRISPR-Cas9. Rogue Chinese scientist He Jiankui deactivated their CCR5 gene, which the HIV virus uses as a gateway into the body. His actions were rightfully condemned around the world for endangering the twins’ health by using a procedure that has not yet been fully vetted in animal studies, let alone in human trials (Lulu and Nana’s father is HIV+ but it is debatable whether the children were at an elevated risk of infection). He Jiankui remains under house arrest at the university where he worked. But whatever his fate, the dam has been broken. For better or for worse, the era of personal eugenics has arrived. The Return Of The Silver Fox It is easier to delete a gene than to add one. It is even more difficult to swap out a large number of genes in a way that achieves a predictable outcome. Thus, the successful manipulation of highly polygenic traits such as intelligence — traits that are linked to hundreds of different genes – may still be decades away.28 Predicting a trait is much simpler than modifying it, however. The cost of sequencing a human genome has fallen by more than 99% since 2001 (Chart II-17). Start-up company Genomic Prediction has already developed a test for fertilized embryos for IVF users that predicts height within a few centimetres and IQ with a correlation of 0.3-to-0.4, roughly as accurate as standardized tests such as the SAT or ACT.29 Other companies are following suit.30 Some will recoil in horror at the prospect of selecting prospective children in this manner. They will argue that such technologies, beyond being simply immoral, will widen social inequality between those who can afford them and those who cannot. Others will counter that screening embryos for certain traits is not that dissimilar to what people already do with prospective romantic partners. They will also point out that mass usage of these technologies will drive down prices to the point that even poor people will be able to access them, thus giving low IQ parents the chance to have high IQ kids. They might also note that such technologies may be the only way to reverse the ongoing accumulation of deleterious mutations within the human germline that has been the unintended by-product of the proliferation of life-saving medicines.31 We will not wade into this thorny debate, other than to note that there will be huge incentives for people to avail themselves of these technologies. The Coming Eugenic Wars And not just individuals either – governments too. While the initial impact of eugenic technologies will be small, the effects will compound over time. Carl Shulman and Nick Bostrom estimate that genetic screening could boost average IQs by up to 65 points in five generations (Table II-2). China has been investing heavily in genetic technologies. As Geoffrey Miller has argued, China’s infatuation with eugenics spans into the modern day.32 Like most other countries, fertility in China is negatively correlated with IQ. Mingrui Wang, John Fuerst, and Jianjun Ren estimate that China is currently losing nearly one-third of a point in generalized intelligence per decade, with the loss having accelerated rapidly between the 1960s and mid-1980s.33 The decline in the genetic component of Chinese IQs is coming at a time when the population itself is about to shrink. According to the UN’s baseline forecast, China will lose 450 million working-age people by the end of the century (Chart II-18). Meanwhile, the country is saddled with debt, the result of an economic model that has, for decades, recycled copious household savings into debt-financed fixed-investment spending in an effort to shore up domestic demand. The authorities may be tempted to tackle all three problems simultaneously by adopting generous pro-natal measures – call it the “at least one-child policy”– which increasingly harnesses emerging eugenic technologies. The resulting baby boom would strengthen domestic demand, thus making the economy less dependent on exports, while ensuring China’s long-term geopolitical viability. The Eugenic Wars are coming, and they will be unlike anything the world has seen before. BOX II-1 The Diffusion Of Bourgeois Values: Culture Or Genes? Higher-income people had more surviving children in the centuries leading up to the Industrial Revolution. Real per capita income was broadly stable during this period. This implies that there must have been downward social mobility, with sons, on average, being less wealthy than their fathers. This downward mobility, in turn, spread the characteristics of higher-income people across the broad swathe of society. What were these characteristics? Cultural values that emphasized thrift, diligence, and literacy were undoubtedly part of what was passed on to future generations. But surprisingly, it also appears that genetic transmission played an important, and perhaps pivotal, role. Models of genetic transmission make very concrete predictions about the correlations in economic status that one would expect to see among relatives. Biological brothers share 50% of their genes, as do fathers and sons. Likewise, first cousins share 25% of their genes, the same as grandfathers and sons. These facts yield two testable predictions: The first is that the correlation coefficient on status measures such as wealth, occupation, and education should be the same for relatives that share the same fraction of genes such as sibling pairs and father-son pairs. Box Chart II-1 shows that this is borne out by the data. The second prediction is that the correlation between status and genetic distance should follow a linear trend so that, for example, the correlation in wealth among brothers is twice that of first cousins and four times that of second cousins. Box Chart II-2 shows that this is also borne out by the data.   Other evidence supports the importance of genes in the transmission of status across generations. The correlation in measures such as wealth, education, and occupation is much higher among identical twins than fraternal twins. Adopted children turn out to be more similar to their biological parents on these measures when they reach adulthood than their adopted parents, even when the children have never met their biological parents. The parent-child correlation also remains the same regardless of family size, suggesting that spreading the same resources over more children may not harm life outcomes to any discernible degree, at least on the measures listed above. Peter Berezin Chief Global Strategist Global Investment Strategy III. Indicators And Reference Charts Our tactical equity upgrade to overweight last month has still not been confirmed by most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicator for the U.S. is falling fast. It is also eroding for Europe, although it has ticked higher in Japan. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors have clearly moved funds away from the U.S. equity market and there is no sign yet that this is reversing. Our Revealed Preference Indicator (RPI) for stocks continued to issue a ‘sell’ signal in January. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. While the RPI is still cautious, value has improved significantly according to BCA’s composite valuation indicator. It is a composite of 11 different valuation measures. This indicator almost reached the fair value line in December. Moreover, our Monetary Indicator has suddenly shifted out of negative territory for stocks, rising to the neutral line in December. Calming words from the Fed has improved the monetary backdrop by removing expected rate hikes from the money market curve. Given the improvement in both value and the monetary backdrop, the RPI could generate a ‘buy’ signal next month. Our Composite Technical indicator for stocks broke down last month, providing a clear ‘sell’ signal, and has not yet delivered a ‘buy’. However, sentiment is now washed out and earnings expectations have been revised heavily downward. These signals are bullish from a contrary perspective.  The 10-year Treasury yield is in the neutral range according to our valuation model. Bonds are not overbought, despite the rally in December, because they were still working off oversold conditions. Contrary to the bond valuation model, the 10-year term premium moved further into negative territory in January, suggesting that yields are unsustainably low. Our bond-bearish bias is consistent with the view that the Fed rate hike cycle is not over. The U.S. dollar is somewhat overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. EQUITIES: Chart III-1U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator   Chart III-18U.S. Dollar Fundamentals   Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators   Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst   Footnotes 1       Please see The Bank Credit Analyst Special Report "The Long Shadow Of The Financial Crisis," dated October 25, 2018, available at bca.bcaresearch.com 2       The amount of spread widening required for corporate returns to break-even with duration-matched U.S. Treasuries on a one-year horizon. 3       Please see Geopolitical Strategy Special Report "Five Black Swans In 2019," dated January 16, 2019, available at gps.bcaresearch.com 4       Xi Song, Cameron Campbell, and James Lee, "Descent Line Growth and Extinction From A Multigenerational Perspective, Extended Abstract," American Sociological Review 80:3, (April 21, 2015): 574-602. 5       Gregory Cochran and Henry Harpending, "The 10,000 Year Explosion: How Civilization Accelerated Human Evolution," Basic Books, (2009). 6       Mark Grinblatt, Matti Keloharju, and Juhani T. Linnainmaa, “IQ, Trading Behavior, and Performance,” Journal of Financial Economics, 104:2, (May 2012): 339-362. 7       Thomas Bouchard, "Genetic Influence On Human Psychological Traits - A Survey," Current Directions in Psychological Science 13:4, (August 2004): 148-151. 8      The tendency for the genetic contribution to IQ to increase until early adulthood and then to remain at high levels until old age is known as the Wilson Effect. There is no consensus on what causes it, but it probably reflects a number of factors: 1) It may take some children longer than normal to reach full intellectual maturity. Testing their IQs at a young age will result in scores that are lower than those expected based on their parents’ IQs. The opposite is true for children whose IQs increase relatively quickly in young age, but possibly top out earlier; 2) Environmental effects are probably more important in young age when a child’s brain is still quite malleable; 3) Self-reinforcing gene-environment interactions tend to increase with age. Children do not have much control over their environment, but as they get older, they will seek out activities that are more in keeping with their genetic predispositions. For example, a studious child may pursue a career that reinforces their love of learning. 9       "Cache Cab: Taxi Drivers' Brains Grow to Navigate London's Streets," Scientific American, (December 2011). 10       Atheendar Venkataramani, "Early Life Exposure to Malaria and Cognition in Adulthood: Evidence from Mexico," Journal of Health Economics 31:5, (July 2012): 767-780; Hoyt Bleakley, "Health, Human Capital and Development," Annual Review of Economics 2, (March 2010): 283-310; Hoyt Bleakley, "Malaria Eradication in the Americas: A Retrospective Analysis of Childhood Exposure," American Economic Journal: Applied Economics 2, (April 2010): 1-45. 11       "Anthropologists Find American Heads Are Getting Larger," ScienceDaily, (May 2012). 12       "British Teenagers Have Lower IQs Than Their Counterparts Did 30 Years Ago," The Telegraph, (February 2009). 13     Bernt Bratsberg and Ole Rogeberg, "Flynn Effect And Its Reversal Are Both Environmentally Caused," Proceedings of the National Academy of Sciences 115:26, (June 2018): 6674-6678. 14     On the face of it, artificial intelligence would appear to be a substitute for human intelligence. Many applications of AI would undoubtedly have this feature, especially those that allow computers to perform complex mental tasks that humans now must do. However, there are several ways that AI may eventually come to complement human intelligence. First, and most obviously, AI could be used to augment human capabilities either directly by hardwiring it into our brains, or indirectly through the development of drugs or genetic techniques which improve cognition. Second, looking further out, the benefits of highly intelligent AI systems would be limited if humans did not possess the requisite intelligence to understand certain concepts that are currently beyond our mental reach. No matter how well intentioned, trying to explain string theory to a mouse is not going to succeed. There are probably a multitude of ideas that AI could reveal that we simply cannot comprehend at current levels of human intelligence. 15     James Heckman and Paul La Fontaine, "The American High School Graduation Rate: Trends and Levels," The Review of Economics and Statistics 92:2, (May 2010): 244–262. 16     "Turning Around Chronically Low-Performing Schools," The Institute of Education Sciences (IES), (May 2008). 17     E. von Mutius, F.D. Martinez, C. Fritzsch, T. Nicolai, G. Roell, and H. H. Thiemann, "Prevalence Of Asthma And Atopy In Two Areas Of West Germany And East Germany," American Journal of Respiratory and Critical Care Medicine 149:2, (February 1994): 358-64. 18     "Sperm Counts In The West Plunge By 60% In 40 Years As ‘Modern Life’ Damages Men’s Health," Independent, (July 2017). 19     Kaspar Sørensen, Annette Mouritsen, Lise Aksglaede, Casper P. Hagen, Signe Sloth Mogensen, and Anders Juul, "Recent Secular Trends in Pubertal Timing: Implications for Evaluation and Diagnosis of Precocious Puberty," Hormone Research in Paediatrics 77:3, (May 2012): 137-145. 20     “Results from the 2017 National Survey On Drug Use And Health: Detailed Tables,” Substance Abuse and Mental Health Services Administration, Center for Behavioral Health Statistics and Quality, Rockville (Maryland), (September, 2018). 21     Laura A. Pratt, Debra J. Brody, and Qiuping Gu, "Antidepressant Use Among Persons Aged 12 and Over: United States, 2011–2014," NCHS Data Brief No. 283, Centers for Disease Control and Prevention, (August 2017). 22     Some, but not all, of the increase in reported rates of mental illness may be due to more aggressive diagnosis by health practitioners. For example, a recent study revealed that children born in August were 30% more likely to receive an ADHD diagnosis than those born in September, simply because they were less mature compared to other kids in the first few years of elementary school. See: Timothy J. Layton, Michael L. Barnett, Tanner R. Hicks, and Anupam B. Jena, "Attention Deficit-Hyperactivity Disorder and Month of School Enrollment," New England Journal of Medicine 379:22, (November 2018): 2122-2130. 23     Tamara C. Daley, Shannon E. Whaley, Marian D. Sigman, Michael P. Espinosa, and Charlotte Neumann, "IQ On The Rise: The Flynn Effect In Rural Kenyan Children," Psychological Science 14:3, (June 2003): 215-9; Jakob Pietschnig and Martin Voracek, "One Century of Global IQ Gains: A Formal Meta-Analysis of the Flynn Effect (1909-2013)," Perspectives on Psychological Science 10:3, (May 2015): 282-306. 24     N. Bleichrodt and M. P. Born, “Meta-Analysis of Research on Iodine and Its Relationship to Cognitive Development,” In: ed. J. B. Stanbury, "The Damaged Brain of Iodine Deficiency," Cognizant Communication Corporation, New York, (1994): 195-200; "Iodine status worldwide: WHO Global Database on Iodine Deficiency," World Health Organization, Geneva, (2004). 25     Mohd Fareed and Mohammad Afzal, "Estimating the Inbreeding Depression on Cognitive Behavior: A Population Based Study of Child Cohort," PLOS ONE 9:12, (October 2015): e109585. 26     H. de Wit, J. D. Flory, A. Acheson, M. McCloskey, and S. B. Manuck, "IQ And Nonplanning Impulsivity Are Independently Associated With Delay Discounting In Middle-Aged Adults," Personality and Individual Differences 42:1, (January 2007): 111-121; W. Mischel and R. Metzner, "Preference For Delayed Reward As A Function Of Age, Intelligence, And Length Of Delay Interval," Journal of Abnormal and Social Psychology 64:6, (July 1962): 425-31. 27     James Flynn, “IQ decline and Piaget: Does the rot start at the top?” Lifetime Achievement Award Address, 18th Annual meeting of ISIR, (July 2017). 28     For a good discussion of these issues, please see Richard J. Haier, “The Neuroscience of Intelligence,” Cambridge Fundamentals of Neuroscience in Psychology, (December 2016). 29     "The Future of In-Vitro Fertilization and Gene Editing," Psychology Today, (December 2018). 30     "DNA Tests For IQ Are Coming, But It Might Not Be Smart To Take One," MIT Technology Review, (April 2018). 31     Michael Lynch, "Rate, Molecular Spectrum, And Consequences Of Human Mutation," Proceedings of the National Academy of Sciences 107:3, (January 2010): 961-968. 32     Geoffrey Miller, "What *Should* We Be Worried About?" Edge, (2013). 33     Mingrui Wang, John Fuerst, and Jianjun Ren, "Evidence Of Dysgenic Fertility In China," Intelligence 57, (April 2016): 15-24. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Highlights We advocate implementing asset allocation not across EM assets, but rather relative to their DM counterparts. EM stocks should be part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is beneficial. We continue recommending below benchmark allocation to EM equities, credit and local bonds. The rebound in various EM financial markets is reaching a critical technical level where it will either stop or, if broken, will carry on for some time. In Peru, further decline in industrial metals prices and ongoing involuntary monetary tightening bode ill for share prices; continue underweighting. Feature We frequently receive questions from our clients on how they should be positioning their portfolios within EM asset classes such as equities, EM U.S. dollar bonds (credit markets) and local currency government bonds – whether they should be overweight EM stocks versus EM credit markets and domestic bonds, or vice versa. While BCA’s Emerging Markets Strategy service covers EM stocks, credit and domestic bonds and exchange rates, we do not make asset allocation calls between EM equities, EM credit and local currency bonds. The reason is very simple: in a risk-on market, EM equities always outperform EM credit and local bonds, and in a risk-off environment, stocks always underperform fixed income (Chart I-1). Chart I-1EM Stocks Versus EM Credit And Local Bonds With respect to the relative performance of EM credit markets versus domestic bonds, the performance of EM currencies is key. A large portion of total returns on EM local currency bonds comes from exchange rates (Chart I-2). Hence, when EM currencies appreciate, domestic bonds outperform EM credit markets (U.S. dollar bonds), and vice versa (Chart I-3). Chart I-2EM Currencies Are Key To EM Local Bonds Returns Chart I-3EM Local Bonds Versus EM Credit: It Is A Currency Call For investors willing to allocate across EM asset classes, a directional view on financial markets should drive allocation between equities and fixed-income. In rallies, equities should be favored, while during risk-off periods, fixed income should be preferred. It follows that investors should overweight EM credit markets versus domestic bonds when EM currencies depreciate, and tilt allocation toward local currency bonds versus EM credit markets when EM exchange rates appreciate. Recommended Approach To Asset Allocation We advocate implementing asset allocation not across EM assets, but relative to their DM counterparts: EM stocks should be part of a global equity portfolio. A pertinent asset allocation decision should be whether to be overweight, neutral or underweight EM within a global equity portfolio. In short, EM stocks should not be compared with EM credit or local bonds, but rather versus their DM counterparts. Having mentioned that, we are maintaining our underweight recommendation on EM within a global equity portfolio for now. EM sovereign and corporate credit should be part of a global credit portfolio – i.e., asset allocators should compare them with other credit instruments such as U.S. and European corporate bonds. Total returns on EM U.S. dollar-denominated sovereign and corporate bonds can be deconstructed into the total return on U.S. Treasurys and the excess return of these EM bonds over U.S. Treasurys. Investors can obtain exposure to U.S. Treasurys by owning them outright. Hence, the unique feature of EM sovereign and corporate bonds is their spreads over U.S. government bonds. EM sovereign and corporate bond spreads over U.S. Treasurys reflect issuers' ability and willingness to pay. Thereby, investors should treat EM dollar-denominated bonds as a pure credit product and this asset class should be part of a global credit portfolio. At the moment, we recommend asset allocators underweight EM sovereign and corporate credit versus U.S./DM corporate credit, in line with our short EM equities/long U.S./DM equities strategy (Chart I-4). Within credit markets, EM investment-grade and high-yield credit should be compared with their peers in U.S./DM, respectively. The reason we are negative on EM credit markets relative to the U.S. and DM universe is that the majority of EM sovereign and corporate bond issuers in Latin America and the EMEA are commodity producers. Hence, their revenues fluctuate with commodity prices, and their spreads should be under upward pressure as commodity prices drop further and EM currencies correspondingly depreciate (Chart I-5). Chart I-4EM Credit Versus U.S. Credit Chart I-5EM Credit Spreads Are Sensitive To Commodities And EM Currencies In the meantime, Chinese property companies, financials and industrials/materials remain the largest issuers of corporate debt in emerging Asia. Specifically, U.S. dollar bonds issued by Chinese companies account for 32% of the Barclay’s overall EM USD Credit index and 56% of the EM Asia USD Credit index. Crucially, Chinese corporate credit is essential to trends in emerging Asian credit markets. We are bearish on the fundamentals of Chinese corporate bond issuers due to our negative view on Chinese capital spending, particularly in the real estate sector. With respect to EM local-currency government bonds, this is an entirely different asset class with returns often uncorrelated with any other asset. Table 1 shows that EM local currency bond returns in U.S. dollars have a low correlation with most other asset classes. Therefore, adding EM local-currency bonds to a global multi-asset class portfolio will help achieve risk diversification provided an expectation of a positive return on this asset class in the long run. EM domestic bond returns are comprised of local yield carry and capital gains/losses, as well as currency appreciation/depreciation. Business cycles and monetary policies could from time to time be desynchronized across EM countries, and EM currencies could also at times diverge. In short, all of this will add idiosyncratic risk to any global multi-asset class portfolio and push out the portfolio’s efficient frontier – i.e., the portfolio could achieve higher returns for the same amount of risk (volatility). The exposure to EM local currency bonds should be altered according to the view on this asset’s absolute performance. Presently, we recommend below benchmark allocation to this asset class because we expect the majority of EM currencies to depreciate versus the U.S. dollar, the euro and the Japanese yen. The key driver of EM currencies is not U.S. interest rates but the global business cycle (Chart I-6). Odds are high that global trade will continue disappointing as China’s growth weakens further. This will lead to tumbling EM currencies and outflows from high-yielding EM domestic bonds. Chart I-6What Drive EM Currencies Within an EM local currency bond portfolio, our recommended overweights are Mexico, Brazil, Chile, Russia, central Europe, Thailand and Korea. The list of our overweights and underweight across EM stocks, credit markets, local bonds and currencies is always published at the end of our reports. Bottom Line: Global asset allocation should treat EM stocks as part of a global equity portfolio. EM sovereign and corporate credit should be part of a global credit portfolio. In turn, EM local currency government bonds are a unique asset class with idiosyncratic features and a low correlation with other assets. Hence, their addition to any multi-asset class portfolio is recommended given an expectation of a positive return in the long run. A Make It Or Break It Juncture The rebound in various EM financial market segments is reaching a critical technical level. At that point, it will either reverse, or will break through and carry on the upward momentum for some time: EM share prices have troughed at their three-year moving averages but are now facing resistance at their 200-day moving averages (Chart I-7). Failure to break above their 200-day moving averages would signal higher risks of a major breakdown. Conversely, a decisive break above their 200-day moving averages would suggest that the recent rebound has much farther to go. Our Risk-on versus Safe-Haven currency ratio has found support at its 6-year moving average but is now facing resistance at its 200-day moving average (Chart I-8, top panel). This ratio is highly correlated with EM share prices, and its breakout or breakdown will be an important signal for the direction of EM, commodities and global cyclical assets in general (Chart I-8, bottom panel). Chart I-7EM Share Prices Are Between Support And Resistance Chart I-8This Currency Ratio Is Key To EM And Commodities Trend A relapse from this level would be a major bearish signal, as it would confirm the formation of a head-and-shoulders pattern in this currency ratio. The latter would entail a major breakdown. A number of EM currencies such as ZAR, MXN, KRW, TWD, MYR and CNY are at a critical juncture (Chart I-9). A breakout or failure to do so will entail a major move. Chart I-9AEM Exchange Rates Are At Make It Or Break It Juncture Chart I-9BEM Exchange Rates Are At Make It Or Break It Juncture Meanwhile, the BRL may be forming an inverted head-and-shoulders pattern (Chart I-10). Hence, continuous BRL strength would signal rising odds of an extension to the rally in Brazilian markets. Chart I-10The Brazilian Real: An Inverted Head-And-Shoulder? Finally, industrial metals prices have failed to rebound and appear to be forming a head-and-shoulders formation. This pattern foreshadows considerable downside from current levels (Chart I-11, top panel). In the meantime, oil prices have bounced off their long-term moving average and might have a bit more room to advance before hitting a major resistance between $65-$70 for Brent (Chart I-11, bottom panel). Bottom Line: Our fundamental view on EM risk assets remains negative due to our expectations of further weakness in China’s growth. However, we are monitoring various signals and indicators to gauge whether the latest rebound can last much longer, which would cause us to change our stance tactically. Arthur Budaghyan, Senior Vice President Emerging Markets Strategy arthurb@bcaresearch.com Peru: Involuntary Monetary Tightening Peru’s central bank is tightly managing the country’s exchange rate. As a result, it has little control over local interest rates. The Impossible Trinity thesis stipulates that in a country that has an open capital account, the central bank can control either interest rates or the exchange rate, not both simultaneously. Provided Peru has an open capital account, its central bank can have tight control over either the exchange rate or interest rates. So long as the central bank focuses on exchange rate stability, local interest rates will fluctuate with its balance of payments (BoP). Therefore, Peru’s credit cycle and hence domestic demand swings and bank share prices are driven by BoP (Chart II-1). Negative BoP dynamics – shrinking inflow of U.S. dollars – causes local interest rates to move higher while a positive BoP leads to lower borrowing costs (Chart II-2). Chart II-1Commodities Prices & Bank Stocks Are Correlated Chart II-2Trade Balance Drives Interbank Rates We expect negative BoP dynamics for Peru going forward – metals prices will drop as China’s growth continues to decelerate, and EM countries will likely experience a bout of portfolio capital outflows. If Peru’s central bank continues to favor limited currency depreciation, its interbank rates will march higher. Chart II-3 illustrates that the pace of net foreign exchange reserves accumulation often negatively correlates with interbank rates and leads loan growth by around 12 months (Chart II-4). Chart II-3Peruvian Local Rates Have Risen Chart II-4Peru: Bank Loan Growth Will Relapse When the monetary authorities purchase foreign exchange reserves, they inject local currency excess reserves (liquidity) into the banking system. More plentiful banking system liquidity drives down interbank rates and allows banks to expand credit, boosting domestic demand. The reverse also holds true. The Peruvian central bank was able to mitigate upside in local rates amid the negative terms-of-trade shock in 2014-‘15 by conducting foreign currency swaps with banks. This swap led to an injection of local currency reserves into the system. Currently these swaps are being unwound and banks’ excess reserves are dwindling, putting upward pressure on local rates. Hence, the rise in interbank rates in the past 12 months has not only been due to negative terms of trade but also due to the expiration of foreign currency swaps. As metals prices drop and exports contraction deepens, the currency will come under selling pressure (Chart II-5). To prevent the currency from depreciating considerably, the central bank has to tighten liquidity, producing higher interbank rates. The latter bodes ill for domestic demand. Chart II-5Money Growth Is Contingent On Trade Bottom Line: We continue to underweight the Peruvian bourse because of its exposure to mining companies and banks. The former is at risk from falling industrial metals prices, while the latter will suffer from rising interbank rates. Within the mining sector, gold and silver stocks should outperform copper producers because we foresee more downside in industrial metals than precious metals prices. Andrija Vesic, Research Analyst andrijav@bcaresearch.com Footnotes Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. The two main tail-risks are a messy Brexit and financial market volatility, but these are not our central case. Stay overweight the Eurostoxx50 versus the S&P500. Go underweight German bunds. Go overweight the German DAX versus German long-dated bunds. Add the German DAX as a new long position to the existing long basket holdings in France, Ireland and Switzerland. Maintain the short basket holdings in Norway and Denmark. Feature Chart of the WeekThe Underperformance Of German Equities Vs. German Bonds Is At A Euro Debt Crisis Extreme! Economies do not grow in straight lines. Rather, the process of economic expansion is a never-ending ebb and flow, creating clockwork-like oscillations in economic activity. As a perfect illustration, the growth in the euro area wage bill has trended higher through the past five years and is now running at very healthy 4 percent clip. Yet this strong uptrend has been interspersed with wobbles that have occurred with a remarkable regularity (Chart I-2). Chart I-2Economies Have Regular Wobbles... The recent setback in euro area activity has spooked some economy watchers. Even the ECB has just moved its risk assessment surrounding the growth outlook to the downside. But the downgrade was largely a result of its ‘data-dependency’ which, by definition, is always backward looking. This meant that the downgrade had a negligible effect on the financial markets which are always forward looking. For the markets, there is a much more important issue: is the recent setback the start of something serious, or can we expect a bounce back? The Setback The explanation for the regular wobbles in euro area growth comes from the oscillations in global economic activity (Chart I-3). But here we need to be wary of a potentially circular argument. As Europe is a dominant component of the global economy, euro area domestic demand setbacks could themselves be the root cause of the over-arching global growth oscillations. Chart I-3...Because Of Clockwork-Like Oscillations In Global Economic Activity Recently, Italy and Germany have suffered idiosyncratic ‘country and sector specific’ setbacks. The spat between Rome and Brussels over Italy’s 2019 budget caused Italian bond yields to soar and Italian bank lending to contract viciously (Chart I-4). Meanwhile, the auto sector – a major engine of the German economy – spluttered as it absorbed the new WLTP emissions testing standard. Through the middle of 2018 German vehicle exports suffered a €20 billion hit which shaved 0.6 percent from the €3.4 trillion German economy (Chart I-5).  Chart I-4Italian Bank Lending Contracted Viciously, But Will Now Recover Chart I-5German Auto Exports Plunged, But Will Now Recover Despite all of this, the epicentre of the 2018 growth setback was not inside Europe, but outside Europe. The ECB correctly blames the recent down-oscillation not on domestic causes, but on softer external demand, specifically “vulnerabilities in emerging markets”. The central bank argues that once there is clarity on the exports and the trade sector, much of the euro area’s weakness will wash out.  Another very important driver of European growth oscillations is the oil price. In recent years, the growth in GDP in excess of wages has perfectly and inversely tracked oscillations in the oil price (Chart I-6). The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending. Chart I-6Oil: Another Driver Of European Growth Somewhat contrary to received wisdom, one thing that does not generally drive euro area growth oscillations is the euro exchange rate. When the euro weakens, it does of course make the euro area’s exporters more competitive. But working against this, a weaker euro also raises the prices of imported energy and food, thereby squeezing euro area consumers’ real incomes. And vice-versa when the euro strengthens. Hence, while the euro’s moves do create growth winners and losers within the euro area, these tend to cancel out at the aggregate economy level. The Bounce Back The main headwinds to euro area growth in 2018 are easing in 2019, at least in part and for the time being. Regarding the vulnerabilities in emerging markets, many ECB governors argue that “everything we know says that the Chinese government is taking strong measures to address its slowdown”. Recent improvements in China’s monetary statistics provide strong evidence for this view (Chart I-7). Chart I-76-Month Credit Impulses Are Bouncing Back Everywhere Meanwhile, credit growth in the euro area itself is also accelerating, albeit modestly. This is hardly surprising given that financing conditions are very favourable. Even though the ECB has done nothing to policy interest rates, more dovish forward guidance has effectively made euro area monetary policy more accommodative: since October, core euro area 10-year bond yields are down 40 bps. And with banks’ balance sheets stronger, the ECB claims “the conditions for a continuation of credit to the economy are in place.”  Over the same three month period, the crude oil price has plunged by 35 percent (Chart I-8). Draghi confirmed our observation above: lower energy prices support real disposable income for euro area households. Chart I-8Double Boost: Lower Bond Yields And Lower Oil Draghi also pointed out another positive impulse: fiscal policy in the euro area has now flipped from contractionary to slightly expansionary. As regards the idiosyncratic sector specific setbacks, the Italian 10-year BTP yield has unwound its budget spat spike, and is down 100 bps since October. It follows that Italian bank credit growth is likely to recover. And Draghi explained that “the specific episode of the car industry in Germany will soon wash out because there is going to be a rebound in the sector.” Still, two significant tail-risks could smother the bounce back: Uncertainties related to geopolitical factors and the threat of protectionism, specifically, a messy Brexit. Financial market volatility. The Investment Implications Our central case is that the tail-risks do not materialise. And that the recent combination of more favourable financing conditions in the euro area and globally, lower energy prices, fiscal thrust, and the removal of specific setbacks in Italy and Germany should engineer some sort of growth bounce back in the euro area.  One important implication is that the strong recent rally in German bunds is close to exhaustion, and even vulnerable to a short-term retracement. This is supported by our trusted technical indicator warning of an imminent liquidity shortage and a corrective price reversal (Chart I-9). Go underweight German bunds on a short term horizon. Chart I-9The Rally In The German Bund Is Exhausted A mirror-image implication is that the underperformance of the German DAX relative to German long-dated bunds is now at euro debt crisis extremes (Chart I-1 and Chart I-10). This relative performance also appears technically exhausted and ripe for a reversal. As an asset allocation position, go overweight the DAX versus German long-dated bunds on a tactical. Chart I-10The Extreme Underperformance Of The DAX Will Reverse In line with the growth rebound thesis, stock market selection – through the underlying sector exposures – should now have a modest tilt towards cyclicality. Stay overweight the Eurostoxx50 versus the S&P500. Within Europe, our current long positions in France, Ireland, and Switzerland combined with short positions in Norway and Denmark do provide the required tilt towards cyclicality. Nevertheless, today we are adding the oversold German DAX to our long stock markets basket. Fractal Trading System* In line with the fundamentals-based arguments in the main body of this report, this week’s recommended trade is to go long the DAX versus the 30-year bund. Set a profit target of 2.5 percent with a symmetrical stop-loss For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-11 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com   Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations