Global

Highlights Duration: With rate hikes more likely than cuts over the next 12 months, it makes sense to maintain below-benchmark duration in U.S. bond portfolios. However, timing the next up-move in Treasury yields is difficult. We recommend that investors initiate positive carry yield curve trades to boost returns while we wait for Treasury yields to bottom alongside the CRB/Gold ratio. Corporates: The Fed’s pause is leading to improvement in our global growth indicators. The end result is a window where corporate spreads will tighten during the next few months. Remain overweight corporate bonds, but be prepared to downgrade when spreads reach our targets. CMBS: We upgrade our allocation to non-agency CMBS from underweight to neutral, due to elevated spreads relative to other Aaa-rated sectors. While spreads are currently attractive, the macro back-drop is also fairly bleak. If spreads tighten to more reasonable levels or CMBS delinquencies start to rise we will be quick to downgrade. Feature Green Shoots For Global Growth Since 1994 the Global (ex. U.S.) Leading Economic Indicator (LEI) has contracted relative to its 12-month trend six times. In all six episodes it eventually dragged the U.S. LEI down with it (Chart 1). As we predicted last August, the U.S. economy cannot remain an oasis of prosperity when the rest of the world is in turmoil.1 However, to focus on the weakening U.S. data right now is to miss the bigger picture. Chart 1U.S. Follows The Rest Of The World Corporate bond spreads already reacted to the global slowdown by widening near the end of last year. Then, the Federal Reserve reacted to tighter financial conditions by signaling a pause in its rate hike cycle. We took that opportunity to turn more bullish on spread product, and now, there are budding signs of improvement in the global growth outlook. While the Global LEI (including the U.S.) remains in a downtrend, our Global LEI Diffusion Index is well off its lows (Chart 2). Historically, the Diffusion Index has a good track record leading changes in the overall indicator. Chart 2Global LEI Diffusion Index Is Back Above 50% Similarly, the timeliest indicators of global growth that called the early-2016 peak in credit spreads are starting to improve (Chart 3). The CRB Raw Industrials index is breaking out, the BCA Market-Based China Growth Indicator has recovered and Global Industrial Mining Stock prices are heading up. Chart 3Global Growth Checklist All told, it appears that the Fed’s pause and related dollar weakness, along with less restrictive fiscal and monetary policies in China, are starting to pay dividends.2 The end result is a window where leading global growth indicators will improve and financial conditions will ease. We recommend that investors maintain an overweight allocation to corporate bonds during this supportive window, though we also note that the continued rapid pace of corporate re-leveraging is a cause for concern. We will be quick to downgrade our recommended allocation to corporate bonds when our near-term spread targets are hit. Our spread target for Aa-rated corporates is 57 bps, the current spread level is 61 bps. Our spread target for A-rated corporates is 85 bps, the current spread level is 92 bps. Our spread target for Baa-rated corporates is 128 bps, the current spread level is 159 bps. Our spread target for Ba-rated corporates is 188 bps, the current spread level is 243 bps. Our spread target for B-rated corporates is 297 bps, the current spread level is 400 bps. Our spread target for Caa-rated corporates is 573 bps, the current spread level is 827 bps. We recommend avoiding Aaa-rated corporate bonds, which already look expensive. We explore the universe of Aaa-rated spread product in more detail below. Implications For Treasury Yields The Fed’s pause and the nascent improvement in global growth are both obvious positives for corporate spreads. The impact on Treasury yields is somewhat less obvious. We contend that once financial conditions ease sufficiently, the market will start to price-in further Fed rate hikes and this will pressure Treasury yields higher at both the short and long ends of the curve. The ratio between the CRB Raw Industrials index and the gold price can help clarify this concept. Chart 4 shows that the 10-year Treasury yield tends to rise when the CRB index outpaces gold, and vice-versa. The rationale for this correlation is that the CRB index is a proxy for global growth and gold is a proxy for the stance of monetary policy. Chart 4Timing The Next Treasury Sell-Off A rising gold price suggests that monetary policy is becoming increasingly accommodative. This eventually leads to an improvement in global growth and a rising CRB index. But Treasury yields do not rise alongside the CRB index. They only increase once the improvement in global growth is sufficient for the market to discount a tighter monetary policy. That moment occurs when the CRB index rises more quickly than the gold price. The bottom line is that with rate hikes more likely that cuts over the next 12 months it makes sense to maintain below-benchmark duration in U.S. bond portfolios. However, timing the next up-move in Treasury yields is difficult. We recommend that investors initiate positive carry yield curve trades to boost returns while we wait for Treasury yields to bottom alongside the CRB/Gold ratio.3 Checking In On The Labor Market Based on the number of emails we’ve received on the topic, the last two U.S. employment reports have stoked some confusion among investors. This is not surprising given the volatility in the headline numbers: Nonfarm payrolls increased +311k in January and only +20k in February. The U3 unemployment rate jumped to 4% in January, then fell back to 3.8% in February. The U6 unemployment rate jumped to 8.1% in January, then fell back to 7.3% in February. Much of the volatility is likely explained by data collection issues related to the partial government shutdown, which makes it useful to look through the noise and focus on a few important trends. Trend #1: Slow Growth In Q1 The employment data clearly point to a U.S. growth slowdown in the first quarter of 2019. Real GDP growth can be proxied by looking at the sum of the growth rate in aggregate hours worked and the growth rate in labor force productivity (Chart 5). The recent steep decline in hours worked suggests that first quarter growth is going to be weak. Chart 5Employment Data Point To Slow Growth In Q1 But as was noted in the first section of this report, weak Q1 GDP is the result of the global growth slowdown dragging the U.S. lower. Crucially, the market has already discounted this eventuality and the budding improvement in leading global growth indicators suggests that the U.S. slowdown will prove temporary. Trend #2: No More Slack A broad set of indicators now all point to the fact that the U.S. economy is at full employment (Chart 6). The implication is that we should expect wage growth to accelerate and payroll growth to decelerate as we move deeper into the cycle. Chart 6At Full Employment Some investors may retain the belief that a rising labor force participation rate will keep wage growth capped, but even here the prospects are dim. The participation rate for people of prime working age (25-54) has risen rapidly during the past few years, but that has only led to a small bounce in overall participation (Chart 7). This is because the aging of the population has pushed more and more people out of that prime working age demographic bucket. Chart 7Labor Force Participation The dashed line in the top panel of Chart 7 shows where the labor force participation rate would be, based on current demographics, if the participation rate for each narrow age cohort reverted to its July 2007 level. The message is that the scope for a further increase in labor force participation is limited. Trend #3: No Recession Risk Yet The full employment state of accelerating wage growth and decelerating employment growth can last for some time before a recession hits. In our research we have noted that, from a financial markets perspective, one of the best leading indicators is the change in initial jobless claims. Typically, a bottom in initial jobless claims coincides with an inflection point in Treasury excess returns (Chart 8). Chart 8Jobless Claims Have Called Troughs In Treasury Returns Initial jobless claims have risen somewhat during the past few weeks, and while this trend is worth monitoring, it is premature to flag it as a concern. The 4-week moving average in claims has already fallen back to 226k from a recent high of 236k, and next week an elevated print of 239k will roll out of the 4-week average. Any initial claims print below 239k next week will cause the 4-week average to decline further. Bottom Line: The U.S. labor market has reached full employment. Going forward we should expect a continued acceleration in wage growth and deceleration in payroll growth. This situation can persist without causing a recession until initial jobless claims start to head higher. We see no evidence of this as of yet. Aaa-Rated Spread Products In this week’s report we consider the risk/reward trade-off on offer from the major Aaa-rated spread products. Specifically, we consider corporate bonds, agency and non-agency CMBS, conventional 30-year residential MBS and consumer ABS (both credit cards and auto loans). Focusing purely on expected returns, we find that non-agency CMBS offer the highest option-adjusted spread of 73 bps. This is followed by 65 bps from corporates, 50 bps from Agency CMBS, 41 bps from MBS, 35 bps from auto ABS and 31 bps from credit card ABS. But this is just one side of the equation. Chart 9 shows each sector’s spread relative to the likelihood that it will experience losses versus Treasuries. To measure the risk of losses we use our measure of Months-To-Breakeven. This is defined as the number of months of average spread widening that each sector requires before it starts to lose money relative to a duration-matched position in Treasury securities. Essentially, the Months-To-Breakeven measure is each sector’s 12-month breakeven spread adjusted by its spread volatility since 2014. We only calculate spread volatility since 2014 because that it is when data for Agency CMBS start. Chart 9 shows that while Aaa corporate bonds offer elevated expected returns compared to the other sectors, they also offer a commensurate increase in risk. Similarly, consumer ABS offer lower expected returns than the other sectors but with considerably less risk. According to Chart 9, the only sector that offers an attractive risk/reward trade-off is non-agency CMBS. This warrants further investigation. Looking at spreads throughout history, we see that non-agency CMBS spreads also look relatively attractive. While Aaa-rated consumer ABS spreads are near all-time lows, non-agency CMBS spreads are still not quite one standard deviation below the pre-crisis mean (Chart 10). Chart 10CMBS Spreads Have Room To Narrow We noted in last week’s report that consumer ABS look even worse when we incorporate the macro environment.4 All-time tight ABS spreads currently coincide with tightening consumer lending standards and a rising consumer credit delinquency rate. This is why we downgraded consumer ABS from neutral to underweight last week. The macro environment for CMBS is also fairly bleak (Chart 11). Commercial real estate lending standards are tightening, loan demand is waning and prices are decelerating. The one saving grace is that, so far, this has not translated into a rising CMBS delinquency rate (Chart 11, bottom panel). It is probably only a matter of time before CMBS delinquencies start to trend higher, but with spreads so attractive relative to the investment alternatives, the sector warrants better than an underweight allocation. Chart 11Delinquencies Biased Higher? Bottom Line: We upgrade our allocation to non-agency CMBS from underweight to neutral. Spreads are currently attractive relative to other Aaa-rated sectors, but we will keep a close eye on the evolving macro backdrop. If spreads tighten to more reasonable levels or if CMBS delinquencies start to rise, we will be quick to downgrade.   Ryan Swift,  U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “An Oasis Of Prosperity”, dated August 21, 2018, available at usbs.bcaresearch.com 2 For further details on recent shifts in Chinese policy please see China Investment Strategy Weekly Report, “Dealing With A (Largely) False Narrative”, dated February 27, 2019, available at cis.bcaresearch.com 3 For more details on the attractiveness of positive carry yield curve trades please see U.S. Bond Strategy Weekly Report, “Paid To Wait”, dated February 26, 2019, available at usbs.bcaresearch.com 4 Please see U.S. Bond Strategy Portfolio Allocation Summary, “The Sequence Of Reflation”, dated March 5, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights The deceleration in global growth that began in 2018 is entering a transition phase. The bottoming out process could prove to be volatile, warning against betting the farm too early on pro-cyclical currencies. Tactical short USD bets should initially be played via the euro1 and Swedish krona. The poor Canadian GDP report last week could be a harbinger for more data disappointments down the road. Meanwhile, the dovish shift by the ECB could paradoxically be bullish for the euro beyond the near term. Go short USD/SEK and buy EUR/CAD for a trade. Feature A currency exchange rate is simply a measure of relative prices between two countries. As such, the starting point for any currency forecast should be how those values are likely to evolve over time. For much of 2018, U.S. growth benefited from the impact of the Trump tax cuts, a boost to government spending agreed in January of that year, and the lagged effect of an easing in financial conditions from December 2016 to January 2018. Outside the U.S., what appeared to be idiosyncratic growth hiccups in both Europe and Japan finally morphed into full-blown slowdowns. Slower Chinese credit growth and the U.S.-China trade war were the ultimate straws that broke the camel’s back, deeply hurting global growth (Chart I-1). Consequently, the greenback surged. Chart I-1The Global Growth Slowdown Persists Fading U.S. Dollar Tailwinds At first glance, the picture remains largely similar today, with global growth still slowing and U.S. growth still outperforming. However, a key difference from last year is that U.S. growth leadership is set to give way to the rest of the world. The U.S. ISM manufacturing PMI peaked last August and has been steadily rolling over relative to its trading partners. The U.S. economic surprise index tells a similar story, with last month’s disappointing retail sales numbers nudging the series firmly below zero. Relative leading economic indices also suggest that U.S. growth momentum has slowed relative to the rest of the world. Historically, the relative growth differential between the U.S. and elsewhere has had a pretty good track record of dictating trends in the dollar (Chart I-2). Chart I-2U.S. Growth Leadership Might Soon End Whether or not these trends persist beyond the first quarter will depend on the sustainability of China’s recent stimulus efforts. On the positive side, typical reflation indicators such as commodity prices, emerging market currencies, and industrial share prices have perked up in response to a nascent upturn in the credit impulse. On the other hand, policy shifts affect the economy with a lag, suggesting it is too early to tell whether the latest credit injection has been sufficient to turn around the Chinese economy, let alone the rest of the world. What is clear is that the bottoming processes tend to be volatile and protracted, suggesting it is still too early to bet the farm on pro-cyclical currencies. In the interim, investors could track the following indicators to help time a definitive turning point: Whether or not easing liquidity conditions will lead to higher growth is often captured by the CRB Raw Industrial index-to-gold, copper-to-gold, and oil-to-gold ratios. It is encouraging that these also tend to move in lockstep with the U.S. bond yields, another global growth barometer. The power of the signal is established when all three indicators peak or bottom at the same time, as is the case now (Chart I-3). The next confirmation will come with a clear break-out in these ratios. Chart I-3Reflation Indicators Are Perking Up Chinese M2 relative to GDP has bottomed. Historically, this ratio has lit a fire under cyclical stocks and, by extension, pro-cyclical currencies (Chart I-4). The growth rate is still at zero, meaning excess liquidity is not accelerating on a year-over-year basis. Meanwhile, our Emerging Markets team argues that broad credit growth is still decelerating.2 A break above the zero line, probably in the second half of this year, could be a catalyst to shift fully to a pro-cyclical currency stance. Chart I-4Chinese Excess Liquidity Improving On a similar note, currencies in emerging Asia that sit closer to the epicenter of stimulus appear to have bottomed. If those in Latin America can follow suit, it would indicate that policy stimulus is sufficient, and the transmission mechanism is working (Chart I-5). Chart I-5EM Currencies Are Trying To Bottom Finally, China-sensitive industrial commodities, especially metals and building materials, appear to have troughed and are perking up nicely. There was a supply-related issue with the Vale dam bursting in Brazil and a subsequent surge in iron-ore prices, but it is now clear that the entire industrial commodity complex has stopped falling (Chart I-6). Chart I-6Chinese Industrial Commodities Are Rallying Be Selective On USD Shorts Our strategy is to be selective as U.S. dollar tailwinds shift to headwinds, by initially expressing tactical USD shorts via the euro and the Swedish krona. Last week, we highlighted the fact that investors are currently too pessimistic on Europe’s growth prospects. More importantly, most of the factors that toppled European growth domestically – the implementation of new auto-emission standards in Germany, the rising cost of capital in Italy via exploding bond yields, and the populist Gilets Jaunes protests in France – are mostly behind us. Fiscal policy is also set to be loosened this year, and last year’s weakness in the euro will contribute to easier financial conditions. The improvement in European investor sentiment relative to current conditions could be a harbinger of positive euro area data surprises ahead (Chart I-7). Chart I-7Euro Zone Data Might Surprise To The Upside The European Central Bank left rates unchanged at yesterday’s policy meeting but the decision for a new Targeted Long Term Refinancing Operation (TLTRO III – or in other words, cheap loans), could be paradoxically bullish for the euro. If a central bank eases financing conditions at a time when growth is hitting a nadir, it is tough to argue that this is bearish for the currency. Our Global Fixed Income team nailed the move by the ECB in this week’s report.3 European banks have been in the firing line of sluggish growth, negative interest rates, and increased regulatory scrutiny. In the case of Italy, an NPL ratio 9.4% is nearly triple that of the euro area. And with circa 10% of total bank lending in Spain and Italy funded by TLTROs, re-funding by the ECB is exactly what the doctor ordered. In the case of the Sweden, the undervaluation of the krona has begun to mitigate the effects of negative interest rates – mainly a buildup of household leverage and an exodus of foreign direct investment. The GDP report last week was well above expectations, with year-on-year growth of 2.4%. Encouragingly, this was driven by net exports rather than consumption. The Swedish manufacturing PMI release for February was also very encouraging. Orders jumped from 50.4 to 54.0 while export orders jumped from 51.5 to 53.4. The growth in wages is beginning to catch up to new borrowings, meaning domestic consumption could be increasingly financed through income. This will alleviate the need for the Riksbank to maintain an ultra-accommodative policy. On a relative basis, the Swedish economy appears to have bottomed relative to that of the U.S., making the USD/SEK an attractive way to play USD downside. From a technical perspective, the cross is facing strong resistance at the triple top established from the 2009 highs around 9.45 (Chart I-8). Aggressive investors should begin accumulating short positions, while being cognizant of the negative carry. Chart I-8The Swedish Krona Looks Like A Buy Bottom Line: Our favorite indicator for gauging ultimate downside in the dollar is the gold-to-bond ratio. Ever since the global financial crisis, gold has stood as a viable threat to dollar liabilities, capturing the ebb and flow of investor confidence in the greenback tick-for-tick (Chart I-9). Any sign that the balance of forces are moving away from the U.S. dollar will favor a breakout in the gold-to-bond ratio. For now, USD short positions should be played via the euro and Swedish krona.   Chart I-9Pay Close Attention To The Gold-To-Bond Ratio Buy EUR/CAD For A Trade Last week saw an extremely disappointing GDP report out of Canada, which prompted the Bank of Canada to keep interest rates on hold this week, followed by quite dovish commentary. In a 90-degree maneuver from its January policy statement that rates will need to rise over time, BoC Governor Stephen Poloz said the path for future increases had become “highly uncertain.”   Like many central banks around the world, the BoC has been blindsided by the depth of the negative growth impulse outside its borders, which has begun to seep into the domestic economy. The economy grew at an annualized pace of 0.4% in the fourth quarter, the lowest in over two years. Capital expenditures collapsed at a rate of 2.7%, marking the third consecutive quarter of declines. The forward OIS curve is pricing in no rate hikes for Canada this year, meaning sentiment on the loonie is already depressed. However, our contention is that even if growth bottoms by the second half of this year, the Canadian dollar will offer little value to play this cyclical rebound. Our recommendation is to play the loonie’s downside via the euro. First, valuations and balance-of-payment dynamics favor the euro versus the CAD on a long-term basis. Second, we estimate there is more scope for long-term interest rate expectations to rise in the euro area than in Canada (Chart I-10). European rates are further below equilibrium, and the ECB’s dovish shift will help lift the growth potential of the euro area. Meanwhile, the Canadian neutral rate will be heavily weighed down by the large stock of debt in the Canadian private sector, exacerbated by overvaluation in the housing market. This means that expectations in the 2-year forward market are likely to favor the euro versus the CAD. Chart I-10Buy EUR/CAD For A Trade The biggest risk to this view is the price of oil. The EUR/CAD exchange rate is not as negatively correlated with oil as the USD/CAD, but nonetheless the CAD benefits more from rising oil prices than the euro does. BCA’s bullish oil view is a risk over the next six months. On the downside, the EUR/CAD could potentially test the bottom of the upward trending channel that has existed since 2012. This would put EUR/CAD in the vicinity of 1.45 (currently trading at 1.5049). However, initial upside resistance rests at the triple top a nudge above 1.6 (Chart I-11). Chart I-11EUR/CAD Technicals: Limited Downside Meanwhile, economically, Canada is benefiting less from oil prices today than it has in the past. First, the Canadian oil benchmark trades at a large discount to Brent, and second, Canada is having trouble shipping its own oil at a moderate cost due to lack of pipeline capacity.4  Bottom Line: Investors should buy the EUR/CAD for a trade. The Canadian dollar is likely to outperform its antipodean counterparts, but faces limited upside versus the U.S. dollar. There are better opportunities to play USD downside, namely via the Swedish krona and the euro. Stand Aside On The Australian Dollar For more than two decades, the Australian dollar has tended to be mostly driven by external conditions, especially the commodity cycle. But for the first time in several years, domestic factors have joined in to exert powerful downward pressure on the currency. The Australian Prudential Regulation Authority (APRA) has been on a mission to surgically deflate the overvalued housing market, while engineering a soft landing in the economy. Initially, their macro-prudential measures worked like a charm, as owner-occupied housing activity remained resilient relative to “investment-style” housing. What has become apparent now is that the soft landing intended by the authorities is rapidly morphing into a housing crash (Chart I-12). Chart I-12Australia: Anatomy Of A Hard Landing In addition, the upcoming general election could exacerbate the risks to the country’s banks and the housing market.5 The center-left Labour Party, which has moved further to the left in this electoral cycle, has promised several regulatory changes. First, the Labour government would want to get rid of “negative gearing,” the practice of using investment properties that are generating losses to offset one’s income tax bill. Second, the capital gains tax exemption from selling properties will be reduced from 50% to 25%. Third, the Labour government would end the policy of reimbursing investors for the corporate tax paid by the company. This would end the incentive for retirees to own high dividend yielding equities, such as those of Australian banks. This week, the Reserve Bank of Australia kept rates on hold and acknowledged risks to the housing market, but bank stocks suggest they remain well behind the curve (Chart I-13). The futures market is already pricing in 23 basis points of rate cuts by the end of the year, and the contention of our fixed income team is that more might be needed down the road. First, all the preconditions for a rate hike – underemployment below 8%, a rebound in Chinese economic activity and core CPI in the range of 2-3% – have not been met. The reality is that core CPI has lagged the target range since late-2015, and now faces downside risks. Chart I-13Australian Bank Stocks Are Pricing In A Curve Inversion That said, a lot of the bad news already appears priced into the Australian dollar, which is down 14% from its 2018 peak, and 37% from its 2011 peak. This suggests outright short AUD bets are at risk from either upside surprises in global growth, or simply the forces of mean reversion (Chart I-14). Chart I-14Stand Aside On The Australian Dollar For Now Bottom Line: Sentiment on the Aussie dollar is already bearish, warning against putting on fresh shorts. Our short AUD positions, expressed via the NZD and the CAD, are currently 6.74% and 1.99% in the money, respectively. Investors should hold onto these positions, but tighten stops to protect profits.   Chester Ntonifor,  Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Please see Foreign Exchange Strategy Special Report titled “A Contrarian Bet On The Euro,” dated March 1, 2019 available at fes.bcaresearch.com 2 Please see Emerging Markets Strategy Weekly Report titled “EM: A Sustainable Rally Or False Start?,” dated March 7, 2019 available at ems.bcaresearch.com 3 Please see Global Fixed Income Strategy Special Report, titled “The ECB’s Next Move: Taking Out Some Insurance,” dated March 5, 2019, available at gfis.bcaresearch.com 4 Please see Commodity & Energy Strategy Weekly Report, titled “Oil Price Diffs: Global Convergence,” dated March 7, 2019, available at ces.bcaresearch.com 5 Please see Geopolitical Strategy Special Report, titled “A Year Of Change In Australia?,” dated December 5, 2018, available at gps.bcaresearch.com Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. have been mixed: Annualized Q4 GDP growth came in line with expectations at 2.6%, but both the Atlanta and New York Fed models suggest sub 1% growth in Q1 this year. ISM manufacturing PMI missed expectations, falling to 54.2, while the non-manufacturing PMI increased to 59.7. Q4 unit labor costs increased to 2%, surprising to the upside. The DXY index has gained 1.17% this week. Upside on the dollar will be based on Fed’s capacity to continue tightening monetary policy later this year. However, there are increasing signs pointing to a weakening in leadership of U.S. growth this cycle, which could be a headwind for the counter-cyclical dollar. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area show some specter of stabilization: Yearly consumer price inflation increased to 1.5%, in line with expectations. Q4 GDP growth on a year-on-year basis fell to 1.1%, marginally in line. Encouragingly, the Markit composite PMI increased to 51.9. The manufacturing PMI came in at 49.3, while services PMI came in at 52.8.  Finally, retail sales grew higher than expected, with a reading of 2.2%. EUR/USD has fallen by 1.3% this week. The ECB kept interest rates on hold with a dovish tilt. Paradoxically, this could be bullish for the euro, if it allows growth to definitively bottom. Easing financial conditions in the euro area are reflationary and risks to the periphery have been curtailed. Report Links: A Contrarian Bet On The Euro - March 1, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been mixed: Yearly inflation surprised to the upside, coming in at 0.6%. The core inflation excluding fresh food also came in higher than expected at 1.1%. January unemployment rate missed expectations, climbing to 2.5%; while the jobs-to-applicants ratio stayed at 1.63. Nikkei manufacturing PMI surprised to the upside, coming in at 48.9. USD/JPY has risen by 0.4% this week. While we are positive on the safe-haven yen on a structural basis, we struggle to see any near-term upside amid significant Japanese stock and bond outflows. We will be discussing the outlook for the yen in an upcoming report. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Yen Fireworks - January 4, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. have been improving: February consumer confidence came in at -13, slightly higher than expectations. Markit manufacturing PMI came in at 52, in line with expectations; while the services PMI surprised to the upside, coming in at 51.3. The Halifax house price index surprised to the upside, rising 5.9% mom in February. GBP/USD has fallen by 1.2% this week. During the speech on March 5, the Bank of England governor Mark Carney highlighted the market underestimates the potential for interest rate hikes. Overall, we remain bullish on the pound in the long-term, but volatility is set to rise in the near term as we approach the Brexit March 29 deadline. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Deadlock In Westminster - January 18, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been dismal: The RBA commodity price index advanced by 9.1% year-on-year in February, but this was supply related. Building permits continue to contract at 29% year-on-year. Finally, the annualized Q4 GDP growth fell to 0.2%, more than 50% below expectations. AUD/USD fell by 1.2% this week. The RBA kept the interest rate unchanged at 1.5%. Governor Philip Lowe acknowledged the downside risks to the housing market and overall economy, and warned about the “significant uncertainties around the forecast.” That said, AUD/USD has fallen by a 13% since the January 2018 highs, warning against establishing fresh shorts at this juncture. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been mixed: Seasonally adjusted building permits increased 16.5% month-on-month in January, a huge jump. However, the ANZ activity business confidence dropped to -30.9. Most importantly, terms of trade fell to -3% in the fourth quarter, underperforming expectations. NZD/USD depreciated by 0.9% this week. The key for the Kiwi will be a pickup in agricultural commodity prices, which remain in a definitive bear market. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Updating Our Intermediate Timing Models - November 2, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been disappointing: Q4 current account balance has deteriorated, coming in at C$ -15.48 billion. Moreover, annualized Q4 GDP growth missed analysts’ forecast, coming in at 0.4%. Finally, the Markit manufacturing PMI weakened to 52.6 in February. USD/CAD has gained 2.1% this week. The BoC kept interest rates on hold at 1.75% given that domestic economic conditions have now coupled to the downside with a bleak external picture. The caveat for the Canadian dollar is that rising oil prices could provide some support. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 CAD And AUD: Jumping Higher To Plunge Deeper - February 1, 2019   Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland have been negative: Annualized Q4 GDP growth missed analysts’ expectations by 50%, coming in at 0.2%.  In addition, the retail sales contracted 0.4% year-on-year. Lastly, CPI was in line at 0.6%, but this is a far cry from the March 2018 peak. EUR/CHF has been flat this week. Overall, we are bullish EUR/CHF on a cyclical basis. Stabilization in global growth will make safe-haven currencies like the franc less attractive. In addition, the foreign direct investment and portfolio investment outflows from Switzerland should put more downward pressure on the franc. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Waiting For A Real Deal - December 7, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been mixed: Monthly unemployment rate fell to 2.5%, in line with expectations. However, the Q4 current account balance fell to 46.8 billion from 91.36 billion in Q3. The manufacturing PMI has been stable for a few months now, coming in at 56.3 for the month of February. USD/NOK increased by 2.2% this week. We are optimistic on the NOK on a structural basis, given the positive outlook for oil prices. Moreover, the NOK is undervalued and trading at a large discount to its long-term fair value. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been positive: Retail sales was in line with expectations at 0.8% month-on-month. However, annualized Q4 GDP growth was double expectations at 1.2%. The February manufacturing PMI also came in higher at 52.5. In addition, industrial production yearly growth came in higher at 3.4%. Lastly, the Q4 current account balance increased to 39.6 billion. USD/SEK increased by 2% this week. The SEK is still trading at a large discount to its long-term fair value. We remain bearish on USD/SEK on a structural basis as we see many signs pointing to a recovery in the Swedish economy, which is a tailwind for the Swedish krona.   Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Special Report

Highlights Many on the left have embraced Modern Monetary Theory because it seemingly provides a politically expedient way to increase social welfare spending without raising taxes. Money-financed budget deficits can be justified when an economy is stuck in a liquidity trap, but can be extremely inflationary once full employment is reached. Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation and larger budget deficits. The path to high rates is lined with low rates, meaning that an extended period of accommodative monetary policy is usually necessary to stoke inflation. Investors should maintain a bullish bias towards global equities for now, but be prepared to turn bearish late next year as inflation begins to accelerate in the United States. An earlier turn to a more defensive posture on stocks may be necessary if Bernie Sanders, or some other far-left candidate, emerges as the likely victor in the next presidential election. Feature Print Some Money And Feel The Bern You know that an economic theory has reached the big leagues of policy debate when the Fed Chair is asked about it during his congressional testimony. This is exactly what happened on February 26, 2019, when Senator David Perdue questioned Jay Powell about his views on Modern Monetary Theory, or simply MMT as it is often called. Rather ironically given its name, MMT plays down the influence of monetary policy over the economy. Its adherents argue that Congress, and not the Fed, should be responsible for maintaining full employment. MMT proponents abhor the idea of a “balanced budget.” They contend that worries about sovereign debt levels are overblown. The U.S. government can always print money to finance itself. Fiscal deficits matter, but only to the extent that excessive deficits can cause inflation. The theory’s backers are a bit cagey about exactly how much inflation they are willing to tolerate or what they would do if, as in the 1970s, inflation and unemployment both rose together. Whether one thinks MMT is crackpot economics is not the point. What matters is that its supporters are growing in number. They include Stephanie Kelton, Bernie Sanders’ former economic advisor, and one of the speakers at BCA’s forthcoming annual New York Investment Conference. In my personal opinion, Sanders stands a very good chance of winning the 2020 presidential election. This makes MMT about as market-relevant as anything out there. In the following Q&A, we discuss the details of MMT and what it means for investors: Q: How does Modern Monetary Theory differ from standard Keynesian economics? A: MMT is almost indistinguishable from Keynesian economics when an economy is stuck in a liquidity trap, an environment where even interest rates of zero are not enough to revive demand. What really separates the two schools of thought is that MMT proponents tend to see liquidity trap conditions as the normal state of affairs, whereas most Keynesians see them as the exception to the rule. Q: Who’s right? The Keynesians or the MMTers? A: That remains to be seen. Near-zero rates have been the norm for most of the last decade, and much longer in Japan. This is a key reason why MMT has grown in popularity. The future may be different, however. Output gaps are shrinking and some of the structural forces which have held down rates over the last decade may fade. For example, the ratio of workers-to-consumers has peaked around the world, which may result in a decline in global savings (Chart 1). This could push up interest rates. Chart 1The Worker-To-Consumer Ratio Has Peaked Globally Q: Does the tendency of MMT backers to see the world as chronically ensnarled in a liquidity trap explain why they seem to consistently argue for bigger budget deficits? A: It does. If an economy needs negative interest rates to reach full employment, but actual rates are constrained by the zero-lower bound, anything which incrementally adds to aggregate demand will not result in higher rates. This means that increased government spending will not crowd out private investment – indeed, quite to the contrary, bigger budget deficits will “crowd in” private spending by boosting employment. The standard MMT prescription is to run a budget deficit that is large enough, but no larger, to maintain full employment. In effect, this means taking any excess private-sector savings – that is, savings which cannot be transformed into private investment or exported abroad via a current account surplus – and having the government absorb them with its own dissavings. Q: So MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time? Good luck with that. A: Yes, that is a common problem with most left-wing theories: They assume that the government should not be trusted with anything unless it is run by fellow leftists, in which case it should be trusted with everything. To make the fiscal response timelier, MMT supporters have proposed creating a government job guarantee. The basic idea is that the government would hire more workers when the private sector is hunkering down, while shedding workers when the private sector is expanding. In theory, automatic fiscal stabilizers of this sort could help dampen the business cycle. The consensus among MMT backers in the U.S. is that a $15 wage would be high enough to offer a tolerable standard of living without enticing many people to opt for government work when suitable private-sector employment is available. MMT supporters are assuming that the government is competent and agile enough to tighten and loosen fiscal policy at exactly the right time. Unfortunately, as is often the case with such ideas, the devil is in the details. For example, does the $15 wage include potentially generous government benefits? What will the government do if someone shows up for work but decides to just loaf around? What about low-skilled workers who would be more productive in the private sector but are instead diverted into government make-work projects? Inquiring minds want to know. Q: And the price tag could be huge! Wouldn’t an extended period of large budget deficits – even if justified by economic circumstances – cause debt levels to spiral out of control? A: A prolonged period of large budget deficits would most certainly lead to a significant increase in the government debt burden. However, if the interest rate on government borrowing is lower than the growth rate of the economy, as MMT supporters tend to assume, the debt-to-GDP ratio will eventually stabilize.1 In such a setting, the government could just roll over the existing stock of debt indefinitely, while issuing enough new debt to cover interest payments. No additional taxes would be necessary. Chart 2 shows this point analytically. Right now, projected GDP growth is higher than 10-year government borrowing rates for most countries (Chart 3). That’s the good news. The bad news is that there is no guarantee that this will remain the case indefinitely. If interest rates ever rose above GDP growth for an extended period of time, debt dynamics would quickly become unsustainable. MMTers argue that the government can borrow at any rate it wants because they see the currency as a public monopoly.  Q: Isn’t it crazy to assume that interest rates will always stay below GDP growth? A: Not according to MMTers. They argue that the government can borrow at any rate it wants. This is because they see the currency as a public monopoly. As long as a government is able to issue its own currency, it can create money to pay for whatever it purchases, and by definition, money pays no interest. This means that the interest rate can always be held below the growth rate of the economy. The only reason policymakers may wish to raise interest rates is if inflation is getting out of hand. However, even then, most MMT adherents would prefer that the government tighten fiscal policy either by hiking taxes on the rich or cutting spending programs they don’t like (the military is usually high on their list). Raising rates is widely seen by MMT supporters as simply providing a handout to bondholders. Q: It sounds like MMT basically cuts the Fed and other central banks out of the loop. A: That’s right. MMTers contend that monetary policy has little impact on the economy. In fact, many MMT advocates believe that higher rates raise aggregate demand by putting more income into bondholders’ pockets. It’s a very odd argument. Yes, corporate investment tends to respond more to animal spirits than to changes in interest rates. However, there is little doubt that rates affect housing, the currency, and asset prices (and all three, in turn, affect animal spirits). It is almost as if the 1982 recession – an episode where the Volcker Fed took interest rates to 19% – never happened. Q: An odd argument, but perhaps not a surprising one? A: That’s where the “Magic Money Tree” moniker comes in. When an economy is suffering from high unemployment, there really is a free lunch: Putting more people to work can increase someone’s spending without decreasing someone else’s. However, when an economy is at full employment, scarcity becomes relevant again. If a government wants to spend more, it has to convince the private sector to spend less, which it normally does by raising interest rates. MMTers like to throw out the old chestnut about how budget deficits endow the private sector with financial assets such as cash or government bonds. But if additional government spending leads to higher inflation, an increase in the volume of financial assets will simply result in the erosion of the value of existing financial assets. There may be times when more government spending is beneficial even in a full-employment economy, such as funding for basic scientific research or public infrastructure. However, there may also be times when increased government spending is wasteful and comes at the expense of valuable private-sector investment. MMT does not distinguish between the two cases because its adherents seem to deny that any such trade-off exists. Q: It sounds like MMTers want to have their cake and eat it too. A: Exactly. The political appeal of MMT is that it seemingly promises European-style welfare spending without Europe’s level of taxes. Just print more money! Let us ignore the fact that the Fed actually pays interest on bank reserves. Under the current rules, increasing the monetary base would not be costless for the government if that money ended up back at the Fed in the form of excess reserves, as it surely would. The bigger problem is that a large increase in government spending, which is not matched by much higher taxes, will quickly cause the economy to overheat. At that point, policymakers would either need to rapidly tighten fiscal policy, aggressively hike interest rates, or face hyperinflation and a plunging currency. Q: That seems like an obvious point. Why don’t MMTers see it? A: It gets back to what we discussed at the outset – MMTers regard the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity globally, including in the United States, where the unemployment rate has fallen below official estimates of NAIRU (the Non-Accelerating Inflation Rate of Unemployment). MMT supporters tend to be skeptical of these NAIRU estimates, believing them to be biased upwards. MMTers see the world as being chronically stuck in a liquidity trap. The prevailing view among MMTers is that there is still a lot of spare capacity in the world. To be fair, the methodology used by the OECD and many other statistical agencies to calculate the full employment rate, which effectively just smooths out past values of the actual unemployment rate, has probably understated the degree of labor market slack in a few countries (Chart 4). Chart 4AThe Unemployment Rate Versus NAIRU (I) Chart 4BThe Unemployment Rate Versus NAIRU (II) That said, we doubt that NAIRU is overstated in the United States. Both the Fed and the OECD peg NAIRU at 4.3%, slightly below the CBO’s estimate of 4.6%. As it is, the current CBO estimate is nearly one percentage point below the post-1960 average (Chart 5). Back in the 1960s and 1970s, most economists thought NAIRU was lower than it actually turned out to be (Chart 6). This caused the Fed to keep rates below where they should have been. Chart 5U.S. NAIRU Is Estimated To Be The Lowest On Record Chart 6The Fed Continuously Overstated The Magnitude Of Economic Slack In The 1970s Q: Let’s bring this back to market strategy. What does the increasing popularity of MMT mean for investors? A: Investors should regard MMT as simply an extreme example of the increasingly permissive attitude that policymakers are adopting towards inflation. The idea that central banks should raise rates preemptively to avoid overheating is slowly giving way to the belief that they should wait to see the “whites of inflation’s eyes” before tightening monetary policy. Meanwhile, on the fiscal side, austerity is out, and big deficits are in. None of this should be all that surprising. Attitudes towards inflation move in generational cycles. The generation that grew up during the 1930s was highly sensitized towards deflation risk. As a result, policymakers focused on increasing employment, even at the expense of higher inflation. In contrast, the generation that came of age in the 1970s favored policies that clamped down on inflation. For today’s generation, the stagflation of the seventies is a distant memory. “Maximum employment” is the name of the game again. It often takes several years for an overheated economy to produce inflation. This is particularly true when the Phillips curve is quite flat, as appears to be the case today. To the extent that the Fed raises rates over the next 12 months, it will be in response to better-than-expected growth. The stock market should be able to do well in that environment. However, as we get into late-2020 or early-2021, inflation may begin to move materially higher, forcing the Fed to crank up the pace of rate hikes. At that point, equity prices will drop and a maximum short duration stance towards government bonds will be warranted. Q: Just in time for Bernie Sanders’ inauguration! You predicted Trump would win, but Crazy Bernie? Come on, seriously? A: My guess is that Trump was the only Republican candidate who could have beaten Hillary Clinton in 2016, while Clinton was the only Democratic candidate who could have lost to Trump. Had it been Bernie versus Trump, Trump would have lost. Given how close the election turned out to be, Sanders would have probably prevailed.   This is not just idle speculation. During the tail end of the 2016 primary season, head-to-head polls showed Sanders leading Trump by about 10 points, compared to a 3-point lead for Clinton (Chart 7). The final results would have been more favorable for Trump, but given how close the election turned out to be, Sanders would have probably prevailed. A strong economy will help Trump this time around. However, demographic trends continue to move against Republicans. Trump also made a strategic mistake during his first two years in office by focusing on Republican pet issues like corporate tax cuts and gutting Obamacare, rather than securing funding for the border wall, which was his signature campaign promise. For its part, the Democrat establishment will try to stymie Sanders again, but having recently watered down the “superdelegate” rules, it will be in a much weaker position to do so than last time. Q: Yikes, President Bernie doesn’t sound good for stocks! A: In our client conversations on “tail risks” facing the markets, Bernie Sanders almost never comes up. Admittedly, a lot can change in the next 12 months, including the possibility that Joe Biden will enter the race. Biden is more moderate than Sanders and has broad-based appeal. This means that it is still too early to make any significant changes to portfolio strategy. However, if Bernie Sanders, or some other far-left candidate, begins to do well in the polls, markets may start to get antsy later this year.     Peter Berezin Chief Global Investment Strategist peterb@bcaresearch.com       1      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019.     Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights Price differentials between global light-sweet crude oil benchmarks Brent and WTI will narrow over the next three years, as U.S. light-sweet crude oil exports expand and North Sea production growth remains challenged. U.S. product exports also will expand, as investments by Gulf Coast refiners allow them to take in more of the domestic light-sweet crude output. Growing volumes of WTI being exported to Europe are being priced relative to Brent. Over time, we expect the marginal light-sweet crude barrel for the global oil market – and the benchmark of refiners’ primary cost – will be directly linked to WTI – Houston pricing. Given this expectation of increased U.S. exports, we are initiating a long WTI vs. short Brent swap position at tonight’s close in 2020. The 2020 swap settled Tuesday at $6.6/bbl; we project it will average $3.25/bbl. In the heavy-sour markets, differentials – most prominently the Brent – Dubai spread – will remain tight, owing to OPEC 2.0 production cuts, lost Venezuelan and Iranian exports, due to U.S. sanctions, and ongoing difficulties getting Canadian heavy crude to refining markets. Energy: Overweight. OPEC 2.0 likely will decide to extend production cuts to year-end in June, as opposed to May, as was expected earlier.1 This will allow the Cartel to respond to whatever the U.S. decides on May 4 re extending waivers on Iranian export sanctions, and to export losses from U.S. sanctions on Venezuela’s state oil company. Base Metals/Bulks: Neutral. Chinese Premier Li Keqiang announced tax cuts amounting to almost $300 billion (~ 2 trillion RMB), as policymakers attempt to hit a GDP growth target of 6.0 to 6.5% this year. We are getting tactically long spot copper at tonight’s close, expecting this fiscal stimulus to boost prices over $3.00/lb in the next 3 – 6 months. Feature In a little more than two years from now, Exxon will add 1mm b/d of pipeline take-away capacity to the Permian Basin. The new pipe is in addition to the 2mm b/d of takeaway capacity currently being added to the basin, which is expected to be fully operational by the end of this year. Current production in the Permian is close to 4mm b/d, so the combined incremental new pipe will provide considerable room for production growth into the 2020s. Exxon’s pipeline expansion – undertaken with Plains All American and Lotus Midstream – was announced in January, just before the company proceeded with its final investment decision (FID) to expand the capacity of its Beaumont, TX, refinery by 250k b/d to 616k b/d. The new capacity is expected to come online in 2022, and will make Beaumont the largest refinery in the U.S. The refinery expansion will take in light-sweet crude from the Permian, where Exxon plans to triple production to 600k b/d by 2025.2 These announcements are not one-offs: Permian production, and shale-oil output generally, is booming. In the Permian, oil output rose just over 800k b/d last year, according to the U.S. EIA (Chart of the Week, panel 1). Overall U.S. shale output in the Big 5 basins – Anadarko, Bakken, Eagle Ford, Niobrara and Permian – rose close to 1.5mm b/d in 2018.3 Output growth in the Permian will remain super-charged on the back of the pipeline buildout, and the capex being poured into it as the Majors and large E&P companies industrialize production there, not unlike a manufacturing process. We expect the Permian to lead the development of shale-oil production, driving total crude and liquids growth in the U.S., which last year grew by 2.2mm b/d to reach 19mm b/d by December (Chart of the Week, panel 2). Chart of the WeekBrent Physical Liquidity Continues To Fall Continued investments in state-of-the-art refinery expansions in the U.S. Gulf are expected to continue as well, given the production growth we expect for the Permian, and the pipeline expansions that will take that output to the Houston refining market. Chevron, for example, is expected to close on an acquisition from Brazilian state oil company Petrobras for the 110k b/d Pasadena Refining System, also in the Houston Ship Channel. The company will feed this unit with light-sweet crude from the Permian, which it told analysts this week it expects to grow to 600k b/d by end-2020 and 900k b/d by 2023.4 At present, the U.S. Gulf Coast refining infrastructure cannot absorb all of the light-sweet crude that will be produced in the Permian and the other major basins in coming years. The export markets – particularly the Atlantic Basin, which is home to the physical Brent market – will be absorbing more and more of U.S. light-sweet production in coming years as North Sea production stagnates relative to the U.S. shales (Chart of the Week, panel 3). Output in the U.K. North Sea was at its lowest level since 1973 in 2017, following the price collapse of 2014 – 2017 instigated by the OPEC market-share war launched in 2014. UK output was flattish last year, while Norwegian production was down slightly more than 6% in 2018, bringing it to just under 1.5mm b/d. Drilling activity is picking up this year, along with M&A activity as private equity firms step in to buy properties being sold by the U.S. Majors. As can be seen in the Chart of the Week, production is expected to begin picking up at the end of this year, but base effects from the low levels of late exaggerate the gains in percentage terms. U.S. Crude Exports Set To Soar The North Sea Brent market is arguably the most important crude oil market in the world. It is the underlying physical market for the world’s benchmark crude oil – Brent Blend – against which up to two-thirds of the world’s crude oil prices are indexed.5 Production of the five constituent streams comprising the Brent index – the Brent, Forties, Oseberg, Ekofisk and Troll crudes – has been falling year on year, and one of the streams (Forties) is regularly being exported to Asian refining markets. This has prompted the main price-reporting agencies to consider adding to the constituents of the Brent index, and changing the type of pricing it records.6 At the same time, increasing volumes of WTI light-sweet crude are making their way into the Brent North Sea physical market.7 These export volumes will increase, supported by the buildout of pipeline takeaway and deep-water harbor capacity in the U.S. Gulf, which, when done, will expand the capacity of Gulf ports to accommodate very large crude carriers (VLCCs).8 On the back of these rising exports to the European market, Argus Media, one of the price-reporting agencies, this year began publishing U.S. waterborne pricing assessments as differentials to the ICE Brent futures. According to Argus, slightly over a quarter of the 2.6mm b/d of crude exports out of the U.S. last November went to Europe to compete with North Sea grades like Brent and Forties, two of the Brent index constituents. For the week ended February 22, 2019, the four-week average of crude oil exports from the U.S. was close to 3.1mm b/d, a record for average exports. According to S&P Global Platts, “There have been 48 VLCCs booked for loading out of the USGC so far in 2019 – about five times the amount booked in the first two months of 2018 and a drastic difference to the two VLCCs that were booked during the same period in 2017.”9 Most of the growth in U.S. exports is coming from the shale-oil production boom, which is swelling the volume of light-sweet barrels in the Gulf. While increasing volumes of WTI are making their way into European wet markets, it is too early to call WTI delivered to the Houston refining market (WTI – Houston) a benchmark; it’s more of a reference price for now. All the same, the necessary and sufficient conditions are falling into place for WTI – Houston to become a global benchmark: It has consistent quality; diversity of buyers (refiners and trading companies), sellers (producers and traders), and speculators to provide hedging liquidity to physical-market participants; and, in due course, will have reliable shipping facilities, including ports capable of handling VLCCs and smaller vessels. This last condition is the critical limiting factor at present.10 We expect that, by the early 2020s, the necessary and sufficient conditions will be in place to allow WTI – Houston to become a global benchmark. By that time, we project the U.S. will be exporting in excess of 10mm b/d of crude and liquids, and refined products, with crude exports alone exceeding 5mm b/d by then. Currently, the U.S. exports slightly more than 8mm b/d of crude oil and products (Chart 2). The six largest importers of U.S. crudes are found in the Atlantic and Pacific basins (Charts 3A & 3B). Chart 2U.S. Will Expand Its Lead As Largest Crude and Products Exporter Chart 3AU.S. Exports To Atlantic ... Chart 3B... And Pacific Growing Bottom Line: We expect the Brent vs. WTI crude oil differential to narrow next year, as U.S. light-sweet crude oil exports expand and North Sea production stagnates. On the back of this, we are opening a long WTI vs. short Brent position in 2020. We expect this differential to average $3.25/bbl next year versus current market levels of $6.6/bbl. Canadian WCS Differentials Could Relapse The Western Canadian Select (WCS) differential to WTI YTD contracted to a discount of $10.50/bbl from an average discount of $26.3/bbl in 2018, as the Alberta government’s production curtailment took effect (Chart 4).11 This is allowing Alberta’s excess inventories to start declining, which was one of the primary motivations of the government’s action. Chart 4Government-mandated Production Cuts Reverse Inventory Builds in Alberta Not all the news out of Canada is good for producers, however. An unexpected delay in Enbridge’s Line 3 replacement and expansion puts future Canadian production growth in jeopardy. This will complicate the Alberta government’s plan to stabilize the sound discount to WTI, which is necessary to maintain investors’ confidence in the sector. In our previous analysis of the Canadian oil sector, we assumed the Line 3 replacement project would be completed in the fourth quarter of this year. This is now pushed back by at least 6 months, likely into 2H20.12 The replacement was expected to restore Line 3’s original takeaway capacity of 760k b/d from 390k b/d, and was a crucial input in our Canadian oil output forecasts. The reduction of the production curtailment to ~ 95k b/d in 2H19 previously announced by the Alberta government will not be sufficient to maintain the WCS transportation discount below $15/bbl (Chart 5). Thus, the government most likely will extend part of the ~ 325k b/d mandatory cuts into 2H19. A rollback of the curtailment policy to 95k b/d ahead of the Line 3 replacement would push the differential back above the crude-by-rail range – i.e., a $15-to-$22/bbl discount over the quality discount for heavy sour crude vs. the light-sweet. We expect a combination of production decreases and increased crude-by-rail transport, which will have to go to record levels, could help alleviate the negative pressure on the WCS-WTI discount (Chart 6). For instance, maintaining a 225k-barrel-per-day production curtailment from April to December 2019, combined with an increase in crude-by-rail transport to ~ 460k b/d by year-end would be enough to maintain the discount in our estimated crude-by-rail range (Chart 7).13 Heavy Crude Differentials Will Remain Tight The prolongation of Canadian crude bottlenecks will contribute to keeping heavy-sour vs. light-sweet price differentials tight. Altogether, our expectation of high compliance to the output cuts agreed by OPEC 2.0 countries, which primarily export heavy-sour crudes; larger-than-expected Venezuelan output declines in heavy-sour output; and continued takeaway capacity constraints in Canada will keep the price differentials between light-sweet and heavy-sour crudes tight. This can be seen in the Brent – Dubai spread, which at times, favors the heavy-sour crude streams (Chart 8). Chart 8Heavy-Sour Crude Differentials Tighten As Supply Contracts Bottom Line: The WCS differential vs. WTI is at risk of weakening once again, following the unexpected delay in Enbridge’s Line 3 replacement and expansion. The Alberta government will have to get more deeply involved to keep unconstrained production from hammering the differential once again.   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Hugo Bélanger, Senior Analyst Commodity & Energy Strategy HugoB@bcaresearch.com   Footnotes 1 Please see “OPEC likely to defer output policy decision until June – sources,” published by uk.reuters.com, March 4, 2019. 2 Please see “Permian Majors Expand Downstream Processing,” published by Morningstar Commodities Research, February 11, 2019. 3 These data were sourced from the EIA’s Drilling Productivity Report for February 2019. 4 See fn 2 above. See also “Chevron, Exxon take turns wooing investors with shale boasts,” published by reuters.com March 5, 2019. 5 This estimate comes from ICE Brent Crude Oil, published by The Intercontinental Exchange (ICE), which runs the Brent futures market. 6 Please see “Viewpoint: North Sea benchmark changes looming” which was published by Argus Media on December 27, 2018. 7 Please see “US waterborne crude trade shifts toward Brent basis” published by Argus Media on February 15, 2019. 8 See, e.g., Carlyle Group’s recently announced involvement in such a venture. Carlyle expects its deep-water buildout to be done in late 2020. 9 Please see “In the LOOP: Record US crude exports boost VLCC tanker demand, rates,” published by S&P Global Platts on March 5, 2019. 10 Please see Liz Bossley’s article “There Can (Not) Be Only One,” beginning on p. 15 of the May 2018 issue of the Oxford Energy Forum – Oil Benchmarks – Issue 113, for a discussion of different oil-price benchmarks. 11 We discuss Canada’s take-away dilemma in our November 29, 2018, publication entitled “The Third Man At OPEC 2.0’s Meeting.” It is available at ces.bcaresearch.com. 12 Please see “Enbridge’s Line 3 pipeline replacement likely won’t be in service until second half of 2020,” published by The Globe and Mail on March 3, 2019. 13 The government intends to increase the production ceiling by 100k b/d by April 2019, this makes the mandatory cuts at 225k b/d from 325k b/d in January 2019. https://www.alberta.ca/protecting-value-resources.asp Investment Views and Themes Recommendations Strategic Recommendations Tactical Trades Commodity Prices and Plays Reference Table Trades Closed in Summary of Trades Closed in

Feature Recommendations Two Key Questions For Asset Allocators Stocks have rallied this year – MSCI ACWI is up 17% from its late December low – despite the fact that economic growth outside the U.S. has continued to deteriorate. The PMI in Germany has fallen to 47.6, in Japan to 48.5, and the average in Emerging Markets to 49.5 (Chart 1). Chart 1PMIs Ex-U.S. Still Falling U.S. growth remains robust, though recent data have showed some signs of weakness. The Citigroup Economic Surprise Index has fallen sharply, capex indicators have slipped, and December retail sales were terrible (Chart 2). The New York Fed NowCast for Q1 is now pointing at only 1.2% real GDP growth. Most of the slippage, however, was caused by the six-week government shutdown, and should be reversed in Q2. And the retail sales number appears “rogue”, perhaps caused by irregular data-collection methods during the shutdown, since other retail data do not support it (Chart 2, panel 3). The tightening of financial conditions in the last months of 2018 – which has now partly reversed – may have added to the slowdown (Chart 3). BCA’s view is that U.S. GDP growth is likely to come in well above 2% in 2019, slower than last year’s 2.9% but still above trend. Chart 2Should We Worry About U.S. Growth Too? Chart 3Financial Conditions Now Easing Our recommendation, therefore, is to continue to overweight equities (particularly U.S. equities), which should be supported by decent earnings growth (our top-down model points to 12% EPS growth for the S&P500 this year, compared to a bottom-up consensus forecast of only 5%), reasonable valuations, and sentiment that appears still to be damaged by the Q4 sell-off (Chart 4). Chart 4Environment Still Positive For U.S. Equities Two key questions will determine which asset allocation will be optimal this year. First, how long will the Fed stay “patient” and keep rates on hold? The futures market has almost completely priced out the possibility of any rate hikes in 2019, and even assigns a 15% probability of a cut (Chart 5). We still see upside risk to inflation, with core PCE likely to print above the Fed’s target of 2% by mid-year, partly because of the year-on-year base effect (in January 2018, monthly inflation was especially high), but also because underlying inflation pressures remain (Chart 6). Chart 5Is The Fed Really Going To Cut Rates? Chart 6Inflation Pressures Haven't Gone Away The market has misunderstood two of the Fed’s recent messages. Its mooted plan to end balance-sheet reduction by year-end is not intended as part of monetary policy. It is simply that bank excess reserves will have reached USD1-1.2 trillion, the level required to operate monetary policy using current tools, rather than those used before 2007 when reserves were zero (Chart 7). Second, recent discussions about changing the Fed’s inflation target from 2% a year to a price-level target will probably become effective only when the effective lower bound is hit in the next recession and, anyway, no decision will be taken until mid-2020. Chart 7Excess Reserves Will Be At Equilibrium Soon The market has taken this talk as dovish. We read recent comments by Fed Chairman Jay Powell to mean that if, by June, the economy is robust, risk assets are still rebounding, and inflation is ticking up, the Fed will continue to hike, maybe two or three times by year-end. This implies long-term bond yields will rise too. Equities may wobble initially but, as long as the Fed is hiking because growth is solid and not because of an inflation scare, this should not undermine the 12-month case for equity outperformance. The second key question is whether China has now abandoned its focus on deleveraging and switched to a 2016-style liquidity-driven stimulus. Certainly, the January total social financing number pointed in that direction, with new credit creation of almost 5 trillion RMB ($750 billion) and the first signs of an easing of restrictions on shadow banking (Chart 8). But the jury is still out on whether this is the massive reflation the market has been waiting for. Premier Li Keqiang criticized the increase, saying, “the increase in total social financing appears rather large…it may also bring new potential risks”. A PBOC official commented that the big increase was “due to seasonal factors” and emphasized that China was not embarking on “flood irrigation-style” stimulus. The recent more positive noises on the U.S./China trade war may also alleviate the pressure on China to stimulate. Chart 8First Signs Of Chinese Reflation? If and when Chinese growth does rebound, this will have major implications for asset allocation. It would signal a bottoming of the global cycle, which would favor stocks in Emerging Markets, Europe and Japan. It would push up commodity prices, and imply a weaker dollar. For now, we are not positioning ourselves like this, since global growth remains weak. Nonetheless, the first signs of a bottoming are appearing with, for example, the diffusion index of the global Leading Economic Index (which often leads the LEI itself) turning up (Chart 9). We may shift in this direction mid-year, and are now making some minor changes to our recommendations (see below) to hedge against this risk. But for the moment we prefer U.S. equities, expect further USD appreciation, and remain cautious on EM. Chart 9Is The LEI Close To Bottoming? Equities: We prefer U.S. equities given their better growth, reasonable valuations, and depressed sentiment (despite their outperformance year-to-date). But we are watching for an opportunity to increase our weighting in Europe, where growth still looks poor but may rebound in H2 due to fiscal stimulus, improving wage growth, a dovish turn by the ECB, and an eventual recovery in exports to China (Chart 10). We still see problems in EM, since earnings growth expectations need to be revised down further and stock prices have risen prematurely on expectations of a Chinese recovery (Chart 11). But we reduce the size of our underweight bet, to hedge against Chinese credit growth continuing to accelerate. We are also raising our recommendation for the industrials sector (with its large weight in capital goods companies dependent on exports to China) to overweight for the same reason.  We fund this by cutting consumer staples to underweight. We also raise our weighting on the energy sector, given our positive view on oil prices (see below). This gives our sector weightings a slightly more cyclical tilt, in line with our macro view. Chart 10Some Good News In Europe Too Chart 11EM Has Further Downside Fixed Income: It has been a conundrum this year why equities have risen and credit spreads tightened significantly, but the 10-year Treasury yield remains stuck below 2.7%. One explanation is that inflation expectations have been dampened by the crude oil price and if, as we forecast, oil continues to recover, the inflation component of the yield will rise (Chart 12). U.S. yields have also been dragged down by weak growth in other developed markets, where bond yields have therefore fallen. The spread between U.S. and German and Japanese yields reached record high levels in late 2018 (Chart 13). The term premium also is deeply into negative territory because many investors remain highly bearish and have hedged this view by buying Treasuries. If our view of robust U.S. growth, rising inflation, and more Fed hikes is correct, we would see 10-year Treasury yields rising towards 3.5% over the next 12 months. Accordingly, we are underweight global government bonds. We raised credit to neutral last month, but continue to have some qualms about this asset class, and prefer equities as a way of taking exposure to further upside for risk assets. Besides high leverage among U.S. corporates, we are worried about the deterioration in the quality of the credit market, since duration has been extended, covenants weakened, and the average credit rating fallen (Chart 14). Chart 12Inflation Expectations Driven By Oil Chart 13U.S. Yields Pulled Down By Europe And Japan Chart 14Deterioration In Credit Market Fundamentals Currencies: We see some more upside in the U.S. dollar over the next few months, given U.S. growth and monetary policy relative to the euro area and Japan (Chart 15). This may reverse, however, if global cyclical growth rebounds in the second half. The dollar is particularly vulnerable if macro conditions change, since it looks around 10% overvalued relative to other major DM currencies, and speculative positions are predominantly long dollar (Chart 16). Chart 15Relative Rates Support USD Chart 16But Dollar Vulnerable To Macro Shifts Commodities: With demand likely to grow steadily this year, but supply under pressure because of production cuts by OPEC and Canada, lower U.S. shale oil output, and disruptions in Venezuela and elsewhere, our energy strategists see drawdowns in inventories throughout the year (Chart 17). They forecast Brent to average $75 a barrel during 2019 (compared to $66 now), with WTI $5 a barrel lower. Industrial commodities continue to be driven by China which means, given our view expressed above, that we may see further weakness short-term, with a possible rebound in H2 (Chart 18). Chart 17Oil Supply/Demand Is Tight Chart 18When Will Metal Prices Bottom?   Garry Evans Chief Global Asset Allocation Strategist garry@bcaresearch.com   GAA Asset Allocation  

Special Report

Highlights Investors are currently too pessimistic on Europe’s growth prospects. In fact, European growth will soon bottom. European growth and inflation are also set to improve relative to the U.S. This should give investors an opportunity to reassess the long-term outlook for European Central Bank policy relative to the Fed. Global growth dynamics are also moving in an increasingly dollar-bearish direction, which should create a tailwind for the euro. Based on the pricing of European assets relative to the U.S., there is scope to see more capital flows into the euro area, implying that more euro buying is forthcoming. The entire European currency complex is a buy relative to the dollar; while the NOK, the SEK, and even the GBP could outperform the euro, the CHF will underperform. EUR/JPY also has upside. Feature The case to sell the euro is easy to make. European growth has been very poor: PMIs, industrial production and even German exports are all pointing to a contraction in output; and economic surprises are testing levels recorded during the euro area crisis. Most importantly, this economic retrenchment is particularly sharp when compared to the U.S., which suggests that real interest rate differentials should continue to hurt EUR/USD (Chart 1). Chart 1Selling The Euro Seems So Easy... The problem with this narrative is that investors are already well aware of Europe’s woes. Could Europe instead recover and the euro rebound against the dollar? After all, in the past, when investor pessimism towards Europe experienced as pronounced a dip as the one just witnessed, EUR/USD invariably rebounded soon after (Chart 2). Chart 2...But Maybe We Should Look The Other Way In this piece, we explore what could go right for the euro, and argue that the euro is indeed attractive at current levels. European Growth Has Hit A Nadir It is safe to say that the euro area is in a funk today: European real GDP growth dipped to a 1.1% annual rate in the fourth quarter of 2018, while industrial production has plunged by 3.9% on a year-on-year basis. But the markets warned us this would happen: The euro has fallen 9% from its February 2018 top, German bund yields are again flirting with the 0.1% level and European banks plunged by more than 40% between January and December last year. Going forward, for European yields to remain as depressed as they are, for the euro to fall again by a similar margin, or for domestic plays to suffer large declines, European growth will have to slow even further. We are not expecting such a scenario. Instead, we expect European growth to recover significantly this year. First, when it comes to Germany, the locomotive of Europe, the shock from the implementation of the new WLTP auto emission standards is passing: Automobile production is stabilizing, capex is accelerating and inventories have been pared down. Moreover, the slowdown in foreign demand has already percolated through the domestic economy, as domestic manufacturing orders are already experiencing one of their sharpest declines since the Great Financial Crisis (Chart 3, top panel). Chart 3European Growth Is Set To Rebound Another source of optimism comes from the credit market. As the middle panel of Chart 3 illustrates, the European 12-month credit impulse has begun to bottom. This points to stronger euro area-wide domestic demand. Moreover, the Chinese credit and fiscal impulse is also bottoming, suggesting the drag from foreign demand could be dissipating (Chart 3, bottom panel). When looking at other specific trouble spots, Italy first springs to mind. In our view, the most recent deceleration in Italy was mainly a consequence of the tightening in financial conditions that resulted from the surge in Italian yields following the budget standoff between Rome and Brussels. However, the Lega Nord / Five Star Movement coalition has folded and is more or less acquiescing to the EU’s demands. Moreover, the rising probability that the European Central Bank will continue to provide long-term liquidity to the eurozone banking system via some form of new LTRO should diminish the funding risk to the Italian banking system, and thus, the risks to Rome’s fiscal sustainability. This implies that the decline in Italian borrowing costs could deepen (Chart 4), further easing Italian financial conditions and improving the growth outlook in the euro area’s third-largest economy. Chart 4Easing Financial Conditions In Italy France, too, has had its fair share of problems, though it is interesting that its industrial sector is not suffering as much as Germany’s, as highlighted by a French manufacturing PMI above the 50 boom/bust line. Instead, the French service sector is the one contracting (Chart 5). This bifurcation is likely to be a byproduct of the gilets jaunes protests that have lasted since November 2018 and affected retail trade. However, the intensity of the protests is declining and the French population is getting used to this. As a result, we are seeing a rebound in French household confidence, which implies that consumption, the main engine of French growth, is likely to perk up. Chart 5Fade The Gilets Jaunes, Paris In Spring Is Beautiful Finally, euro area fiscal policy is set to be loosened this year, with the fiscal thrust moving from 0.05% of GDP to 0.4% of GDP (Chart 6). The response of French President Emmanuel Macron to the gilets jaunes protests could even make the fiscal policy support slightly bigger this year. Chart 6Positive Fiscal Thrust In 2019 Ultimately, this combination of factors suggests that the large dip in European industrial production is likely to prove transitory, and that European activity will revert back toward the levels implied by the Belgian Business Confidence Index, which has historically been a good leading indicator of European growth (Chart 7). Chart 7European IP To Follow Brussels' Mood Bottom Line: The deterioration in European growth has captured the imagination of investors. However, the performance of European assets last year forewarned that growth would decelerate meaningfully. What matters now is how growth will evolve. Developments from Germany, France, Italy, the credit channel and the fiscal front all suggest that European activity will perk up soon. It’s All Relative While getting a sense of European growth is important when making a call on EUR/USD, economic trends must also be considered relative to the U.S. Surprisingly, despite notorious European growth underperformance, rays of hope are emerging. A major structural negative for EUR/USD has abated: The European debt crisis is behind us, and the aggregate European banking sector has been getting healthier, albeit slowly. This means that the euro area credit growth is not declining anymore against that of the U.S. This is a very long-term force that dictates multi-year cycles in the EUR/USD. As Chart 8 shows, it will be difficult for EUR/USD to move below 1.10 so long as the broad trend in the relative credit growth does not weaken anew. Chart 8Credit Dynamics Suggest That The Worst Is Over For EUR/USD More immediately, the euro area leading economic indicator relative to the U.S. is forming a bottom (Chart 9). Since the U.S. is not benefiting from as large a fiscal boost as in 2018, and financial as well as monetary conditions have tightened there relative to Europe, this suggests the improvement in the euro area relative LEI could continue this year. Chart 9Bottoming European LEI Versus U.S. Relative labor market slack is also evolving in a euro-friendly fashion. From 2013 to 2018, the euro area suffered from greater labor market slack than the U.S., courtesy of a double-dip recession and generally more-moribund growth. However, thanks to a 4.2-percentage-point fall in the European unemployment rate since 2013 to 7.9%, the euro area unemployment gap has not only closed, it is also below that of the U.S. Historically, when the U.S. unemployment gap leapfrogs that of Europe, EUR/USD tends to appreciate (Chart 10). Chart 10Less Slack Leads To A Stronger EUR/USD Relative slack does not only have value in itself, it also matters for relative inflation trends, which have been a crucial determinant of EUR/USD. As Chart 11 illustrates, EUR/USD tends to follow how euro area core CPI evolves relative to the U.S. After sharply falling last year, European relative core inflation is trying to rebound, which at a minimum suggests that EUR/USD has limited downside. Moreover, EUR/USD has correlated positively with German market-based inflation expectations (Chart 11, bottom panel). This suggests that actual relative inflation as well as euro area inflation expectations play a key role in determining perceptions among investors of how ECB policy will evolve relative to the Federal Reserve. Chart 11EUR/USD Trades Off Of Inflation Dynamics The recent euro decline has matched the decline in inflation expectations. However, inflation expectations have been much weaker than implied by the level of wage growth in Europe (Chart 12). This suggests that European inflation breakevens have scope to improve, a positive for the euro. Moreover, European wage growth is not only picking up steam in isolation, it is also rising relative to the U.S., which highlights that European inflation should not just stabilize vis-à-vis the U.S., but also accelerate. Chart 12European Wages Point To Rising Inflation Expectations This case is made even more saliently by looking at relative financial conditions. Due to the tightening in U.S. financial conditions compared to the euro area, European headline and core inflation is set to accelerate relative to the U.S. (Chart 13). Again, this reinforces the case that maybe the euro has upside this year. Chart 13Relative Euro Area Inflation Will Rise Thanks To Easier FCI Ultimately, for the euro to rise, investors will have to begin pricing in some switch in policy spreads between the ECB and the Fed. In the past, we showed that short-term policy expectations are important, but long-term ones can be even more relevant, especially when a central bank is well along the path of lifting rates, as the Fed is, while the other remains at maximum accommodation, like the ECB is today.1  Currently, investors expect euro area short rates to be only 0.5% 5-years from now (Chart 14, top panel). The spread between the eurozone and U.S. 5-year forward 1-month OIS rates remains near all-time lows, which explains the weakness in the euro. Now that European policy is much more accommodative than the U.S.’s, there’s scope for investors to upgrade the path of long-term euro area rates relative to the U.S. This would be bullish for the euro (Chart 14, bottom panel). Recovering relative credit flows and improving relative slack and inflation dynamics could catalyze this change. Chart 14The ECB Is Never Raising Rates Bottom Line: To make the euro an attractive buy, European growth and inflation conditions cannot just increase, they need to improve relative to the U.S. Since long-term interest rate expectations are very depressed in Europe relative to the U.S., a small improvement in the relative growth profile could be enough to catalyze a repricing of the ECB vis-à-vis the Fed, creating a powerful tailwind behind the euro. Nothing Happens In A Vacuum Ultimately, exchange rates, like other prices in the economy, do not only respond to domestic determinants but are also influenced by much larger, global forces. This is because those global trends percolate through domestic economies, resulting in changing relative expected returns that drive money across borders, leading to currency movements. In the case of the euro, global growth matters a lot, because European growth is much more sensitive to global economic fluctuations than U.S. growth is. This is particularly true if shocks emanate from emerging markets (Chart 15). Today, global cyclical variables are increasingly pointing toward an end to the global growth slowdown. A stabilization and reacceleration in global activity would support the euro. First, Chinese monetary conditions have begun to ease, which historically tends to be linked with improvements in European growth relative to the U.S. (Chart 16). Questions remain surrounding this point: How durable will the rebound in Chinese credit be? By how much will Chinese policymakers nurture this bounce? And will this jump be large enough to lift economic activity in the Middle Kingdom? Nonetheless, a reflationary wind from China has begun to blow, and since investors have already discounted much bad news out of Europe, only small improvements could turn the euro around.   Chart 16If China Is Really Stimulating, Europe Will Rip A Greater Dividend Second, as Chart 17 shows, our Nowcast for global industrial activity has decisively stepped down. Yet, the countercyclical dollar has been flat since October 2018. Historically, the performance of EM carry trades funded in yen tends to lead global growth. Currently the performance of these strategies is stabilizing. If EM carry trades funded in yen can rally further, this will spell trouble for the greenback, helping the euro – the anti-dollar – in the process. Chart 17An Early Positive For Global Growth Third, EUR/USD tends to correlate with the relative performance of global cyclical equities (Chart 18). The stabilization in these sectors since 2015 suggests it will be difficult for the euro to fall further from current levels. In fact, if EM carry trades can rebound more, cyclicals have additional scope to outperform, and the euro could rally. Chart 18Cyclical Stocks Pointing To No Real Downside In EUR/USD Fourth, the prospects for the semiconductor sector are improving. Demand for semis is highly pro-cyclical, and the U.S. Chip Stock Timing Model developed by our U.S. Equity Strategy service colleagues is currently sending a bullish signal.2 Since such developments link to improving global growth prospects, they are also associated with a stronger EUR/USD (Chart 19). This is also consistent with a generally weaker dollar and stronger Asian currencies. Chart 19The Outlook For Semiconductors Point Toward A Stronger Euro And A Weaker Dollar Finally, the breakout in copper prices, the stabilization in the CRB Raw Industrials Index and the rally in gold prices all support an improving global growth outlook that could lift EUR/USD. Bottom Line: Various indicators, such as Chinese monetary conditions, EM carry trades, semiconductor demand determinants and commodity prices are suggesting that global growth may soon bottom. Such a development should hurt the countercyclical dollar, amounting to a macro tailwind for EUR/USD. The Bad News Is Priced In Ultimately, the capacity of EUR/USD to rally rests on how much investors upgrade their outlook for Europe. It is therefore crucial to get a sense of exactly how uninspiring Europe currently is to global market participants. There is no better gauge of relative economic pessimism than the price of euro area financial assets relative to U.S. ones. Essentially, money talks. On this front, markets already seem to have internalized the known bad news from Europe, and there is scope for a contrarian rally in the euro, especially if, as we expect, European economic activity improves. First, on a 12-month forward P/E ratio basis, euro area equities are trading at the kind of deep discount to U.S. stocks normally symptomatic of a trough in relative sentiment toward Europe. Such a discount is often followed by a rally in EUR/USD (Chart 20). Chart 20Stock Valuations: Investors Do Not Like Europe Second, retailers’ equities can often give a more focused assessment of how investors perceive the comparative outlook for domestic demand between two nations. Currently, euro area retailers trade at a 16-year low versus their U.S. counterparts (Chart 21). Investors are therefore much more ebullient about the prospects for U.S. domestic demand than in Europe. Interestingly, the euro’s gyrations since 2016 have tracked the direction of the relative performance of retailers but have diverged in terms of levels. This suggests some underlying support for the currency. Chart 21Can European Domestic Demand Really Validate Such Pessimistic Expectations? Third, the relative stock-to-bond ratio also often provides a good read on investors’ comparative economic euphoria/pessimism towards two nations. In 2018, the annual performance of the euro area stock-to-bond ratio relative to the U.S. collapsed to levels not recorded since the euro area crisis was at its apex (Chart 22). This further confirms that investors were massively depressed on European growth prospects relative to the U.S. While this indicator is rebounding, it is still in negative territory, implying that market participants still have room to upgrade their assessment of the euro area relative to the U.S. Historically, this kind of setup has been associated with a rebound in the EUR/USD. Chart 22The Stock-To-Bond Ratio Points To Some Upside Potential Fourth, European net earnings revisions relative to the U.S. have also hit bombed-out levels and are in the process of improving. Since earnings are tightly linked to global growth and reflect the same information that informs capital flows into a country (Chart 23), sell-side analysts becoming more positive on Europe at the margin could indicate that investors are in the process of re-assessing whether to buy European assets. A decision to do so would support EUR/USD. Chart 23When The Sell-Side Move From Deeply To Mildly Bearish, EUR/USD Rallies Bottom Line: Financial market pricing suggests that investors are displaying deep pessimism toward the euro area’s relative growth prospects. The euro could be a contrarian buy. Most importantly, there are early signs that this growth pricing is starting to move in favor of Europe. If our economic view on Europe and global growth is correct, this trend has further to go, implying that more capital could move into Europe, creating a potent tailwind for EUR/USD. What Else? Three additional factors need to be considered: Currency valuations, balance-of-payment dynamics, and technicals. First, while it is not as cheap as it once was, the real trade-weighted euro is still trading below its historical average (Chart 24). Purchasing-power considerations can rarely be used as a timing tool, but our confidence in the euro’s upside would be greatly dented if the euro were a very expensive currency. It is not even mildly pricey. Chart 24Euro Valuations: No Headwinds There Second, balance-of-payment considerations have become increasingly euro-positive. The euro area runs a current account surplus of 3.3% of GDP, and despite large FDI outflows – a natural consequence of being a savings-rich economy – the basic balance of payments remains in surplus. Moreover, as fixed-income outflows have been dissipating, the aggregate portfolio flows into Europe have also been improving (Chart 25). The end of the ECB’s Asset Purchase Program should solidify this trend. Chart 25The Euro Area Balance Of Payments Is Increasingly Favorable Finally, technical oscillators are behaving increasingly well. As Chart 26 shows, not only does our Intermediate-Term Indicator remains oversold, but also, it is has begun to form a positive divergence with the price of EUR/USD. If the economic outlook is becoming more bullish, such a technical setup can often be translated into significant gains. Chart 26EUR/USD: Oversold And A Positive Divergence Is Forming Bottom Line: The euro’s valuation is not as attractive as it once was, but it remains cheap. Moreover, the euro area’s balance-of-payment dynamics and the EUR/USD’s technical setup both suggest the timing is increasingly ripe to buy the euro against the dollar. Investment Conclusions A trough in European growth, improving growth and inflation prospects relative to the U.S., green shoots for global growth and deep pessimism toward Europe relative to the U.S. all argue that the timing is right to bet on a euro rebound. At this point, the durability of the euro rebound remains unclear. Investors are under-appreciating the ability of the Fed to raise rates this year, which could help the dollar. On the other hand, they seem even more sanguine toward the ECB ever lifting rates. Ultimately, the capacity of the euro to rebound on a long-term basis against the dollar will be constrained by global growth. This means that China will continue to play a center-stage role for this crucial FX pair. At this point, it is unclear how determined Chinese policymakers are to reflate their economy. Thus, we recommend investors monitor Chinese policy to gauge how long to stay in the euro. For the time being, enough pieces are falling into place to warrant buying EUR/USD for three to six months. However, if the Chinese credit impulse can continue on its recent rebound, the durability of a euro rally could be extended, implying that the euro may be in the process of forming a long-term bottom against the dollar. A strengthening euro should support the entire European currency complex against the dollar. In fact, the NOK, the SEK and the GBP may even outperform the EUR. The NOK is being boosted by rising oil prices, a more hawkish central bank, better valuations and an even healthier balance of payments. The SEK is also supported by a Riksbank that is slightly more hawkish than the ECB, and better valuations; it also benefits from a Swedish economy that is even more pro-cyclical than the euro area’s. The GBP also benefits from a greater valuation discount than the euro, and political developments in the U.K. are beginning to move toward a more clear-cut positive outcome on the Brexit front.3 The countercyclical and expensive CHF will prove the European laggard. Finally, EUR/JPY is also set to continue its rebound that began on January 4th. In fact, it may be one of the best vehicles to express a euro-bullish view because it is less sensitive to what the Fed does than EUR/USD is. Rising bond yields are an unmitigated positive for EUR/JPY, and BCA firmly believes that U.S. Treasury yields have upside, whether or not the Fed goes back to lifting rates. The Fed will mostly impact whether it is the real or inflation component that lifts Treasury yields. Bottom Line: The entire European currency complex is set to rise along with the euro against the greenback. In fact, the NOK, the SEK and the GBP are likely to outperform the euro, while the CHF should underperform. EUR/JPY may in fact offer the best risk-adjusted returns to play a euro rebound. While it is clear that at this moment that buying the euro makes sense, the principal risk lies around how long this rally will last. We are increasingly convinced that the euro has made a low for the cycle and that its long-term outlook is looking increasingly bright.  Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Footnotes 1 Please see the EUR/USD: Focus On The Western Shores Of The Atlantic section of the Foreign Exchange Strategy Weekly Report, titled “Canaries In The Coal Mine Alert: EM/JPY Carry Trades”, dated December 1, 2017, available at fes.bcaresearch.com 2 Please see U.S. Equity Strategy Weekly Report, titled “Reflationary Or Recessionary”, dated February 25, 2019, available at uses.bcaresearch.com 3 Please see European Investment Strategy Weekly Report, titled “Why A Catastrophic No-Deal Might Be Good… For The EU”, dated February 28, 2019, available at eis.bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades