Inflation/Deflation

Highlights Duration: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Relative Value In Global Government Debt: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds. Feature Reflexivity Chart 1A Brief Inversion The decline in global bond yields has been unrelenting, and it took on a life of its own last week when the U.S. 2-year/10-year slope briefly inverted (Chart 1). After the inversion, the 30-year U.S. Treasury yield broke below 2% and the 10-year yield broke below 1.50%. The average yield on the 7-10 year Global Treasury Index closed at 0.49% last Thursday, just above its all-time low of 0.48% (Chart 1, bottom panel). There’s an interesting self-fulfilling prophesy that can take hold when the yield curve inverts. Investors interpret the inversion as a signal of weaker economic growth ahead. They then bid up long-dated bond prices causing the curve to invert even more. This sort of circular reasoning can cause bond yields to disconnect from the trends in global economic data, often severely. While recession fears have benefited government bonds, risky assets – equities and corporate bonds – have experienced relatively minor pain. The S&P 500’s recent sell-off pales in comparison to the one seen late last year (Chart 2). Meanwhile, corporate bond spreads remain well below early-2019 peaks. Risky assets have clearly benefited from the drop in bond yields, as markets price-in a future where central banks ease monetary policy in response to weaker economic growth, and where that easing is sufficient to keep equities and credit well supported. Chart 2Low Yields Support Risk Assets I Chart 3Low Yields Support Risk Assets II Further evidence of this dynamic is presented in Chart 3. The chart shows the sensitivity of daily changes in the U.S. 10-year Treasury yield to changes in the S&P 500 for each year since 2010. The sample is split into days when the S&P 500 rose and when it fell. For example, in 2010 the sensitivity on “up days” was 2.6, meaning that on days when the S&P 500 rose, the 10-year yield rose 2.6 basis points for every 1% increase in the S&P 500. Similarly, the sensitivity in 2010 on “down days” was 3.2. This means that the 10-year yield fell 3.2 bps for every 1% drop in the equity index. The main takeaway from Chart 3 is how dramatically the sensitivities have shifted in 2019. The yield sensitivity on “up days” has fallen sharply – down to 0.8. This means that yields barely rise on days when equities move up. Meanwhile, the sensitivity on “down days” has shot higher, to just under 4. This means that yields fall a lot on days when equities sell off. The perception of easier monetary policy has been the main support for risk assets this year.  The logical interpretation of these trends is that the perception of easier monetary policy has been the main support for risk assets this year. Global Growth Needed At present, we are stuck in an environment where aggressively easy monetary policy and low bond yields are the sole supports for risky assets. In turn, falling bond yields are stoking concerns about the economy, leading to even easier monetary policy. Only one thing can bust us out of this pattern, and that’s a resurgence of global manufacturing growth. Unfortunately, there is little evidence that this is taking place (Chart 4). The Global Manufacturing PMI is now down to 49.3, below the 2016 trough of 49.9 (Chart 4, top panel). U.S. Industrial Production growth remains weak, but is showing signs of stabilization above the 2016 trough (Chart 4, panel 2). European Industrial Production, on the other hand, continues to contract (Chart 4, panel 3). The downtrend in our favorite real-time indicator of global manufacturing – the CRB Raw Industrials index – remains unbroken (Chart 4, bottom panel). However, even though evidence of a turnaround in global manufacturing is scant, we expect a rebound near the end of this year, for the following reasons: Global financial conditions have eased this year, the result of aggressive central bank stimulus. Financial conditions are easier now than they were in 2018, and much easier than they were prior to the 2015/16 global growth slowdown (Chart 5, top panel). China has started to ease credit conditions in response to U.S. tariffs and the slowdown in growth. So far, stimulus has been tepid relative to 2015/16 levels, but it should ramp up in the coming months.1 Many large important segments of the global economy remain unaffected by the global manufacturing slowdown. The U.S. consumer continues to spend: Core retail sales are growing at a robust 5% year-over-year rate, and consumer sentiment remains elevated (Chart 5, panels 2 & 3). Even in the Eurozone, the service sector has not experienced the same pain as manufacturing (Chart 5, bottom panel). Fiscal policy will remain a tailwind for economic growth this year and next. Last week, there were even rumors of increased fiscal thrust from Germany if the growth slowdown persists.2 Strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary.  On the whole, we expect that the above 4 factors will lead to a rebound in global manufacturing growth near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon, but the global growth indicators shown in Chart 4 will need to rebound first. Chart 4Global Growth Indicators Chart 5Catalysts For Economic Recovery Inflation Puts Pressure On Powell Chart 6Strong Inflation Could Complicate The Fed's Message Strong U.S. inflation prints during the past two months add an interesting wrinkle to the macro landscape. Core U.S. inflation grew at an annualized rate of 3.55% in July, following an annualized rate of 3.59% in June (Chart 6). However, these strong inflation readings only increased market worries that the Fed might not be as accommodative as necessary. This exacerbated the flattening of the yield curve and sent long-dated TIPS breakeven inflation rates lower. Our sense is that the Fed is chiefly concerned with re-anchoring inflation expectations (Chart 6, bottom panel). This probably means that another rate cut is coming in September, and that Chairman Powell will do his best to sound accommodative in his Jackson Hole address on Friday. However, recent strong inflation data could prompt Powell to sound more hawkish than the market would like, causing yield curves to flatten and risky assets to fall. Bottom Line: Global manufacturing growth will rebound near the end of this year. Much like in 2016, this will result in higher global bond yields on a 12-month horizon. Investors should keep portfolio duration close to benchmark for now, but be prepared to shift to below-benchmark when our global growth indicators show signs of improvement. Country Allocation & The Zero Lower Bound Perhaps the most straightforward way to think about country allocation within a portfolio of developed market government bonds is to classify the different markets as either “high beta” or “low beta”. Chart 7 shows the trailing 3-year sensitivity of major countries’ 7-10 year bond yields relative to the global 7-10 year yield.3 The U.S. and Canada have the highest betas, followed by the U.K. and Australia. Germany has a beta close to one, and Japan’s beta is the lowest. Chart 7Global Yield Beta In other words, if global growth falters and global bond yields decline, U.S. and Canadian bond markets should perform best, followed by the U.K. and Australia. German bonds should perform in line with the global index, and Japanese bonds should underperform the global benchmark. What makes this approach to portfolio allocation even better is that the calculation of trailing betas is not really necessary. A very similar ordering of countries – from “high beta” to “low beta” – is achieved by simply ranking the markets from highest yielding to lowest yielding. High yielding countries, like the U.S. and Canada, have the most room to ease monetary policy in response to a negative growth shock. This means that yields in those countries will respond most to global growth fluctuations. On the other hand, the entire Japanese yield curve is already pinned near the effective lower bound. Even in the event of a negative growth shock, there is little scope for easier Japanese monetary policy, and JGB yields will be relatively unaffected. Chart 8High Beta Countries Are Most Sensitive To Economic Growth It’s interesting to note in Chart 7 that while German yields are actually below JGB yields, bunds remain somewhat less defensive than the Japanese market. This is because the German term structure has only recently moved to the effective lower bound, and investors likely still retain some hope that an improvement in global growth could lead to European policy tightening at some point in the future. This belief is largely absent in Japan, where the term structure has been pinned at the lower bound for many years.   Chart 8 provides some further evidence of the split between “high beta” and “low beta” bond markets. It shows that the bond markets with the highest yields are also the most sensitive to trends in global growth, as proxied by the Global Manufacturing PMI. U.S. bond yields are highly correlated with the Global PMI, while Japanese bond yields are hardly correlated at all. It follows that if the slowdown in global growth continues and all nations’ yield curves converge to Japanese levels, then the overall economic sensitivity of global bond yields will decline. Bottom Line: Countries with yield curves furthest away from the effective lower bound also have the most cyclical bond markets. At present, this means that U.S. and Canadian bond markets will perform best if global growth continues to weaken. They will also perform worst in the event of an economic turnaround. Japanese bonds will perform best in a bond bear market, with German debt a close second. Looking For Positive Carry Yield curves have undergone dramatic shifts in recent months, in terms of both level and shape. Not only have curves for the major government bond markets shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape (Charts 9A-9F). With that in mind, in this week’s report we look for the best “positive carry” opportunities in global government bond markets. Yield curves for the major government bond markets have shifted down since the beginning of the year, they also now exhibit varying degrees of a ‘U’ shape. We use the term carry to mean the expected return from a given bond assuming an unchanged yield curve. This is essentially the combination of yield income (i.e. coupon return) and the price impact of rolling down (or up) the yield curve. For the purposes of this report, we assume a 12-month investment horizon and incorporate the impact of currency hedging into each security’s yield income. Rolldown ‘U’ shaped yield curves mean that bonds near the base of the ‘U’ currently suffer from negative rolldown, while the rolldown for long maturities is often highly positive. Table 1 shows that rolldown is currently negative for all 2-year bonds, but especially for U.S. and Canadian debt. The U.S. and Canada have the highest policy rates within developed markets, so it’s not surprising that the front-end of their yield curves are also the most steeply inverted. In other words, their yield curves are pricing-in that they have more room to cut rates than other countries. Table 112-Month Rolldown* (%) For A Long Position In Government Bonds In general, rolldown is relatively modest for most 5-year and 7-year maturities. The exceptions being German 5-year debt and Aussie 7-year debt, which benefit from 31 bps and 45 bps of positive rolldown, respectively. As mentioned above, rolldown is currently very positive for long maturity debt. In fact, a 10-year U.K. bond offers a whopping 85 bps of rolldown on a 12-month horizon. Yield Income & Overall Carry As mentioned above, rolldown is only one part of a bond’s carry. The other is the yield an investor earns over the course of the investment horizon – the yield income. Because we assume that investors hedge the currency impact of their bond positions, this yield income also depends on the native currency of the investor. Therefore, we show yield income and overall carry below from the perspective of investors in each of the major currency blocs (USD, EUR, JPY, GBP, CAD, AUD). USD Investors Being the global high yielder, USD investors benefit the most from currency hedging. That is, USD investors earn a lot of additional income on their currency hedges, making non-U.S. bonds look more attractive. Unsurprisingly, carry is most positive at the long-end of yield curves (Tables 2 & 3). Table 2In USD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 3In USD: 12-Month Carry (%) For A Long Position In Government Bonds EUR Investors The polar opposite of USD investors, EUR-based investors give up a lot of return through currency hedging. This makes the potential for positive carry much less. In any case, the best positive carry opportunities still lie in German, Japanese and Australian 30-year bonds. U.K. and Japanese 10-year bonds are also attractive (Tables 4 & 5). Table 4In EUR: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 5In EUR: 12-Month Carry (%) For A Long Position In Government Bonds JPY Investors Yen-based investors currently have more opportunities to earn positive carry than those based in euros. But these opportunities remain confined to long-maturity debt. Once again, the standouts are Japanese, German and Australian 30-year bonds, and also U.K. and Japanese 10-year debt  (Tables 6 & 7). Table 6In JPY: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 7In JPY: 12-Month Carry (%) For A Long Position In Government Bonds GBP Investors Currency hedges work more in favor of GBP than EUR or JPY. As a result, GBP-based investors see more opportunities to earn positive carry (Tables 8 & 9). Table 8In GBP: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 9In GBP: 12-Month Carry (%) For A Long Position In Government Bonds CAD Investors As with USD-based investors, CAD-based investors also benefit from currency hedging. All securities continue to offer positive carry when hedged into CAD (Tables 10 & 11). Table 10In CAD: 12-Month Yield Income* (%) For A Long Position In Government Bonds Table 11In CAD: 12-Month Carry (%) For A Long Position In Government Bonds AUD Investors AUD-based investors also see positive carry across the entire global bond space, after factoring-in the impact of currency hedging (Tables 12 & 13). Table 12In AUD: 12-Month Yield Income* (%) For A Long Position In Government Bond Table 13In AUD: 12-Month Carry (%) For A Long Position In Government Bonds Bottom Line: Changes in the level and shape of global yield curves have altered the relative value opportunities in the global government bond space. We find that the most positive carry (including both yield income and rolldown) in global government bond markets is earned in 30-year German, Japanese and Australian bonds, and in 10-year U.K. and Japanese bonds.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 Please see U.S. Bond Strategy Weekly Report, “The Trump Interruption”, dated August 13, 2019, available at usbs.bcaresearch.com 2 https://www.bloomberg.com/news/articles/2019-08-16/germany-ready-to-raise-debt-if-recession-hits-spiegel-reports  3 We calculate betas using average yields from the Bloomberg Barclays Global Treasury Master index. 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Special Report

Highlights So What? Maintain a cautious stance on Turkish currency and risk assets. Why? Following the AKP’s defeat in Istanbul, Erdogan has doubled down on unorthodox economic policies. Improvements in the current account balance are temporary. Unless investor sentiment is meaningfully repaired, the lira will resume its decline in 2020. In the meantime, tensions with the West – especially the U.S. – will remain elevated. The imposition of secondary sanctions from the U.S. is likely. Feature U.S. President Donald Trump is wavering in the trade war, which is ostensibly positive news for global risk assets that are selling off dramatically amid very gloomy expectations about the near future. The question is whether the delay is too little, too late to halt the slide in financial markets in the near term. The reason to be optimistic is that interest rates have fallen and the global monetary policy “put” is fully in effect. Moreover, it is irrefutable now that President Trump is sensitive to the negative financial effects of the trade war. He is delaying new tariffs on some of the remaining $300 billion worth of imports from China not simply because consumer price inflation has ticked up but more fundamentally because the tightening of financial conditions increases the risk of a recession. A president can survive a small increase in inflation but not a big increase in unemployment. The reason to be pessimistic is that global economic expectations are threatening the crisis levels of 2008 (Chart 1) and Trump’s tariff delay offers cold comfort. His administration has not delayed all the tariffs, and the delay lasts only three months. Rather than renew the license for U.S. companies to do business with Chinese telecom giant Huawei, his Commerce Department has deferred any decision – leaving uncertainty to fester in the all-important tech sector. Chart 1Global Economic Expectations Near Crisis Levels Chart 2More China Stimulus Needed To Prevent EM Breakdown Beneath the surface is the fact that China’s money-and-credit growth faltered in July, suggesting that negative sentiment is still suppressing credit demand and preventing policy stimulus from having as big of a bang as in 2015-16. The late-July Politburo meeting signaled a more accommodative turn in policy, as we have expected, and BCA’s China strategist Jing Sima expects more fiscal stimulus to be announced after the October 1 National Day celebration. But high-beta economies and assets will suffer in the meantime – especially emerging market assets (Chart 2). Emerging markets are also seeing geopolitical risks rise across the board – and with the exception of China and Brazil, these risks are underrated by markets: Greater China: Beijing is getting closer to intervening in Hong Kong with police or military force. Such a crackdown will increase the odds of a confrontation with Taiwan and a backlash across the region and world, meaning that East Asian currencies in particular have more room to break down. India: The escalation in Kashmir is not a “red herring.” A single terrorist attack in India blamed on Pakistan could trigger a dangerous military standoff that hurts rather than helps Indian equities, unlike the heavily dramatized standoff ahead of the election earlier this year. Russia: Large-scale protests, overshadowed by Hong Kong, highlight domestic instability amid falling oil prices. These developments bode ill for Russian currency and equities. We will return to these risks in the coming weeks. This week we offer a special report on Turkey, where political risk is becoming extremely underrated as the lira rallies despite a further deterioration in governance (Chart 3). Chart 3Political Risks Are Underrated In Turkey Too Early To Write Off Erdogan “Whoever wins Istanbul, wins Turkey … Whoever loses Istanbul, loses Turkey.” President Recep Tayyip Erdogan Turkey’s ruling Justice and Development Party (AKP) has had a tough year. The March 31 local elections – especially the rerun election for mayor of Istanbul – dealt the party its biggest electoral losses since it emerged as the country’s dominant political force in 2002 (Chart 4). The elections came to be seen as a referendum on President Recep Tayyip Erdogan and thus raise the question of whether the party’s strongman leader is in decline – and what that might mean for emerging market investors. Erdogan’s grip on power has long been overrated – it is his vulnerability that has driven him to such extremes of policy over the past decade. The Gezi Park protests of 2013 and the attempted military coup of 2016 revealed significant strains of internal opposition in the aftermath of the Great Recession. With each case of dissent, the AKP responded by stimulating the economy and tightening state control over society (Chart 5). But this strategy faltered last year when monetary policy finally became overextended, the currency collapsed, and the country slid into recession. The opposition finally had its moment. The AKP is less a source of unity. As a consequence, the AKP is less a source of unity among Turkish voters. Both its share of seats in parliament and the overall level of party concentration in the Turkish parliament have declined since 2002 (Chart 6). Were it not for its coalition partner, the Nationalist Movement Party (MHP), the AKP would not have gained a majority in the 2018 parliamentary election. The AKP’s popular base consists of conservative, rural, and religious voters. This bloc is losing influence in parliament relative to centrist and left-wing parties (Chart 7). Moreover, the share of Turks identifying with political Islam, while still the largest grouping, is declining. Those who identify with more secular Turkish nationalism are on the rise (Chart 8). Does this shift entail a major turn in national policy? Will a new party emerge to challenge the AKP at last? Chart 8Secular Nationalism Is On The Rise There has long been speculation that former AKP leaders such as former Turkish president Abdullah Gul, former prime minister Ahmet Davutoglu, and former deputy prime minister Ali Babacan might form a political alternative. The latter resigned from the AKP on July 8, reviving speculation that a rival party could emerge that is capable of combining disillusioned AKP voters with the broader opposition movement at a time when Erdogan’s vulnerability has been made plain. However, the opposition is likely getting ahead of itself. The ruling party still has many tools at its disposal. Its share of seats in parliament is more than double that of the main opposition party, the Republican People’s Party (CHP). It is also viewed favorably in rural areas, and support for Erdogan there will not shift easily. Moreover, despite the negative electoral trend, the AKP has a lot of enthusiasm among its supporters – it is the party with the highest favorability among its own voters (Chart 9). The March election served as a wakeup call for the AKP – a warning not to take its power for granted. Erdogan can still salvage his position. The next election is not due until June 2023, leaving the party with four years to recuperate. While polls for the 2023 parliamentary election paint an ominous sign (Chart 10), they are very early, and the key will be whether Erdogan can divide the opposition and reconnect with his voter base. Above all, this will depend on what changes he makes to economic policy. Chart 10Erdogan Needs To Reconnect With Voter Base Bottom Line: Erdogan’s and the AKP’s popularity is waning, but it is too soon to write them off. The key question is how Erdogan will handle economic policy now that there are chinks in his armor. Doubling Down On Erdoganomics The fluctuation in the lira “is a U.S.-led operation by the West to corner Turkey … The inflation rate will drop as we lower interest rates.” President Recep Tayyip Erdogan Erdogan needs to see the economy back to recovery in order to secure his success in the next election. A survey conducted early this year reveals that Turks view unemployment, the high cost of living, and the depreciation of the lira as the most significant problems facing Turkey, with 27% of respondents indicating that unemployment is the most important problem facing the country (Chart 11). More importantly, Turks do not have much confidence in the government’s ability to manage this pain – only one-third of respondents viewed economic policies as successful, a 14pp decline from the previous year. This highlights the need for Erdogan to revive confidence in Turkey’s policymaking institutions and to deliver on the economic front.     The key is how Erdogan will handle economic policy. However, it is still too early to call for a sustainable improvement in the Turkish economy as many of the same fundamental imbalances continue to pose risks. While the current account has improved significantly – even registering a surplus in May – the improvement will not endure (Chart 12). On the one hand, the weaker lira has made exports more attractive relative to global competition. However, the improvement in the external balance is in large part due to weaker imports which are now more expensive for Turkey’s residents and have fallen by 19% y/y in 1H2019. Shrinking imports also reflect weak domestic demand which has been weighed down by tight monetary conditions (Chart 13). Chart 12Current Account Improvement Will Not Endure Chart 13Tight Monetary Conditions Weighed On Domestic Demand What is more, portfolio inflows which in the past were necessary to offset the large current account deficit, have collapsed (Chart 14). Were it not for the improvement in the trade balance, the central bank of the Republic of Turkey (CBRT) would have experienced a pronounced decline in its foreign reserves, and currency pressures would have been significant. A meaningful improvement in investor sentiment – which will remain cautious on the back of economic and geopolitical risks – is a necessary precondition for the return of these inflows. Nevertheless, the current account deficit will likely remain narrow in the second half of the year as the trade balance improves on the back of a weak lira and imports remain depressed due to soft domestic demand. This will keep the lira supported over this period. Although risks from a wide current account deficit have been temporarily put off, years of foreign debt accumulation are a hazard to a sustainable improvement in the lira. Foreign debt obligations (FDO) due over the coming 12 months are extremely elevated at $167 billion (Chart 15). It is not clear that they can be paid off. While the FDO figure is overly pessimistic as some of these debts will be rolled over, net central bank foreign exchange reserves can cover only 2.7% of these obligations. This poses downside risks on the lira at a time when inflows have not yet recovered.1 Moreover, unorthodox economic policies will eventually reverse any improvement in the currency. Chart 14Financial Account Does Not Lend Support Chart 15FDO Pose A Risk To The Currency While the 4 years between now and the next election could be an opportunity to embark on unpopular structural reforms that will improve the outlook by the time voting season rolls in, Erdogan has instead doubled down on his current strategy. Less than two weeks after the results of the Istanbul election rerun, CBRT governor Murat Cetinkaya was removed by presidential decree. A month later, key CBRT staff were dismissed.2 At his first monetary policy committee meeting as governor on July 25, Murat Uysal slashed the one-week repo rate by 425bps. Given Erdogan’s outspoken distaste for high interest rates, the president’s consolidation of power over economic decision making implies that the outlook for easier monetary policy is now guaranteed. However, the ramifications of this dovish shift will be concerning for voters. The depreciating lira was singled out as the most important economic problem facing Turkey by the largest number of survey respondents (Chart 16). Erdogan’s pursuit of dovish policies despite popular opinion shows that he is doubling down on unorthodox policy despite popular opinion. Monetary easing threatens to unwind the current account improvement and ultimately de-stabilize the lira. Assuming that the banking sector does not hold back the supply of credit to the private sector, lower rates will generate a pickup in demand which will raise imports and widen the current account deficit. Unless there is a marked improvement in investor sentiment – which will remain tainted by the erosion of central bank independence and increased tensions with the West – a return in portfolio inflows to pre-2018 levels is unlikely. As a consequence the lira will begin to soften anew in 2020. The lira will soften anew in 2020. While inflation will subside as the lira stabilizes this year, it will likely remain elevated relative to pre-2018 levels – in the 10% to 15% range. Contrary to Erdoganomics, traditional economic theory postulates that interest rate cuts pose upside pressure on prices. The resurgence in domestic demand will occur against a backdrop of rising wages (Chart 17). Chart 17Price Pressures Will Persist With foreign currency reserves running low, the CBRT recently adopted several measures to discourage locals from exchanging their liras for foreign currency. These efforts reflect attempts to mitigate the negative impact of monetary easing on the lira, and to ensure FX reserves are supported: A 1-percentage point increase in the reserve requirement ratio for foreign currency deposits and participation funds. A 1-percentage point reduction in the interest rate on dollar-denominated required reserves, reserve options and free reserves held at the bank. An increase in the tax on some foreign exchange sales to 0.1% from zero. These measures make it more expensive for banks to hold foreign currency, incentivizing lira holdings instead. They also raise the CBRT’s foreign reserves highlighting the downside risks on these holdings and the lira. However, given that these measures boost CBRT reserves only superficially – rather than mirroring an improvement in the underlying economic conditions – they highlight that need for policy tightening to defend the lira, even as the CBRT officially pursues an accommodative path. Bottom Line: The Turkish economy will be extremely relevant to Erdogan’s fate in 2023. However with large foreign debt obligations, a rate cutting cycle underway, and foreign investors who remain uneasy, the case for Turkey’s economic recovery – especially amid turbulent global conditions – is weak. In the meantime, Erdogan will continue to blame external factors for the nation’s malaise. Don’t Bet On Trump-Erdogan Friendship “Being Asian and in Asia is as important as being European and in Europe for us.” Turkish Foreign Minister Melvut Cavusoglu For several years Erdogan has attempted to distract the populace from the country’s economic slide by adopting an aggressive foreign policy, particularly toward the West. The immediate cause is Syria, where Turkey has fundamental security interests that clash with those of the U.S. and Europe. But tensions also stem from Erdogan’s economic and political instability. This aggressive foreign policy has not changed in the wake of the AKP’s electoral loss. Erdogan is continuing to test the U.S.’s and EU’s limits and the result is likely to be surprise events, such as U.S.-imposed sanctions, that hurt Turkey’s economy and financial assets. Erdogan clashes with the West both because of substantive regional disagreements and because it plays well domestically. Turks increasingly see the U.S. and other formal NATO allies as a threat, while looking more favorably upon American rivals like Russia, China, Iran, and Venezuela (Chart 18). The U.S., meanwhile, is expanding the use of “secondary sanctions” to impose costs on states that make undesirable deals with its rivals, and Turkey is now in its sights. The reason is Erdogan’s decision to purchase the S400 missile defense system from Russia. This decision exemplifies the breakdown in the U.S.-Turkish alliance and Turkey’s search for alternative partners and allies. The arms sale is likely – eventually – to trigger secondary sanctions under the U.S. International Emergency Economic Powers Act and especially the Countering America’s Adversaries Through Sanctions Act (CAATSA). Washington has already imposed sanctions on China for buying the same weapons from Russia. Erdogan recently accepted the first delivery of components for the S400s, which are supposed to go live by April 2020. He stuck with this decision in disregard of Washington’s warnings. He has a solid base of popular support across political parties for this act of foreign policy and military independence from the U.S. (Chart 19). But the full consequences have not yet been felt. President Trump’s response is muted thus far. He banned Turkish pilots from the U.S. F-35 program and training but has not yet imposed sanctions due to his special relationship with Erdogan and ongoing negotiations over Syria. Syria is the root of the breakdown in Turkish-American relations since 2014. Washington and Ankara have clashed repeatedly over their preferred means of intervening into the Syrian civil war and fighting the Islamic State. The U.S. relies on the Syrian Democratic Forces, led by the Kurdish People’s Protection Units (YPG), which are affiliated with the Kurdistan Workers’ Party (PKK). The PKK is based in Turkey and both the U.S. and Turkey designate it as a “terrorist organization” due to its militant activities in its long-running struggle for autonomy from Turkey. Turkey has intervened in Syria west of the Euphrates River and has repeatedly threatened to conduct deeper strikes against the Kurds. The latter would put U.S. troops in harm’s way and could result in lost leverage for Western forces seeking to maintain their YPG allies and force an acceptable settlement to the Syrian conflict. There is a basis for a deal between Presidents Trump and Erdogan that could keep sanctions from happening. Trump is attempting to wash its hands of Syria to fulfill a promise of limiting U.S. costs in wars abroad. Meanwhile an aggressive intervention in Syria is not a popular option in Turkey, which is why Erdogan has not acted on threats to seize a larger swath of territory (Chart 20). As a result, the U.S. and Turkey recently formed a joint operation center to coordinate and manage “safe zones” for Syrian refugees. If they can manage the gray area on the Turkish-Syrian border, the Trump administration can continue to prepare for withdrawal while preventing Erdogan from taking too much Kurdish territory. The tradeoff is clear, but similar agreements have fallen apart. First, the U.S. Congress is ready to impose sanctions over the S400s and Trump is under pressure to punish Turkey for undermining NATO and dealing with the Russians. Second, the Trump administration has not found an acceptable solution to the Syrian imbroglio that makes full withdrawal possible. If Trump becomes convinced that the risks of a total and rapid withdrawal from Syria are greater than the rewards (as many of his GOP allies staunchly believe), then he has less incentive to protect Erdogan. Meanwhile Erdogan could still decide he needs to plunge deeper into Syria to counteract the YPG. Or he could retaliate against any sanctions over the S400s and provoke a broader tit-for-tat exchange. He has threatened to cancel orders for Boeing aircraft worth $10 billion. Clearly U.S. sanctions will cause the lira to fall and send Turkey into another bout of financial turmoil. In the meantime Turkey’s relations with Europe also pose risks. While the refugee crisis has abated, in great part due to Turkish cooperation, other disagreements are still problematic: The EU is not upgrading Turkey’s customs union and both sides know that Turkey is not eligible for EU membership anytime soon. In response to what the EU has deemed as illegal drilling for oil and gas off the coast of Cyprus, the EU called off high-level political meetings with Turkey and suspended EUR 145.8 million in pre-accession aid. EU foreign ministers have also put off talks on the Comprehensive Air Transport Agreement between the two parties which would have led to an increase in passengers using Turkish airports as a transit hub. In addition, EU ministers asked the European Investment Bank to review its lending activities in Turkey, which amounted to EUR 358.8 million last year. Erdogan is taking a bolder approach to Cyprus. He has decided to send a fourth ship to drill for natural gas in Cyprus’s Exclusive Economic Zone in the Eastern Mediterranean. The purpose is to rally support for his government by calling on the public’s strong allegiance to Turkish Cypriots (Chart 21). The problem is that a confrontation sought as a domestic distraction could provoke negative policy reactions from the EU (or the U.S., which is reconsidering its arms embargo on the Greek Cypriot side). Relations with the West would get worse. Chart 22... But Turkey Cannot Afford To Flout The EU Turkey cannot afford to flout the U.S. and EU. Its economy is dependent on Europe (Chart 22). And the U.S. still underwrites Turkey’s NATO membership and access to the global financial system. The problem is that Erdogan is an ambitious and unorthodox leader and he has clearly wagered that he can rally domestic support through various confrontations with Western policies. This means that for the immediate future the country is more likely to clash with Western nations than it is to recognize its own limits. Political risks are frontloaded and investors should be cautious before trying to snap up the depressed lira or Turkish government bonds. Bottom Line: Tensions with the West – especially the U.S. – will likely lead to economic sanctions. While there is a basis for Presidents Trump and Erdogan to avoid a falling out, it is not reliable enough to underpin a constructive investment position – especially given Erdogan has not changed course in the wake of this year’s significant electoral loss. Investment Conclusions Chart 23Optimism On Lira Amid Unresolved Risks The lira has rallied by 3.6% since the Istanbul election. It has risen 0.3% since the replacement of CBRT Governor Murat Cetinkaya and rallied further despite the sacking of the central bank’s chief economist and other high-level staff (Chart 23). Given that the market knows that the central bank reshuffle entails interest rate cuts, is this a clear signal that the lira has hit a firm bottom and cannot fall further? Turkey is more likely to clash with Western nations.  We doubt it. First, Erdogan’s doubling down on unorthodox policy threatens the recovery in the currency and risk assets and his aggressive foreign policy raises the risk of sanctions and further economic pain. Second, although Turkey is not overly exposed to China, it is heavily exposed to Europe, which is on the brink of a full-fledged recession and depends heavily on the Chinese credit cycle – which had another disappointment in July. German manufacturing PMI has been sinking further below the 50 boom-bust mark since the beginning of the year, and the economy contracted in 2Q2019 (Chart 24). Chart 24Global Backdrop Not Yet Supportive Chart 25Improvement In Spread Will Be Fleeting Given these domestic and global economic risks and geopolitical tensions, we expect any improvement in the sovereign spread to be fleeting (Chart 25). While the lira may experience temporary improvement, pressures will re-emerge in 2020 as the lagged impact of Erdogan’s pursuit of growth at all costs re-emerge. Stay on the sidelines as any improvement in the near term is fraught with risk.     Roukaya Ibrahim, Editor/Strategist Geopolitical Strategy roukayai@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategist mattg@bcaresearch.com Footnotes 1 See Emerging Markets Strategy Weekly Report, “Country Insights: Indonesia, Turkey, And The UAE” May 2, 2019, ems.bcaresearch.com. 2 Among those removed are the central bank’s chief economist Hakan Kara as well as the research and monetary policy general manager, markets general manager, and banking and financial institutions general manager.

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

Special Report

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

Highlights The global manufacturing cycle has averaged about three years in length (peak-to-peak). We are near the bottom of the current cycle, which should set the stage for a recovery phase lasting around 18 months. The global economy will start to slow in 2021, culminating in a recession in 2022. The long-term global disinflationary cycle is drawing to a close. Investors should remain bullish on risk assets for the next two years, but expect subpar returns over a longer-term horizon.  Feature The Wheels Are Turning BCA Research has a long and proud history of analyzing economic and financial market cycles. Three types of cycles, in particular, have proven to be important to investors: Short-term manufacturing cycles lasting roughly three years. Medium-term business cycles affecting the entire economy. Long-term supercycles that can span decades. These often involve significant economic, social and political changes. What Really Caused The Global Manufacturing Downturn? The latest global manufacturing downturn has been widely attributed to the escalation of the trade war, the Chinese deleveraging campaign, and the end of the “sugar rush” from the Trump tax cuts. We have no doubt that all these factors exacerbated the downturn. However, it is not clear whether they caused it. As Chart 1 illustrates, the Chinese deleveraging campaign began in late 2016, more than a year before the global manufacturing sector peaked. The trade war only heated up in the spring of last year, after manufacturing activity had already begun to roll over. The jury is still out on the extent to which U.S. corporate tax cuts spurred capital spending, as opposed to being funnelled into retained earnings and share buybacks. Regardless, the fact that capex has weakened less in the U.S. than abroad over the past 18 months suggests that the fading impact from U.S. tax cuts was not the main culprit (Chart 2). Chart 1Chinese Credit Growth Deceleration Preceded The Global Manufacturing Slowdown Chart 2The Capex Slowdown Has Been Less Severe In The U.S.   A Predictable Cycle Chart 3The Global Manufacturing Cycle Has Likely Reached A Bottom Lost in the discussion over the cause of the slowdown is that global manufacturing activity follows a fairly predictable three-year growth cycle: up for the first 18 months, down for the second 18 months (Chart 3). This is not an immutable law of nature, but it is a handy rule of thumb. The last growth cycle began in the late spring of 2016 and reached a crescendo in December 2017 (based on the global manufacturing PMI). For now, the global manufacturing sector remains in the doldrums, with this week’s worse-than-expected Markit PMI readings for both the U.S. and the euro area being prime examples. However, if history is any guide, activity should begin to rebound over the coming months. Global manufacturing activity follows a fairly predictable three-year growth cycle. The large improvement in the Philly Fed manufacturing PMI – arguably the most important of all the regional Fed manufacturing surveys1 – in July, strong U.S. core capital goods orders, as well as the slight uptick in Korean exports on a month-over-month basis, are positive signs in that regard. The same goes for the sales outlook of two manufacturing bellwether companies which reported earnings this week: United Technologies and Texas Instruments. The former manufactures Otis elevators, Carrier air conditioning/HVAC, and Pratt & Whitney jet engines. The latter’s components are widely used throughout the global semiconductor industry. Chart 4 shows that the semiconductor cycle closely tracks the overall manufacturing cycle. Chart 4Semiconductor And Manufacturing Cycles Tend To Overlap Cycles And Feedback Loops What drives the short-term manufacturing cycle? The answer is the same thing that drives all cycles: The existence of self-limiting feedback loops. In the case of the manufacturing cycle, the feedback loop is fairly straightforward to describe. A pickup in manufacturing sales boosts profits and creates new jobs. This causes consumer and business confidence to rise. Improving confidence leads to more sales, which generates even higher confidence. If that were all there was to the story, this virtuous cycle would never end. This is where the “self-limiting” part comes in. Most manufactured goods are durable goods, meaning that they retain value for some time after they are purchased. When spending on, say, automobiles or computers rises to a high level for an extended period of time, a glut will form, requiring a period of lower production. This, in turn, will generate a negative feedback loop where falling sales lead to lower confidence and so forth. The glut will eventually shrink. Once enough pent-up demand has accumulated, a new upcycle will begin.  The Role Of Finance Banks and other financial institutions play a critical role in both perpetuating, and ultimately short-circuiting, the feedback loop described above. Business lending tends to ebb and flow with capital spending (Chart 5). It is not so much that one causes the other. It is better to think of the two as locked in a self-reinforcing tango: Faster output growth leads to more lending, and more lending leads to faster output growth. Chart 5The Ebb And Flow Of Lending And Capex Go Hand In Hand The amount of time it takes for the music to end, and for the dancers to part ways, varies from episode to episode. If both lenders and borrowers are feeling skittish, the party may never reach a fever pitch. While that may sound like a bad thing, it has the redeeming feature that imbalances never get a chance to reach critical levels. This brings us to today: Unlike in the pre-financial crisis period, when banks held Chuck Prince’s view that “as long as the music is playing, you’ve got to get up and dance,” lenders are more circumspect. This is a critical reason why we think the next U.S. recession is not imminent. Private-Sector Imbalances Remain Low In The United States Despite this being the longest U.S. expansion on record, the ratio of private debt-to-GDP is still well below where it was at the start of the decade (Chart 6). Chart 6U.S. Private Sector Leverage Remains Below Its Previous Peak Granted, corporate debt levels have scaled new highs. However, thanks to low interest rates, interest coverage ratios remain above their post-1980 average. This is true for the economy as a whole, as well as for the broad equity market (Chart 7). Chart 7AInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (I) Chart 7BInterest Coverage Ratios Are Not Particularly Stretched In Most Equity Sectors (II) Spending on business equipment, new homes, and consumer durables also remains restrained. This explains why the average age of the U.S. capital stock has increased sharply since the Great Recession (Chart 8). Chart 8The Capital Stock Is Aging Public-Sector Imbalances On The Rise, But Not Yet At Critical Levels Chart 9The Private Sector Is Not Living Beyond Its Means The Way It Was Before The Last Two Recessions The one area where clear imbalances in the U.S. are present is in public finances. The tentative deal between the Trump Administration and Congress to raise spending caps and increase the debt ceiling ensures that fiscal policy will stay accommodative for the foreseeable future. Unfortunately, the cost of this fiscal largesse is a budget deficit that is set to swell to $1 trillion (4.5% of GDP) in FY2020, up from $586 billion (3.2% of GDP) in FY2016. Financing this deficit over the next few years is unlikely to pose serious challenges because the private sector remains an ample source of savings (Chart 9). However, once this reservoir of savings starts to recede, bond yields could rise sharply.   Chinese Imbalances: How Much Of A Concern? Economic and financial imbalances are more pronounced abroad. In China, fixed investment spending has averaged 44% of GDP over the past decade. Debt levels have soared over this period. That said, much of this debt-financed investment should be regarded as a form of stimulus for an economy that suffers from a chronic shortfall of consumption. So far this year, the decline in Chinese private-sector fixed-asset investment has been counterbalanced by an increase in infrastructure spending (Chart 10). As in the U.S. and many other economies, abundant Chinese savings have allowed interest rates to stay low, thereby ensuring that borrowers are able to tap credit at favorable terms. We expect the Chinese authorities to continue stimulating their economy. Unlike in early 2017, credit growth is only modestly above trend nominal GDP growth (Chart 11). In addition, a stronger economy would give the Chinese government more leverage over trade negotiations. Chart 10China: Declining Private-Sector Investment Counterbalanced By Increasing Infrastructure Spending Chart 11China: The Deleveraging Campaign Has Been Put On The Backburner   A Turn In The Long-Term Inflationary Cycle? While the unemployment rate has returned to pre-recession levels in many economies, the scars from the Great Recession still remain. Nowhere is this more manifest than in the hypersensitivity that central banks have displayed towards bad economic news. Just as central bankers in the 1960s were fixated on avoiding the mass unemployment that accompanied the Great Depression, today’s central bankers are laser-focused on propping up demand at all costs. The new conventional wisdom is that the Phillips curve is dead. Chart 12 casts doubt on this assertion: It shows that the relationship between wage growth and various measures of labor market slack still seems very much alive and well. Chart 12A Tighter U.S. Labor Market Has Been Translating Into Stronger Wage Growth... Chart 13...But No Imminent Threat Of A Wage-Price Inflationary Spiral Admittedly, faster wage growth has failed to push up inflation. However, this may be simply because productivity growth has sped up. In the U.S., unit labor cost inflation has actually decelerated sharply since late 2017 (Chart 13). If wage growth continues to grind higher, firms will have no choice but to start raising prices. This could set the stage for an upleg in the longer-term inflationary cycle.   Structural Forces: Not So Deflationary Anymore Once inflation starts to move higher, a number of structural forces could help it along. The period of hyperglobalization, which began with the collapse of the Soviet Union and the integration of China into the global economy, is over. The ratio of global trade-to-GDP has been flat for over a decade (Chart 14).  Chart 14Globalization Has Peaked Demographic trends are shifting from deflationary to inflationary. Now that baby boomers are starting to retire, they will begin running down their savings. Chart 15 shows that ratio of workers-to-consumers globally has begun to fall after a four-decade ascent. Chart 15The Worker-To-Consumer Ratio Has Started Shrinking Globally As more people retire, aggregate savings will fall. The shortage of savings will put upward pressure on the neutral rate of interest. If central banks drag their feet in raising policy rates in response to an increase in the neutral rate, monetary policy will end up being too stimulative. As economies overheat, inflation will pick up. The political winds are also blowing in the direction of higher inflation. Populism is on the rise. Whether it be right-wing populism or left-wing populism, the result is usually bloated budget deficits, compromised central bank independence, and productivity-reducing policies. Stagflation may once again rear its head. Investment Conclusions The path to higher interest rates is paved with lower rates, meaning that the longer a central bank keeps rates below their neutral level, the more economies will overheat, and the larger the eventual inflation overshoot will be. We expect the Fed to cut rates by 25 basis points next week, with another cut possible in September. The ECB and most other central banks are also in easing mode. The good news is that inflation is a notoriously lagging indicator (Chart 16). It will probably take at least a year for clear evidence of overheating to emerge in the U.S., and even longer abroad. The bad news is that once inflation breaks out, it could do so quite dramatically. The market is not prepared for this (Chart 17).     Investors should maintain a bullish stance towards risk assets for the next 12-to-18 months, before starting to scale back exposure. Not only are central banks becoming more dovish, but the global manufacturing cycle is about to turn up. Stronger global growth will lead to a weaker U.S. dollar (Chart 18). EM and European stocks will start to outperform U.S. stocks (Chart 19). Cyclicals will trump defensives. Chart 18The Dollar Is A Countercyclical Currency Chart 19EM And Euro Area Equities Outperform When Global Growth Improves     As global yield curves steepen anew, bank stocks will power higher. U.S. small caps, with their relatively high weighting in regional banks, will outperform their large cap brethren (Chart 20). Chart 20Big Has Crushed Small   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1    The manufacturing segment in the region covered by the Philadelphia Fed is representative of the national manufacturing sector and hence tracks the ISM manufacturing index better than the other regional Fed surveys. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights As central banks continue to push on a string for 2 percent inflation, it will underpin the valuation of equities and other risk-assets. So long as the global 10-year bond yield remains well below 2.5 percent, equity market sell-offs will be limited to corrections rather than an outright bear market. Within bonds, steer towards those where the monetary policy toolbox is not depleted, namely U.S. T-bonds. Within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the yen and the euro. Expect an early U.K. General Election whose result is extremely difficult to call. Until this fog of U.K. political uncertainty clears, steer clear of the pound and go long the international FTSE100 versus the domestic FTSE250.   Dear Client,   In lieu of the next weekly report I will be presenting the quarterly webcast on Tuesday 6 August at 10.00AM EDT, 3.00PM BST, 4.00PM CEST, 10.00PM HKT. Be sure to join me.   Dhaval Joshi Feature How Central Banks Have Misunderstood Inflation Chart Of The WeekInflation Expectations Just Track Actual Inflation Central banks continue to obsess about their failure to achieve inflation of two point zero (Chart I-2). The irony is that they should be rejoicing from the rooftops, because the major developed economies have all now reached the holy grail of price stability. Central banks have misunderstood price stability because they have defined it over-precisely in terms of econometric models and mathematics, when the way we actually perceive it has as much to do with psychology and physiology. Chart I-2Failing To Achieve Two Point Zero The human brain cannot distinguish inflation rates between -1 and 2 percent, a range we just perceive as ‘price stability’. As an example, if a loaf of bread costs 77 pence today, most people – myself included – would not perceive the difference between it costing 70 pence five years ago (2 percent inflation) or 73 pence (1 percent inflation). Compounding the perception difficulty is quality improvements. If the ingredients and nutritional quality are better today, then the price of the loaf may actually have gone down! Yet central banks persist in thinking of inflation within a linear spectrum which they can nail to one decimal place. Even now, Draghi talks about “survey-based inflation expectations at a level of 1.6/1.7 percent” as if the decimal point actually means something! What Draghi fails to recognise is that the human brain cannot perceive inflation to that level of mathematical precision. If I cannot distinguish between -1 and 2 percent inflation, then it is impossible for the central bank to change my inflation expectations within that range, because the entire range just feels like price stability to me. Therefore, my behaviour in terms of wage demands and willingness to borrow will also stay unchanged. And if my behaviour is unchanged, what is the transmission mechanism from -1 to 2 percent inflation? Chart I-3Inflation Expectations Just Track Actual Inflation This largely explains why monetary policy can take an economy from price instability into the range of price stability, but cannot fine-tune inflation within this broad range of price stability between -1 to 2 percent. The ultimate proof is that the market-based inflation expectations that central banks try to guide just track actual inflation (Chart Of The Week and Chart I-3). The problem is that central banks have created a rod for their own back. It is difficult for them to change their targets without gravely undermining their credibility. As Fed Chair Jay Powell points out “2 percent has become the global norm… saying that you’re going to change target – I wonder how credible that will be.” When Monetary Policy Is Depleted Monetary policy operates through the term structure of interest rates. The central bank sets short-term rates directly, and it establishes long-term rates through its forward guidance and QE tools. Other tools, like the TLTROs, simply ensure the effective transmission of the term structure to the banking system. Regarding QE, many people still believe that it is the central bank’s removal of bond supply that drives down their yields. This is plain wrong. The bond market sets the price of the QE transaction according to the signal it receives about future interest rate policy. For example, if QE implied rampant inflation down the road – and therefore higher interest rates – the act of QE would lift bond yields, perhaps considerably. In fact, the market interprets QE as a resolve to keep policy rates lower for longer and this is why it depresses yields.  At this week’s ECB policy announcement, expect the usual flannel and bluster. To achieve its 2 percent inflation target, “the Governing Council stands ready to act and use all the instruments that are in the toolbox”. The trouble is, once the term structure is at its lower bound all along its length – as it almost is in the euro area and Japan – the monetary policy toolbox is out of tools (Chart I-4 and Chart I-5). Chart I-4The Monetary Policy Toolbox Is Out Of Tools... Chart I-5...Once The Term Structure Is At Rock Bottom All Along Its Length The ECB’s increasing impotence is not something it wants to admit. As Upton Sinclair pointed out: it is difficult to get a man to understand something, when his salary depends upon his not understanding it! But to his credit, Draghi has at least hinted that the ECB toolbox is depleted, acknowledging that “in case of adverse contingencies, fiscal policy will have to play a fundamental role.” What Does This Mean For Market Strategy? To repeat, in a range of -1 to 2 percent, inflation expectations become insensitive to monetary policy. So in their obsession to achieve two point zero, central banks have pushed harder and harder on a piece of string. As a result, the experimental policy tools of our era have been forward guidance and QE, which have depressed bond yields to unprecedented lows (Chart I-6 and Chart I-7). Chart I-6Forward Guidance And QE... Chart I-7...Have Depressed Bond Yields To Historic Lows   Now we come to the crucial twist in the story. When bond yields enter a range of -1 to 2 percent risk-asset valuations become hyper-sensitive to monetary policy. We refer readers to previous reports in which we have extensively explained this dynamic. The upshot is that at ultra-low bond yields, the transmission to price inflation breaks down, but the transmission to risk-asset inflation increases exponentially1  (Chart I-8 and Chart I-9). Chart I-8Ultra-Low Bond Yields... Chart I-9...Have Lifted Equity Valuations To Historic Highs For market strategy, the good news is that as central banks continue to push on a string for 2 percent inflation, it will underpin the valuation of equities and other risk-assets. So long as the global 10-year bond yield remains well below 2.5 percent, sell-offs will be limited to corrections rather than an outright bear market.2  The other good news is that if there is no major dislocation in financial markets, economic downturns will be limited to down-oscillations rather than an outright recession. This is because, contrary to popular belief, the causality does not run from recessions to financial market dislocations; it almost always runs the other way, from financial market dislocations to recessions. The final strategic point is: within currencies, steer towards those where the monetary policy toolbox is already depleted, namely the yen and the euro. Conversely, within bonds, steer towards those where the monetary policy toolbox is not depleted, namely U.S. T-bonds. Brexit Update Talking of flannel and bluster, Britain’s Conservative party has elected a new leader who, by default, becomes the new Prime Minister. But while the Conservatives and the U.K. have a new leader, as far as Brexit is concerned, plus ça change plus c’est la même chose. A new leader does not change the tight parliamentary arithmetic in which the Conservative/DUP pact now has a wafer-thin working majority of just four, likely reduced to just three after the Brecon and Radnorshire by-election on August 1. Neither does it change the EU27’s ‘red line’ to protect the integrity of the single market at the Republic of Ireland’s border with Northern Ireland. Meaning that either the whole of the U.K. or Northern Ireland must stay in a customs union with the EU27. Chart I-10When The Pound Weakens, The International FTSE100 Outperforms The Domestic FTSE250 Given these hard constraints we expect an early General Election whose result is extremely difficult to call. This is because the U.K.’s first past the post voting system is designed for a two party structure, and not for the four parties that are now in contention (five in Scotland).3 Until this fog of political uncertainty clears at least partly, steer clear of the pound. U.K. equity investors should go long the international FTSE100 versus the domestic FTSE250 (Chart I-10).    Fractal Trading System* This week we note that the blistering outperformance of the New Zealand electricity sector following the public float last year is technically extended and susceptible to a countertrend reversal. This trade is based on the 52-week fractal dimension and so has a potential duration of a year, longer than our normal trades. Short the New Zealand electricity sector versus the broader New Zealand market setting a profit target of 7 percent with a symmetrical stop-loss. In other trades, short Russia (MOEX) versus Japan (Nikkei) achieved its 5 percent profit target and is now closed. This leaves five open positions. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes.   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com   Footnotes 1      Please see the European Investment Strategy Weekly Report ‘Risk: The Great Misunderstanding Of Finance’ October 25, 2018 available at eis.bcaresearch.com. 2      We define the global bond yield as the simple average of the 7-10 year government bond yields in the U.S., euro area, and China. A proxy is the simple average of the 10-year yields in the U.S., France, and China. 3      From political left to right, the parties are Labour, Liberal Democrat, Conservative, and Brexit. Scotland also has the Scottish National Party. Fractal Trading System The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com. Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields   Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields     Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations   Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations