Gov Sovereigns/Treasurys

Highlights The lack of dollar liquidity has been a tailwind behind the dollar bull market. Going forward, an end to a contraction in the Federal Reserve’s balance sheet should help stem the global shortage of dollars. Outside of a few basket cases, there remains scant evidence that the shortage of dollars has begun to trigger widespread negative feedback loops, symptomatic of a funding crisis. If the global economy picks up steam, a deterioration in the U.S. current account and rising FX reserves will improve the dollar liquidity situation. A trade war remains the key risk to this view. For the remainder of the year, portfolio managers should focus on relative value trades on the crosses rather than outright dollar bets. The European Central Bank’s resumption of quantitative easing could be paradoxically bullish for the euro beyond the near term. For now, stay short the euro versus a basket of petro-currencies. Feature At the center of the global financial architecture is the U.S. dollar and the Federal Reserve. The process behind the creation of dollars is a simple one, which goes as follows: In order to stimulate the U.S. economy, the authorities pursue macroeconomic policies that tend to weaken the dollar, such as lowering rates and/or running a wider fiscal deficit. The central bank helps finance this fiscal deficit via expanding the monetary base (seignorage). The drop in rates causes the yield curve to steepen. This incentivizes banks to lend, which in turn boosts U.S. money supply. As the economy recovers, and demand for imports (machinery, commodities, consumer goods) rises, the current account deficit widens. As a reserve currency, the U.S. trade deficit is settled in dollars. This leads to a flow of greenbacks outside U.S. borders. Wary of losing competitiveness via a rising exchange rate, other central banks will purchase these dollars from the private sector in exchange for local currency. The rise in foreign exchange reserves can be reinvested back into Treasurys and held in custody at the Fed, meaning that the current account deficit (or capital account surplus) finances the budget deficit. Call this an exorbitant privilege. The key question is whether dollar liquidity will ease over the near term or the shortage will intensify. A few factors suggest the former.  The sum of the Fed’s custody holdings together with the U.S. monetary base constitutes the root of global dollar liquidity. Each time this measure has severely contracted, the reduction in dollars has triggered a blowup somewhere, typically among other countries running twin deficits (Chart I-1). For example, since the Global Financial Crisis, a fall in the growth of this measure below the critical zero line coincided with the European debt crisis, China’s slowdown, and more recently slowing global trade and a manufacturing recession. Importantly, the slowdown in global trade preceded escalation in trade tensions between the U.S. and China, meaning other endogenous factors were also at play. Lack of dollar liquidity was perhaps a factor. Chart I-1A Liquidity Squeeze Of Dollars Chart I-2The U.S. Budget Deficit Needs To Be Financed In the past, the Fed was quick to correct the situation:  most episodes when the U.S. current account deficit was shrinking, the domestic economy was on the cusp of a slowdown or recession. This time around, easy fiscal policy and a trade-hawkish President have allowed the Fed to ignore the liquidity crisis happening outside the U.S. Key to this is that the lines are now blurred between how much of the trade slowdown is tariff escalation, and how much is due to endogenous factors. As a result, the Fed no longer felt obliged to intervene for markets outside the U.S., especially if the U.S. domestic economy was faring well. A shrinking U.S. current account deficit is incompatible with a resolution to the dollar crisis, especially as the greenback remains the global reserve currency (Chart I-2). On the surface, this is dollar bullish. Meanwhile, our geopolitical strategists contend that the trade war is just a symptom of a much larger battle for hegemonic supremacy, which will last for many years to come. However, the key question is whether dollar liquidity will ease over the near term or the shortage will intensify. A few factors suggest the former. Balance Sheet, Current Account And Foreign Debt Chart I-3The Contraction In Custody Holdings Is Over The Fed’s tapering of asset purchases has been a net drain on global dollar liquidity. But that is slated to change. The Fed’s balance sheet peaked a nudge above US$4.5 trillion in early 2015 and has been falling since. This has triggered a severe contraction in the U.S. monetary base, and severely curtailed commercial banks’ excess reserves. The Federal Reserve’s custody holdings argue that this was a huge drag on international dollar liquidity, even worse than during the 2008 crisis (Chart I-3). The good news is that the Fed has ended the tapering of its balance sheet and has started cutting rates. This combination will improve dollar's liquidity going forward. Meanwhile, balance-of-payment dynamics are heading in the wrong direction. Over the next five years, the U.S. Congressional Budget Office (CBO) estimates that the U.S. budget deficit will swell to 4.8% of GDP. Assuming the current account deficit widens a bit and then stabilizes, this will pin the twin deficits at around 8% of GDP. This assumes no recession, which would have the potential to swell the deficit even further. Part of these deficits will need to be funded through money printing. One difference between now and the past is that over the last several years, the dollar has become expensive. The narrowing of the U.S. current account balance might therefore be over. The U.S. saw its twin deficits swell to almost 13% of GDP following the financial crisis. However, then the dollar was cheap and commodity currencies were overvalued, following a natural resource bust. One way to solve an overvaluation problem is to increase the supply of dollars. Dollar liquidity shortages tend to be vicious because they trigger negative feedback loops. As the velocity of international U.S. dollars rises, offshore dollar rates begin to rise, lifting the cost of capital for borrowing countries. Debt repayment replaces capital spending. Yet there is little evidence that a dollar shortage has been triggering this sort of negative feedback loop. U.S. dollar funding to external entities is growing by circa 4% a year and has slowed to a crawl among both developed and emerging markets (Chart I-4). Historically, this slowdown has been symptomatic of a funding crisis in EM. Yet this time around, there have been other forces at play: The growth in euro- and yen-denominated debt is exploding, which mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. The growth in euro- and yen-denominated debt is exploding (Chart I-5). This is much smaller in outstanding amounts than U.S.-denominated debt, but mirrors the gradual shift in the allocation of FX reserves away from dollars into other currencies. If the U.S. has started to weaponize the U.S. dollar, foreign entities may have no other choice than to rally into other currency blocs, which may eventually entail the Chinese yuan. Chart I-4Growth In The Dollar Short Position Has Eased Chart I-5Lots Of Yen And Euro Debt ##br##Issuance The fall in the use of dollars gradually redistributes the “exhorbitant priviledge” of the U.S. currency. This alleviates the need for the U.S. to run a wider current account deficit (President Trump’s goal). This means lower growth in foreign exchange reserves could become the norm rather than the exception (Chart I-6). Historically, current account imbalances have been a major source of currency crises, meaning the system could actually be more stable. Chart I-6The Drop In FX Reserves Is Not Precarious The performance of some emerging market currency pairs will determine if the so-called funding crisis stays benign or becomes more malignant. Despite a deeper liquidity shortage than during the 2015-2016 crisis, most EM currency pairs are still trading within well-defined wedges and/or above critical thresholds (Chart I-7). Meanwhile, EM volatility remains much subdued – not symptomatic of a funding crisis (Chart I-8). Chart I-7EM Currency Pairs Remain Outside The Danger Zone Chart I-8EM FX Volatility##br## Is Low Bottom Line: One way to track if a dollar-funding crisis is becoming more acute is through the convenience yield, or cross-currency basis swap.1 This measures the difference in yield between an actual Treasury and a synthetic one trading in the offshore market. On this basis, it remains well below the panic levels observed in 2008, 2011 and 2015-2016, suggesting the dollar shortage is not as acute as back then (Chart I-9). Chart I-9The Convenience Yield For The Dollar Remains Low The ECB Bazooka Chart I-10Relative R-Star* In The Eurozone Could Rebound The ECB provided the stimulus the market wanted: they cut rates 10 basis points, offered a tiered system for their marginal deposit facility, and are starting an open-ended QE program at €20 billion a month in November. Yet the euro bounced. Our bias is that European rates were already well below equilibrium compared to the U.S., and the ECB’s dovish shift will help further lift the euro area’s growth potential (Chart I-10). If a central bank eases financing conditions at a time when growth is hitting a nadir, it is hardly bearish for the currency. Since the introduction of the euro, most of the economic imbalances from the region have stemmed from the standard contradiction of a common currency regime. This has been that interest rates have always been too low for one nation, while expensive for others. As such, the euro has typically been caught in a tug-of-war between a rising equilibrium rate of interest for one country, but a very low neutral rate for others.2 In the early 2000s, Spanish and Irish long-term rates were too low, and the reverse was true for Germany. The result was a massive boom in Spanish real estate, the accumulation of debt and buildup of major imbalances. Once bond vigilantes started punishing the periphery for their sins after the Great Recession, Germany found itself with rates that were too low relative to its newly reformed economy, while the periphery deflated. Capital spending in the peripheral countries has been rising faster than in core Europe, suggesting the spread between the cost of capital in these countries and the return on capital remains wide. The good news is this has not been the case for a few months now: 10-year government bond yields in France, Spain and even Portugal now sit at -24 basis points, 22 basis points and 24 basis points respectively, much below the neutral rate. This is severely easing financial conditions across the entire euro zone (Chart I-11). Chart I-11The Common-Currency Dilemma Solved There has been a reason behind the collapse in spreads, aside from a dovish ECB. Labor market reforms in Mediterranean Europe have seen unit labor costs in Greece, Ireland, Portugal and Spain collectively contract by almost 10%. This has effectively eliminated the competitiveness gap that had accumulated over the past two decades (Chart I-12). Italy remains saddled with a rigid and less productive workforce, but overall adjustments have still come a long way to closing a key fissure plaguing the common-currency area. The result is in the numbers. Capital spending in the peripheral countries has been rising faster than in core Europe, suggesting the spread between the cost of capital in these countries and the return on capital remains wide (Chart I-13). More rapid capital spending in the periphery is a key channel to close the productivity gap between member nations and lift the neutral rate of interest for the entire euro zone. Chart I-12The Competitiveness Gap Has Closed Chart I-13The Cost Of Capital Is Low In The Periphery The euro tends to be largely driven by pro-cyclical flows. Fortunately for investors, European equities, especially those in the periphery, remain unloved, given they are trading at some of the cheapest cyclically adjusted price-to-earnings multiples in the developed world. Analysts began revising up their earnings estimates for euro zone equities earlier this year. If they are right, this tends to firmly lead the euro by about nine to 12 months (Chart I-14).  Meanwhile, European bonds in hedged terms still remain very attractive (Table I-1). Chart I-14The Euro Might Soon Pop Table I-1Bond Markets Across The Developed World A key barometer to watch will be the performance of European banks. So far, they have avoided falling below the critical death zone (Chart I-15). We are awaiting further evidence that the global growth environment is becoming less precarious to place outright long euro bets. Stay tuned. Chart I-15Watch Eurozone Banks Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 Arvind Krishnamurthy and Hanno Lustig, “Mind the Gap in Sovereign Debt Markets: The U.S. Treasury basis and the Dollar Risk Factor,” Stanford University, August 29, 2019. 2 Please see Foreign Exchange Strategy Weekly Report, titled “EUR/USD And The Neutral Rate of Interest,” dated June 14, 2019, available at fes.bcaresearch.com. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in U.S. have been mostly positive: Starting with labor market, nominal average hourly earnings were little changed at 3.2% year-on-year in August, however real average hourly earnings yearly growth increased from 1.3% to 1.5% year-on-year. The unemployment rate was unchanged at 3.7%. Nonfarm payrolls increased by 130,000 in August, below expectations of 158,000. NFIB small business optimism index fell from 104.7 to 103.1 in August. Both headline and core PPI increased by 1.8% and 2.3% year-on-year in August. While headline inflation somewhat slowed to 1.7% year-on-year in August, core inflation came in strong at 2.4% year-on-year. DXY index appreciated initially by 0.6% post ECB, then soon plunged, ending -0.2% this week. BLS reported a large increase in temporary positions in the federal government, reflecting the preparation for the 2020 Census. Notable job gains also occurred in health care and finance, while mining lost jobs. During a Q&A session in Zurich last Friday, Powell noted that the outlook remains a favorable one despite global trade risks. The most likely scenario for the U.S. is continued moderate growth.  Report Links: Preserving Capital During Riot Points - September 6, 2019 Has The Currency Landscape Shifted? - August 16, 2019 USD/CNY And Market Turbulence - August 9, 2019 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro area have been mostly negative: GDP growth increased to 1.2% year-on-year in Q2, from a downwardly-revised 1.1% in the previous quarter. Sentix confidence came in at -11.1 in September, remaining in negative territory but higher than expected. Industrial production contracted by 2% year-on-year in July. EUR/USD fell by 0.9% post ECB meeting, followed by a quick rebound, gaining 0.3% in total this week. Mario Draghi’s last meeting as governor delivered another “bazooka.” The deposit facility rate was cut by 10 bps to a new low of -0.5%, and the ECB will restart QE at €20 billion monthly in November. It will also introduce a two-tiered system for interest rates. Report Links: Battle Of The Central Banks - June 21, 2019 EUR/USD And The Neutral Rate Of Interest - June 14, 2019 Take Out Some Insurance - May 3, 2019 Japanese Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan have been negative: Average cash earnings contracted by 0.3% year-on-year in July. Annualized GDP growth slowed from 1.8% to 1.3% quarter-on-quarter in Q2. The adjusted BoP current account balance narrowed to ¥1.65 trillion in July. The BoP trade balance shifted to a deficit of ¥74.5 billion. While the ECO watchers current index rebounded to 42.8 in August, the outlook component dropped to 39.1, the lowest since 2014. Preliminary machine tool orders kept contracting by 37.1% year-on-year in August. Core machinery orders yearly growth fell from 12.5% to 0.3% in July. PPI decreased by 0.9% year-on-year in August. USD/JPY increased by 1% this week. The outlook for Japan remains worrisome in anticipation of the scheduled consumption tax hike next month. Besides that, the relationship between Japan and South Korea is in the worst state in decades. Tourist arrivals between the two neighbors are both deteriorating. However, the BoJ remains out of policy bullets. This puts a floor under the safe-haven yen, until the BoJ acts. Report Links: Has The Currency Landscape Shifted? - August 16, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 Battle Of The Central Banks - June 21, 2019 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in U.K. have been slightly improving: Manufacturing production grew by 0.3% month-on-month in July. On a year-on-year basis, it contracted by 0.6%, an improvement from the previous -1.4%. Industrial production contracted by 0.9% year-on-year in July, higher than the consensus of -1.1%. Total trade deficit (including EU) slightly increased to £0.22 billion in July. Trade deficit (non-EU) widened to £1.93 billion. ILO unemployment rate fell to 3.8% in July. Average earnings growth increased to 4% year-on-year in July. GBP/USD increased by 0.4% this week. We believe that the probability of a no-deal Brexit remains low, but for the time being, we are standing aside while waiting for the chaos to settle. Next week we will be publishing an update on the U.K. economy. Stay tuned. Report Links: Battle Of The Central Banks - June 21, 2019 A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia have been mixed: Home loans grew by 4.2% month-on-month in July, up from 0.4% in the previous month. Westpac consumer confidence fell by 1.7% month-on-month in September. National Australia Bank (NAB) business confidence fell from 4 to 1 in August. AUD/USD appreciated by 0.5% this week. Investor and consumer sentiment remain depressed amid global trade worries and the diminishing returns from Chinese stimulus. However, we are seeing tentative signs of recovery as the housing sector stabilizes. We maintain a positive view on the Australian dollar. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand have been neutral: Net migration increased by 5100 in July. Manufacturing sales contracted by 2.7% quarter-on-quarter in Q2. The New Zealand dollar has been more or less flat against the U.S. dollar this week, but fell by 0.5% against the Australian dollar. China granted several U.S. products a one-year exemption from tariffs this week. While the good news regarding a potential U.S.-China trade deal could benefit pro-cyclical currencies, we believe the kiwi will underperform at the crosses. Report Links: USD/CNY And Market Turbulence - August 9, 2019 Where To Next For The U.S. Dollar? - June 7, 2019 Not Out Of The Woods Yet - April 5, 2019 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada have been solid: In August, 81,100 jobs were added, the unemployment rate was unchanged at 5.7%, and average hourly wages grew by 3.8% year-on-year. Ivey PMI increased to 60.6 in August, from the previous 54.2 in July. Bloomberg Nanos confidence was little changed at 56.5 for the past week. Housing starts increased by 226,600 in August.  Building permits grew by 3% month-on-month in July. New house price index fell by 0.4% year-on-year in July. USD/CAD increased by 0.2% this week. While the oil prices and robust job numbers could benefit the Canadian dollar in the near term, a rising exchange rate, and increasing interest rate differentials might tighten financial conditions, and thus limit the upside of the loonie. Report Links: Preserving Capital During Riot Points - September 6, 2019 Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 There is scant data from Switzerland this week: Producer and import prices contracted by 1.9% year-on-year in August. Unemployment rate was unchanged at 2.3% in August. USD/CHF has been flat this week. Last Friday, during the Q&A session in Zurich, SNB chairman Jordan emphasized that as a small open economy, Switzerland is heavily impacted by global economic developments, notably what is happening in the U.S., Europe, and China. The recent slowdown has weighed on the Swiss economy. More importantly, Jordan noted that price stability remains an important mandate for the Swiss people and the bank. Further policy adjustments, besides interest rates, might be necessary to stimulate the economy. The ECB policy meeting this week has also put more pressure on SNB to further ease monetary policy. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway have been neutral: Manufacturing output grew by 1% in July. Headline and core inflation both slowed to 1.6% and 2.1% year-on-year in August. USD/NOK fell by 0.4% this week, as oil prices continued to rally. Prince Abdulaziz Bin Salman was appointed as the new Energy Minister of Kingdom of Saudi Arabia (KSA), and he is committed to oil production control. Moreover, the possible good news over a U.S.-China trade deal is likely to revive oil demand, thus lifting Norwegian krone. Report Links: Portfolio Tweaks Into Thin Summer Trading - July 5, 2019 On Gold, Oil And Cryptocurrencies - June 28, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden have been mostly negative: Household consumption increased by 2.8% year-on-year in July. Headline inflation slowed from 1.7% to 1.4% year-on-year in August. Core inflation also slowed to 1.6% year-on-year, from the previous 1.7%. USD/SEK fell by 0.4% this week. Last week, the Riksbank kept interest rates on hold, and said that they are still planning to raise interest rates but at a slower pace. The slowdown in inflation this week might further delay their plan for a rate hike.  Report Links: Where To Next For The U.S. Dollar? - June 7, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Limit Orders Closed Trades

Highlights The structural message for equities: prefer equities over bonds. As long as the global 10-year bond yield remains below 2 percent, the equity market’s rich valuation is underpinned, albeit the long-term return from equities is likely to be a feeble low single-digit. The structural message for bonds: overweight the higher yielding versus the lower yielding quality sovereigns, most notably overweight U.S. T-bonds versus German bunds. 10-year yields cannot rise much – maybe only 50-100 basis points – before the rise destabilises equity and other risk-asset valuations. But 10-year yields that are deeply in negative territory can fall even less. The structural message for currencies: tilt towards lower yielding currencies, with a preference for the yen. Once monetary policy is already ultra-accommodative, a central bank’s ability to devalue its currency becomes more and more constrained. Feature Japanification: Bring It On! I have always been bemused and perplexed by people using ‘Japanification’ as a pejorative for the European economy (Chart of the Week). In the west, the received wisdom is that Japan is a ‘basket case’, a fate to be avoided at all costs. Yet nothing could be further from the truth: Japan is, in many ways, an economic role model to which Europe and the rest of the western world should aspire. Chart of the WeekEmbrace 'Japanification' Over the past twenty years, Japan’s productivity growth has outperformed all the other major economies (Chart I-2). To be clear, this is based on real GDP per head of working age (15-64) population, the cohort of people who generate economic output. Still, some people counter that this definition flatters Japan’s productivity growth by omitting the significant number of over 65s who work, and that a fairer definition should divide by the total population. Yet even on this alternative definition, Japan has been doing just fine, performing better than France and broadly in line with Canada (Chart I-3). Chart I-2Japan Is Not A 'Basket Case' Chart I-3Japan Is Doing Just Fine Japan’s real output per head has improved while consumers have enjoyed genuine price stability (Chart I-4). Meaning zero inflation, and not the ‘fake price stability’ of 2 percent inflation that central banks are trying – and failing – to reach. ‘Japanification’ is a state that Europe should not eschew; it is a state that Europe should espouse. Moreover, contrary to what the Philips Curve would have you believe, the absence of inflation does not mean there is a reserve army of the unemployed. Japan’s unemployment rate, at 2.2 percent, is one of the lowest in the world. As is income inequality (Chart I-5). While life expectancy is one of the highest in the world. Chart I-4Japan Has Enjoyed Genuine ##br##Price Stability... Chart I-5...And The Absence Of Extreme Income Inequality This combination of rising productivity, genuine price stability, absence of extreme income inequality, and rising life expectancy means that, in Japan, living standards have been rising for the many, and not just for the few. In turn this has meant that while populist backlashes have erupted elsewhere in the world, Japan has remained a paragon of political stability. In all of these important regards, ‘Japanification’ is a state that Europe should not eschew; it is a state that Europe should espouse. Countering The Counterarguments Nevertheless, in the interests of a balanced debate, we must address the main counterarguments: First, isn’t Japan’s declining population evidence of a national malaise? No. Japan lacks living space. Its mountainous islands are habitable on only tiny slivers along the coasts, and these are among the most densely populated regions in the world. Therefore, as the journalist and Japan specialist Eamonn Fingleton explains, Japan’s low birth rate is a fundamental national policy that can be traced back to the late 1940s. Japan lacks living space. Shorn of empire, Japan faced a major food security problem. At a stroke, Japanese officials stopped dead in its track a huge baby boom which took hold between 1946 and 1948. Ever afterwards Japan has enjoyed – yes, that is the appropriate word – a low birth rate. Although the program’s rationale is not recognized in the West, it is fully understood in the East and both Singapore and China went on to formulate similar policies. Chart I-6Japan's Rising Public Indebtedness Counterbalanced A Plunge In Private Indebtedness Clearly, a nation whose working population is shrinking will produce less than it otherwise might have, but this doesn’t mean the economy is a basket case. Far from it. On a per head basis, as we have shown, Japan is doing just fine, and the imbalance between workers and retirees will gradually work out as people adjust their retirement ages (just as they will have to in the west). A second counterargument is that Japan’s government indebtedness has skyrocketed to over 200 percent of GDP, the highest among any major economy. But this increase in public debt was needed as a crucial counterbalance to a sharp decline in private indebtedness, and thereby prevent a deep slump (Chart I-6). Japan’s total indebtedness has remained broadly flat for decades. Third, the Nikkei 225, at 21,500 today, is barely at half of its 39,000 peak value in 1989. The simple explanation is that the main determinant of any long-term return is the starting valuation. The 1989 peak bubble valuation was so extreme – a price to sales of 2.2 compared to 0.75 today – that the subsequent dire returns were baked in the cake (Chart I-7). Chart I-7Japan's Bubble Was So Extreme That Subsequent Dire Returns Were Inevitable Fourth, Japanese bond yields have been near-zero or negative for almost two decades, which some commentators claim is a classic sign of an economy in ‘secular stagnation’. But as we have shown, these ultra-low yields have coexisted with a Japanese economy that is doing just fine. More recently, the residents of Switzerland and Sweden will vouch for the same thing – that negative bond yields categorically do not mean that their economies are ‘basket cases’. But have these economies progressed only because they have these ultra-low bond yields? No, the charts in this report show no (inverse) relationship between bond yields and long-term productivity growth. Which begs the question: if ultra-low bond yields are not a sign of an economy stuck in a funk, what are they a sign of? The Real Reason For Ultra-Low Bond Yields Chart I-8Inflation Is Stuck Well Short Of The 2 Percent Target Today, like a stuck record, the ECB will repeat again that inflation remains well short of its 2 percent target (Chart I-8), but that its resolve to reach the target is unwavering. Just as it was at the last meeting… last year… the year before that… and five years before that! Instead of loosening even further, the ECB should be explaining why, in spite of years of negative interest rates and trillions of euros of QE, inflation expectations have barely budged. As the ECB will not provide the explanation, we will. The public’s expected inflation – a fundamental input into economists’ models during the past half-century – is not well defined when an economy has reached price stability, as it has now. Chart I-9Unemployment Rates Are At Multi-Decade Lows Confirming what this publication has previously argued, Professor Jeffrey Frankel of Harvard University explains “most people pay little attention to the inflation rate when price growth is as low as it has been in recent years.” As a result, argues a paper from the NBER, large policy change announcements in the U.S., the U.K., and the euro area seem to have only limited effects on the inflation expectations of households and firms.1 However, as most economists and central banks fear that their credibility is at stake, they remain fixated on the need to reach the 2 percent inflation target. This requires them to double down, triple down, and then quadruple down on extreme accommodation, even though prices are stable, the economy is progressing, and unemployment rates have declined to multi-decade lows (Chart I-9). So in answer to our previous question, ultra-low bond yields are not a sign of an economy stuck in a funk; they are a sign of central banks that are chasing the wrong inflation target, and that are too scared to change the target for the damage it would do to their credibility. What Does This Mean For Stocks, Bonds, And Currencies?   Ultra-low bond yields are coexisting with economies that are doing fine, as we have seen in Japan, Switzerland, and Sweden. But at such low yields, the unattractive asymmetry of limited bond price upside with unlimited downside justifies exponentially higher valuations for equities and other risk-assets. Chart I-1010-Year Bond Yields Can Rise By Only 50-100 Basis Points So the structural message for equities is: as long as the global 10-year bond yield remains below 2 percent, the equity market’s rich valuation is underpinned. And on anything other than a trading horizon, equities are to be preferred over bonds – albeit the long-term return from equities is likely to be a feeble low single-digit. The structural message for bonds is: 10-year yields cannot rise much – maybe only 50-100 basis points – before the rise destabilises equity and other risk-asset valuations, thereby acting as a limiter (Chart I-10). But given that there is a lower bound to policy interest rates, 10-year yields that are deeply in negative territory can fall even less. Hence, the risk-reward dynamic suggests going overweight the higher yielding versus the lower yielding quality sovereigns: most notably, overweight U.S. T-bonds versus German bunds. On a structural horizon, prefer equities over bonds. The structural message for currencies is essentially the opposite to that for bonds: tilt towards lower yielding currencies because in a ‘race to the bottom’, a central bank’s ability to devalue its currency becomes more and more constrained. But which low yielding currency? As Japan has already undergone its ‘Japanification’, we like the yen. Fractal Trading System* With geopolitical risks having ebbed somewhat, a good tactical trade would be to lean against the technically overbought conditions in high-quality government bonds. Hence, this week’s recommended trade is to short the U.S. 10-year T-bond setting a profit target of 1.5 percent with a symmetrical stop-loss. In yield terms, this broadly equates to a target yield of 1.9% and stop-loss at 1.5%. Chart I-11U.S. 10-year T-Bond Price 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. 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. Footnotes 1 Please see http://conference.nber.org/conf_papers/f117592.pdf and the European Investment Strategy Special Report ‘The Case Against Secular Stagnation’ August 29, 2019 available at eis.bcaresearch.com. Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Cyclical Recommendations Structural Recommendations Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields   Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Content Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations    

Highlights Growth & Yields: The massive bond rally of 2019 is in its dying days - the sharp downward momentum of global bond yields is fading, just as leading economic indicators are starting to move higher. Data Surprises & Yields: The risk of a snapback in yields is growing in countries where there are more positive economic data surprises but where yields remain depressed – like the U.S., Canada, Australia and New Zealand. Duration Strategy: We still recommend investors to stick to a neutral (at benchmark) stance on overall portfolio duration in the near term (0-3 months). Markets will need more than just one or two positive data points to be convinced that global growth is rebounding, and U.S.-China trade tensions remain a lingering concern. On a cyclical horizon (6-12 months), however, once it is clear that we’ve entered into a new global manufacturing up-cycle, global yields will rise more sustainably, justifying reduced duration exposure. Feature Chart of the WeekA Potential Bottoming Of Growth & Yields Is The Great Global Bond Rally of 2019 finally running out of gas? Government bond yields in the major developed economies have stabilized and are now starting to drift a bit higher. Benchmark 10-year yields are all up by healthy amounts from the inter-day lows reached on September 3rd (U.S. +18bps, Germany +17bps, U.K. +24bps, Canada +24bps). Yields remain well below intermediate term trend measures like the 200-day moving average, however, suggesting that these rebounds may only be corrective in nature and not yet the start of a more sustained cyclical move higher. Reliable economic data like our global manufacturing PMI are still falling and remain at levels suggesting weakening global growth. Yet on a rate-of-change basis, the pace of the decline in the PMI is fading, indicating that the worst of the downturn is likely behind us. A bottoming of the downward momentum of the PMI typically coincides with fading downward momentum in bond yields (Chart of the Week), which suggests that, at a minimum, bond yields are unlikely to fall below the recent lows. A similar signal is given by our global leading economic indicator (LEI), which has clearly bottomed and is now starting to drift higher. We shifted to a tactically neutral stance on global duration exposure back in early August, based on our near-term concerns that the ratcheting up of U.S.-China trade tensions through new tariffs would further raise economic uncertainty and heighten the demand for safe assets like government bonds – especially given the decline in global manufacturing activity. Last week’s announcement that U.S.-China trade talks would resume in early October was a positive step towards a potential de-escalation of trade tensions, which did help provide a pro-risk lift to global bond yields (at least for one day). For now, however, we are staying with a near-term neutral view on duration until we see more concrete signs of progress from the October 5 U.S.-China trade meetings in D.C. The heightened political drama in the U.K. is another reason to be cautious, with the October 31 Brexit deadline – and potentially a U.K. election before then – fast approaching (NOTE: we will be publishing a joint Special Report on the U.K. with our colleagues at Foreign Exchange Strategy and Geopolitical Strategy on September 20). More fundamentally, we will look to reduce our recommended duration exposure back to below-benchmark once global manufacturing data (i.e. U.S. ISM, Markit PMIs) and economic sentiment data (i.e. global ZEW, German IFO) stabilize – an outcome that grows increasingly likely given the signs of improvement we are seeing in the global LEI. Finding The Biggest Disagreements Between Economic Data & Bond Yields One time-tested way to identify a potential cyclical market top or bottom, for any asset class and not just bonds, is to look for divergences in prices from fundamentals. For example, when bond yields continue to fall despite signs that economic data are starting to improve (or, at least, when there is less data underperforming expectations). We can see such a divergence today when looking at bond yields versus data surprise indices. The most visible divergences between better data surprises and low bond yields are in the U.S., Australia, Canada and New Zealand. In Charts 2 & 3, we show the 26-week change in the benchmark 10-year government bond yield (in basis points) versus the widely followed Citigroup Economic Data Surprise Indices for the U.S., euro area, Japan, the U.K., Australia, Canada, New Zealand and Sweden The broad relationship is that yields fall faster when data is weaker than expected, and vice versa. The relationship is stronger in some countries like the U.S. and the U.K., and very weak in Japan, but we can still look for divergences between yield changes and data surprises for signs of bond yields deviating from economic growth. Chart 2Data Surprises Diverging From Yields In The U.S. … Chart 3… And In "The Dollar Bloc" The most visible such divergences are in the U.S., Japan, Australia, Canada and New Zealand; in those countries, more data releases have been surprising to the upside versus consensus forecasts of late, yet bond yields have been falling at a very rapid rate. In the euro area, the U.K. and Sweden, data has been disappointing versus expectations, justifying the rapid move down in bond yields in those countries purely from an economic growth perspective. For all countries shown, interest rate markets are now priced for aggressive monetary easing. Our 12-month discounters, based on pricing from Overnight Index Swap (OIS) curves, all show that money markets expect central banks to ease policy over the next year. Our discounters remain highly correlated to the level of government bond yields (Charts 4 & 5), which means that the biggest risk to the Great Global Bond Rally of 2019 is that policymakers do not deliver the full amount of easing discounted by markets. Chart 4Bond Yields Are Vulnerable To A Rebound … Chart 5… Given Overly Dovish Policy Expectations That risk looks greatest in countries where there is both a divergence between improving data surprises and low bond yields AND a significant amount of interest rate cuts priced into the OIS curve – like the U.S. (98bps of cuts discounted), Australia (42bps), Canada (32bps) and New Zealand (33bps). Japan (13bps), the euro area (22bps) and Sweden (4bps) are all cases where central bank policy rates (and bond yields) are negative but where additional rate cuts are still discounted. Data continues to disappoint to the downside in the euro area and Sweden, however, suggesting that bond yields there are less at risk of a corrective snapback. A similar argument applies in the U.K. (25bps), where there is not a divergence between weak data and falling Gilt yields. Given the weak correlation between data surprises and changes in bond yields in Japan – an unsurprising outcome given the Bank of Japan’s outright manipulation of JGB yields – we find it difficult to make any conclusions on the next move in yields based solely on an analysis of Japanese data surprises. That risk of higher bond yields is greatest in countries where data surprises are diverging from bond yields AND a significant amount of interest rate cuts are discounted. Bottom Line: The massive bond rally of 2019 is in its dying days - the sharp downward momentum of global bond yields is fading, just as leading economic indicators are starting to move higher. The risk of a snapback in yields is growing in countries where there are more positive economic data surprises but where yields remain depressed – like the U.S., Canada, Australia and New Zealand. The Increasingly Schizophrenic Nature Of Global Central Banks The dovish turn of global monetary policy in 2019 has been fairly limited in terms of the size of cuts, but broad in terms of the number of countries that have delivered cuts. Our Global Monetary Easing Indicator (GMEI), which measures the percentage of central banks (out of a list of 29) that have cut policy rates from three months earlier, is a simple way to measure the “breadth” of the global monetary policy cycle. In Chart 6, we compare the GMEI (shown on an inverted scale) to our global LEI. Historically, the GMEI has peaked around three months after the global LEI troughs. Afterward, facing prospects of improving growth, central banks gradually took their feet off the gas pedal, with the GMEI moving to zero as the global LEI continued to climb. Chart 6Introducing Our Global Monetary Easing Indicator The ups and downs of central banker actions have become more complicated since 2008. After the financial crisis, policymakers had to keep rates at or near the zero lower bound. For the Fed looking over at its Japanese counterpart, the prospect of keeping rates too low for too long, and thereby eventually losing the ability to stimulate the economy through rate cuts in the next downturn, was a fearful one. At the same time, creating overly easy financial conditions and indirectly causing the next asset bubble was another concern for policymakers in the aftermath of the financial crisis. After 2016, central bank behavior became particularly misguided. This “bi-polar” policy environment clearly caused a change in the reaction function of global central banks. Post-crisis, they have been slower to react to signs of global weakness. In 2016, for example, the GMEI peaked a full six months after the trough in the LEI – a longer reaction time compared to previous cycles. Even when they did react, however, it was at a lower intensity, with smaller easings by fewer banks, compared to previous cycles After 2016, however, central bank behavior became particularly misguided. The subsequent monetary tightening was clearly too abrupt. Investor sentiment and expectations of global growth, captured by our GFIS duration indicator (Chart 7), were on their way down while global central banks were all too eager to stop easing, ignoring the data showing signs of global weakness – especially from China. Chart 7Central Banks Are Zigging When They Should Be Zagging By June 2018, none of the central banks included in the GMEI were easing, despite the global LEI having peaked six months earlier. In September 2018, despite facing persistent global weakness – the global manufacturing PMI had fallen from its peak of 54.4 nine months earlier to 52.1 and the global LEI was already in negative territory indicating more weakness to come – only a meagre 3% of central banks had begun stimulating. The Fed exemplified this complacency with its rate hike in December 2018 and its refusal to clearly pivot in a dovish direction until three months later. When they ultimately delivered a rate cut in late July of this year, it was clear they had waited too long. Chart 8How Will Dovish Policymakers Respond To Improving Growth? Globally, the overall policy response was non-existent all the way until May 2019, when central banks finally got with the program and scrambled to ease. Now, with the Fed having cut rates and facing the possibility of further rate cuts (possibly hastened by the Tweeter-in-Chief), global central bankers will not want to be left behind, lest they suffer unwanted currency strength and forgo export competitiveness. However, they might be once again misreading the data and the global easing cycle might be much closer to its end than its beginning. BCA’s Chief Global Strategist, Peter Berezin, has noted that global manufacturing cycles average three years from peak to peak. As the last growth cycle began in late spring of 2017, this means that we are likely at the bottom of the current cycle and therefore, global growth should start to pick up soon. This message is reinforced by our Global LEI diffusion index (Chart 8), which indicates that the Global LEI has put in a bottom and will continue climbing higher in the coming months. The easing of global financial conditions, and the lagged impact of China’s policy stimulus measures from earlier in 2019, corroborate the message from the global LEI. With bonds as overbought as they are today, we expect yields to rebound once investors realize that the sky is not really falling. A pick up in the global LEI, in turn, suggests that the global PMI will follow and should soon move higher, with a lead time of six months based on past cycles (as we show in the bottom panel of Chart 1). Another reliable leading growth indicator, the level of high-yield corporate bond spreads, is also signaling a rebound in both the U.S. and euro area economies over the next few quarters (Chart 9). Chart 9High-Yield Spreads Are A Leading Economic Indicator Global bond yields, meanwhile, seem stuck between a rock and a hard place. As shown in Chart 10, yields move with expectations of future growth. Bond investors are sensitive to declines in expectations of future growth, captured by the global LEI, as this necessitates central bank intervention in the future to lower short-term rates, thus bringing down the expectations component of long-term yields. At the same time, a slowdown in growth in the present increases the safe-haven demand for bonds which again drives down yields. Chart 10Potential Triggers For Higher Bond Yields   Although the global is ticking back up, global policy uncertainty (Chart 10, middle panel) is near all-time highs due to the U.S.-China trade war. In such an environment, investors will naturally flock to the safety of bonds. In previous reports, we have shown how similar the current backdrop is to the 2015/2016 episode, when nervous bond investors were less likely to be forward-looking and needed to see firm evidence of a pickup in global growth before they started to push up yields on a sustained basis. Given the increasing likelihood that global central banks will not be able to fully deliver the amount of aggressive easing discounted by markets because of a more stable growth backdrop, any lessening of trade tensions – a growing possibility with U.S. President Donald Trump gearing up for the 2020 election – should allow calmer heads to once again prevail as global economic momentum improves and policy uncertainty wanes. With bonds as overbought as they are today, we expect yields to rebound once investors realize that the sky is not really falling. It remains to be seen how policymakers respond to that outcome. Given recent history, however, we fear that central bankers could end up turning more hawkish once again faster than markets expect, which would set the stage for a more sustainable rise in global bond yields in 2020. Bottom Line: We still recommend that investors stick to a neutral benchmark overall portfolio duration stance in the near term (0-3 months). Markets will need more than just one or two positive data points to be convinced that global growth is rebounding. On a cyclical horizon, once it is clear that we’ve entered into a new global manufacturing up-cycle, global yields are likely to rise. As Trump reaches for a deal ahead of the 2020 election, the decline in global policy uncertainty will contribute to a more bond-bearish environment.   Robert Robis, CFA, Chief Fixed Income Strategist rrobis@bcaresearch.com Shakti Sharma, Research Associate shaktis@bcaresearch.com Recommendations The GFIS Recommended Portfolio Vs. The Custom Benchmark Index Duration Regional Allocation Spread Product Tactical Trades Yields & Returns Global Bond Yields Historical Returns

Highlights Chart 1Waiting For A Manufacturing Rebound The 2015/16 roadmap is holding. As in that period, the ISM Manufacturing PMI has fallen into recessionary territory, but the Services PMI remains strong (Chart 1). As is typically the case, bond yields have taken their cue from the manufacturing index. The resilient service sector and global shift toward easier monetary policy will support an eventual rebound in manufacturing, and the Fed will continue to play its part this month with another 25 basis point rate cut. As for the Treasury market, much stronger wage growth than in 2016 will prevent the Fed from cutting rates back to zero. This means that the 10-year yield will not re-visit its 2016 trough of 1.37% (Chart 1, bottom panel). Strategically, investors should maintain a benchmark duration stance for now, but stand ready to reduce duration once the global manufacturing data stabilize. Feature Investment Grade: Overweight Chart 2Investment Grade Market Overview Investment grade corporate bonds underperformed the duration-equivalent Treasury index by 105 basis points in August, dragging year-to-date excess returns down to +323 bps. In remarks last week, Fed Chairman Powell noted that the Fed has lowered the market’s expected path of interest rates, and that he views this easing of financial conditions as providing important support for the economy.1  The July FOMC minutes echoed this sentiment, sending a strong signal that the Fed will do everything it can to prevent a significant tightening of financial conditions. The accommodative monetary environment is extremely positive for corporate spreads. In terms of valuation, Baa-rated securities offer the most value in the investment grade corporate bond space (Chart 2). Baa spreads remain 13 bps above our cyclical target (panel 2).2 Conversely, Aa and A-rated spreads are 2 bps and 1 bp below target, respectively (panel 3). Aaa spreads are 15 bps below target (not shown). The main risk to spreads comes from the relatively poor state of corporate balance sheets. Our measure of gross leverage – total debt over pre-tax profits – was already high, and was revised even higher after the Bureau of Economic Analysis’ annual GDP revision (panel 4). But for now, likely in large part due to accommodative Fed policy, loan officers aren’t inclined to cut off the flow of credit. C&I lending standards remain in “net easing” territory (bottom panel). Table 3ACorporate Sector Relative Valuation And Recommended Allocation* Table 3BCorporate Sector Risk Vs. Reward* High-Yield: Overweight Chart 3High-Yield Market Overview High-Yield underperformed the duration-equivalent Treasury index by 114 basis points in August, dragging year-to-date excess returns down to +551 bps. The average index option-adjusted spread widened 22 bps on the month. At 385 bps, it is well above the cycle-low of 303 bps. We see more potential for spread tightening in high-yield than in investment grade. Within investment grade, only Baa-rated spreads appear cheap. However, in high-yield, Ba-rated spreads are 49 bps above our target (Chart 3), B-rated spreads are 151 bps above our target (panel 3) and Caa-rated spreads are 398 bps cheap (not shown).3   Junk spreads also offer reasonable value relative to expected default losses. The current Moody’s baseline forecast calls for a default rate of 3.2% over the next 12 months. This translates into 207 bps of excess spread in the High-Yield index after adjusting for expected default losses (panel 4). That 207 bps of excess spread is comfortably above zero, though it is below the historical average of 250 bps. As noted on page 3, C&I lending standards have now eased for two consecutive quarters and job cut announcements are off their highs (bottom panel). Both trends are supportive of lower default expectations in the future. MBS: Neutral Chart 4MBS Market Overview Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 63 basis points in August, dragging year-to-date excess returns down to -31 bps. The conventional 30-year zero-volatility spread widened 9 bps on the month, driven entirely by the option-adjusted spread (OAS). The compensation for prepayment risk (option cost) held flat at 29 bps. At 51 bps, the OAS for conventional 30-year MBS has widened back close to its average pre-crisis level (Chart 4). However, value is less attractive when we look at the nominal MBS spread, which remains near its all-time lows.4 The nominal spread has also widened less than would have been expected in recent months, considering the jump in refi activity (panel 2). The mixed valuation picture means we are not yet inclined to augment MBS exposure. However, we are equally disinclined to downgrade MBS, given our view that Treasury yields are close to a trough. An increase in Treasury yields would cause refi activity to slow, putting downward pressure on MBS spreads. All in all, we expect the next big move in the MBS/Treasury basis will be a tightening, as global growth improves and mortgage rates rise. However, valuation is not sufficiently attractive to warrant more than a neutral allocation. Government-Related: Underweight Chart 5Government-Related Market Overview The Government-Related index underperformed the duration-equivalent Treasury index by 12 basis points in August, dragging year-to-date excess returns down to +152 bps. Sovereign debt underperformed duration-equivalent Treasuries by 45 bps on the month, dragging year-to-date excess returns down to +442 bps. Local Authorities underperformed the Treasury benchmark by 31 bps, dragging year-to-date excess returns down to +212 bps. Meanwhile, Foreign Agencies underperformed by 11 bps, dragging year-to-date excess returns down to +141 bps. Domestic Agencies outperformed by 13 bps in August, bringing year-to-date excess returns up to +44 bps. Supranationals outperformed by 3 bps, bringing year-to-date excess returns up to +39 bps. Sovereign debt remains very expensive relative to equivalently rated U.S. corporate credit (Chart 5). While the sector would benefit if the Fed’s dovish pivot eventually results in a weaker dollar, U.S. corporate bonds would still outperform in that scenario given the more attractive starting point for spreads. We continue to recommend an underweight allocation to Sovereigns. Unlike the debt of most other countries, Mexican sovereign bonds continue to trade cheap relative to U.S. corporates (bottom panel). Investors should favor Mexican sovereigns within an otherwise underweight allocation to the sector as a whole. Municipal Bonds: Neutral Chart 6Municipal Market Overview Municipal bonds underperformed the duration-equivalent Treasury index by 104 basis points in August, dragging year-to-date excess returns down to -46 bps (before adjusting for the tax advantage). The average Aaa-rated Municipal / Treasury (M/T) yield ratio rose 9% in August, and currently sits at 85% (Chart 6). The ratio is close to one standard deviation below its post-crisis mean, but slightly above the 81% average that prevailed in the late stages of the previous cycle, between mid-2006 and mid-2007. We shifted our recommended stance on municipal bonds from overweight to neutral near the end of July.5 The reason for the downgrade was that the sector had become extremely expensive. Yield ratios have risen somewhat since then, but not yet by enough for us to re-initiate an overweight recommendation. We also continue to observe that the best value in the municipal bond space is found at the long-end of the Aaa curve. 2-year and 5-year M/T yield ratios remain below average pre-crisis levels, while yield ratios beyond the 10-year maturity point are above. 20-year and 30-year Aaa M/T yield ratios, in particular, are the most attractive (panel 2). Fundamentally, state & local government balance sheets remain in decent shape and a material increase in ratings downgrades is unlikely any time soon (bottom panel). Our recent shift to a more cautious stance was driven purely by valuation and not a concern for municipal bond credit quality. A further cheapening in the coming months would cause us to re-initiate an overweight stance.    Treasury Curve: Maintain A Barbell Curve Positioning Chart 7Treasury Yield Curve Overview The Treasury curve bull-flattened dramatically in August, as the global manufacturing recession continued to pull yields down. At present, the 2/10 Treasury slope is just above the zero line at 2 bps, 11 bps flatter than at the end of July. The 5/30 slope is currently 60 bps, 9 bps flatter than at the end of July. Our 12-month Fed Funds Discounter is currently -98 bps (Chart 7). This means that the market is priced for almost four more 25 basis point rate cuts during the next year. While we have shifted to a tactically neutral duration stance because of uncertainty surrounding the timing of the next move higher in yields, four rate cuts on a 12-month horizon seems excessive given the underlying strength of the U.S. economy. For this reason, we are inclined to maintain a barbelled position across the Treasury curve, and also to stay short the February 2020 fed funds futures contract. The February 2020 contract is priced for three rate cuts over the next four FOMC meetings. One of those rate cuts will occur this month, but if the global manufacturing data recover, further cuts may not be needed. A short position in this contract continues to make sense. On the Treasury curve, our butterfly spread models continue to show that barbells look cheap relative to bullets (see Appendix B). Further, the 5-year and 7-year yields will rise the most when the market prices-in a more hawkish path for the policy rate. Investors should favor the long-end and short-end of the curve, while avoiding the belly (5-year and 7-year). TIPS: Overweight Chart 8Inflation Compensation TIPS underperformed the duration-equivalent nominal Treasury index by 174 basis points in August, dragging year-to-date excess returns down to -104 bps. The 10-year TIPS breakeven inflation rate fell 21 bps on the month and currently sits at 1.55% (Chart 8). The 5-year/5-year forward TIPS breakeven inflation rate also fell 21 bps in August. It currently sits at 1.74%. As we have noted in recent research, FOMC members are monitoring long-dated inflation expectations and are committed to keeping policy easy enough to “re-anchor” them at levels consistent with the Fed’s 2% target.6 Eventually, this will support a return of long-dated TIPS breakeven inflation rates (both 10-year and 5-year/5-year forward) to our 2.3% - 2.5% target range. However, for breakevens to move higher, investors also need to see evidence that inflation will be sustained near 2%. On that note, recent trends are encouraging. Through July, trimmed mean PCE is running at 2.22% on a trailing 6-month basis (annualized) and at 1.99% on a trailing 12-month basis (bottom panel). As a result, the 10-year TIPS breakeven inflation rate looks very low relative to the reading from our Adaptive Expectations model, a model based on several different measures of inflation (panel 4).7 Supportive Fed policy and rising inflation should support wider TIPS breakevens in the coming months, remain overweight.  ABS: Underweight Chart 9ABS Market Overview Asset-Backed Securities outperformed the duration-equivalent Treasury index by 15 basis points in August, bringing year-to-date excess returns up to +74 bps. The index option-adjusted spread for Aaa-rated ABS tightened 4 bps on the month. It currently sits at 28 bps, below its minimum pre-crisis level of 34 bps (Chart 9). ABS also appear unattractive on a risk/reward basis, as both Aaa-rated auto loans and credit cards have moved into the “Avoid” quadrant of our Excess Return Bond Map (see Appendix C). The Map uses each bond sector’s spread, duration and volatility to calculate the likelihood of earning or losing 100 bps of excess return versus Treasuries. At present, the Map shows that ABS offer poor expected return for their level of risk. In addition to poor valuation, the ABS sector’s credit fundamentals are shifting in a negative direction. Household interest payments continue to trend up, suggesting a higher delinquency rate in the future (panel 3). Meanwhile, senior loan officers continue to tighten lending standards for both credit cards and auto loans. Tighter lending standards usually coincide with rising delinquencies (bottom panel). All in all, the combination of poor value and deteriorating credit quality leads us to recommend an underweight allocation to consumer ABS. Non-Agency CMBS: Neutral Chart 10CMBS Market Overview Non-Agency Commercial Mortgage-Backed Securities underperformed the duration-equivalent Treasury index by 16 basis points in August, dragging year-to-date excess returns down to +218 bps. The index option-adjusted spread for non-agency Aaa-rated CMBS widened 6 bps on the month. It currently sits at 69 bps, below average pre-crisis levels but above levels seen in 2018 (Chart 10). The macro outlook for commercial real estate is somewhat unfavorable, with lenders tightening loan standards (panel 4) amidst falling demand (bottom panel). Commercial real estate prices have accelerated of late, but are still not keeping pace with CMBS spreads (panel 3). Despite the poor fundamental picture, our Excess Return Bond Map shows that CMBS offer a reasonably attractive risk/reward trade-off compared to other bond sectors (see Appendix C). Agency CMBS: Overweight Agency CMBS underperformed the duration-equivalent Treasury index by 31 basis points in August, dragging year-to-date excess returns down to +88 bps. The index option-adjusted spread widened 7 bps on the month and currently sits at 56 bps. The Excess Return Bond Map in Appendix C shows that Agency CMBS offer high potential return compared to other low-risk spread products. Appendix A - The Golden Rule Of Bond Investing We follow a two-step process to formulate recommendations for bond portfolio duration. First, we determine the change in the federal funds rate that is priced into the yield curve for the next 12 months. Second, we decide – based on our assessments of the economy and Fed policy – whether the change in the fed funds rate will exceed or fall short of what is priced into the curve. Most of the time, a correct answer to this question leads to the appropriate duration call. We call this framework the Golden Rule Of Bond Investing, and we demonstrated its effectiveness in the U.S. Bond Strategy Special Report, “The Golden Rule Of Bond Investing”, dated July 24, 2018, available at usbs.bcaresearch.com. Chart 11 illustrates the Golden Rule’s track record by showing that the Bloomberg Barclays Treasury Master Index tends to outperform cash when rate hikes fall short of 12-month expectations, and vice-versa. Chart 11The Golden Rule's Track Record At present, the market is priced for 98 basis points of cuts during the next 12 months. We anticipate fewer rate cuts over that time horizon, and therefore anticipate that below-benchmark portfolio duration positions will profit. We can also use our Golden Rule framework to make 12-month total return and excess return forecasts for the Bloomberg Barclays Treasury index under different scenarios for the fed funds rate. Excess returns are relative to the Bloomberg Barclays Cash index. To forecast total returns we first calculate the 12-month fed funds rate surprise in each scenario by comparing the assumed change in the fed funds rate to the current value of our 12-month discounter. This rate hike surprise is then mapped to an expected change in the Treasury index yield using a regression based on the historical relationship between those two variables. Finally, we apply the expected change in index yield to the current characteristics (yield, duration and convexity) of the Treasury index to estimate total returns on a 12-month horizon. The below tables present those results, along with 95% confidence intervals. Excess returns are calculated by subtracting assumed cash returns in each scenario from our total return projections. Appendix B - Butterfly Strategy Valuation The following tables present the current read-outs from our butterfly spread models. We use these models to identify opportunities to take duration-neutral positions across the Treasury curve. The following two Special Reports explain the models in more detail: U.S. Bond Strategy Special Report, “Bullets, Barbells And Butterflies”, dated July 25, 2017, available at usbs.bcaresearch.com U.S. Bond Strategy Special Report, “More Bullets, Barbells And Butterflies”, dated May 15, 2018, available at usbs.bcaresearch.com Table 4 shows the raw residuals from each model. A positive value indicates that the bullet is cheap relative to the duration-matched barbell. A negative value indicates that the barbell is cheap relative to the bullet. Table 4Butterfly Strategy Valuation: Raw Residuals In Basis Points (As of September 6, 2019) Table 5 scales the raw residuals in Table 4 by their historical means and standard deviations. This facilitates comparison between the different butterfly spreads. Table 5Butterfly Strategy Valuation: Standardized Residuals (As of September 6, 2019) Table 6 flips the models on their heads. It shows the change in the slope between the two barbell maturities that must be realized during the next six months to make returns between the bullet and barbell equal. For example, a reading of +49 bps in the 5 over 2/10 cell means that we would only expect the 5-year to outperform the 2/10 if the 2/10 slope steepens by more than 49 bps during the next six months. Otherwise, we would expect the 2/10 barbell to outperform the 5-year bullet. Table 6Discounted Slope Change During Next 6 Months (BPs) Appendix C - Excess Return Bond Map The Excess Return Bond Map is used to assess the relative risk/reward trade-off between different sectors of the U.S. fixed income market. The Map employs volatility-adjusted breakeven spread analysis to show how likely it is that a given sector will earn/lose money during the subsequent 12 months. The Map does not incorporate any macroeconomic view. The horizontal axis of the Map shows the number of days of average spread widening required for each sector to lose 100 bps versus a position in duration-matched Treasuries. Sectors plotting further to the left require more days of average spread widening and are therefore less likely to see losses. The vertical axis shows the number of days of average spread tightening required for each sector to earn 100 bps in excess of duration-matched Treasuries. Sectors plotting further toward the top require fewer days of spread tightening and are therefore more likely to earn 100 bps of excess return. Chart 12Excess Return Bond Map (As Of September 6, 2019)     Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Jeremie Peloso, Research Analyst jeremiep@bcaresearch.com Footnotes 1 https://www.cnbc.com/2019/09/06/watch-fed-chairman-jerome-powells-qa-in-zurich-live.html 2 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 3 For more details on how we arrive at our spread targets please see U.S. Bond Strategy Weekly Report, “The Value In Corporate Bonds”, dated February 19, 2019, available at usbs.bcaresearch.com 4 The nominal spread is simply the difference between MBS index yield and the duration-matched Treasury yield. No adjustment is made for prepayment risk. 5 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 6 Please see U.S. Bond Strategy Weekly Report, “A Message To The TIPS Market”, dated July 23, 2019, available at usbs.bcaresearch.com 7 For further details on our Adaptive Expectations Model please see U.S. Bond Strategy Weekly Report, “Adaptive Expectations In The TIPS Market”, dated November 20, 2018, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification Corporate Sector Relative Valuation And Recommended Allocation

Highlights Global bond yields have closely tracked the trajectory of global growth. While the global economy remains fragile, some positive signs are emerging: Our global leading economic indicator has moved off its lows; global financial conditions have eased significantly; U.S. household spending remains resilient; and China is set to further increase stimulus. Neither a severe escalation of the trade war nor a hard Brexit is likely. A simple comparison between current dividend yields and bond yields implies that global equities would need to fall by an outsized amount over the next decade for bonds to outperform stocks. As global growth stabilizes and then begins to recover over the coming months, bond yields will rebound from depressed levels. Investors should overweight stocks versus bonds for now, and look to upgrade EM and European equities later this year. Feature Global Growth Driving Bond Yields Chart 1Global Bond Yields: How Low Will They Go? Global bond yields rose sharply yesterday on word that U.S. and Chinese trade negotiators will meet in October. The announcement by China’s State Council of additional stimulus measures and better-than-expected data on the health of the U.S. service sector also drove the bond sell-off. The jump in yields follows a period of almost unrelenting declines. After hitting a high of 3.25% last October, the U.S. 10-year yield fell to 1.43% this Tuesday, just shy of its all-time low of 1.34% reached on July 5, 2016. The 30-year Treasury yield broke below 2% for the first time in history on August 15, falling to as low as 1.91% this week. It now stands at 2.07%. In Japan and across much of Europe, bond yields remain firmly in negative territory (Chart 1). The large movements in bond yields can be attributed to both the state of the global economy as well as to changes in how central banks are reacting to economic uncertainty. Just as stronger global growth pushed yields higher between mid-2016 and early-2018, the deceleration in growth since then has pulled yields lower. Chart 2 shows that there has been a close correlation between changes in the U.S. 10-year yield and the ISM manufacturing index. The release on Tuesday of a weaker-than-expected ISM manufacturing print for August was enough to push the 10-year yield down by seven basis points within a matter of minutes. Chart 2The Deceleration In Growth Has Pulled Yields Down The forward-looking new orders component of the ISM manufacturing index sunk to a seven-year low. The export orders component fell to the lowest level since 2009. Export volumes track ISM export orders quite closely (Chart 3). Not surprisingly, the ISM press release noted that trade remains “the most significant issue” for U.S. manufacturers. Chart 3Export Volumes Track The ISM Export Component The only redeeming feature in the report was that the customers’ inventories index dropped a notch from 45.7 in July to 44.9 in August. A reading below 50 for this subindex indicates that manufacturers believe that their customers are holding too few inventories, which is positive for future production. Global Manufacturing PMI Not Looking Much Brighter The Markit global manufacturing PMI remained below 50 for the fourth month in a row in August. While the global PMI did edge up slightly from July’s reading, this was largely due to a modest rebound in the Chinese PMI, which rose from 49.9 to 50.4. The improvement in the China Markit-Caixin PMI stands in contrast to the further deterioration observed in the “official” National Bureau of Statistics PMI. The former is more heavily geared towards private-sector exporting companies, and hence may have been influenced by the front-loading of exports ahead of the planned tariff increase on Chinese exports to the United States. Some Positive Signs Chart 4Global LEI Has Moved Off Its Lows In light of the disappointing manufacturing data, it is too early to call a bottom in the global industrial cycle. Nevertheless, there are some hopeful signs. Our Global Leading Economic Indicator (LEI) has moved off its lows (Chart 4). It usually leads the PMIs by a few months. Sterling will probably be the best performing currency in the G7 over the next five years. Despite ongoing weakness in the manufacturing sector, household spending has held up in most economies. In the U.S., the nonmanufacturing ISM index jumped to 56.4 in August from 53.7 in July. Real personal consumption is still on track to grow by 2.8% in Q3 according to the Atlanta Fed (Chart 5). The euro area services PMIs have also been resilient (Chart 6). In Germany, where the manufacturing PMI stood at 43.5 in August, the services PMI rose to 54.8.  Chart 5Inventories And Net Exports Have Subtracted From U.S. Growth In Q2 And Q3 Chart 6AThe Service Sector Has Softened Much Less Than Manufacturing (I) Chart 6BThe Service Sector Has Softened Much Less Than Manufacturing (II) Global financial conditions have eased significantly, mainly thanks to the steep decline in bond yields. The current level of financial conditions implies that global growth could rebound swiftly (Chart 7). The Chinese government is also likely to step up fiscal/credit stimulus over the coming months in an effort to shore up growth. In a boldly worded statement released on Wednesday, the Chinese State Council promised to further increase bond issuance to finance infrastructure projects, while cutting interest rates and reserve requirements. A stronger Chinese economy should benefit global growth (Chart 8). Chart 7Easier Financial Conditions Will Benefit Global Growth Chart 8Stronger Chinese Growth Should Benefit The Global Economy   The Trade War: Moving Towards A Détente? The announcement that the U.S. and China will resume trade negotiations on October 5th is a step in the right direction. As we noted last week, both parties have an incentive to de-escalate the trade conflict. President Trump wants to prop up the stock market and the economy in order to improve his re-election prospects. China also wants to bolster growth.1 Chart 9Would China Really Be Better Off Negotiating With A Democrat As President? As difficult as it has been for China to deal with Donald Trump, trying to secure a trade deal with him after he has been re-elected would be even more challenging. This would be especially the case if Trump thought that the Chinese had tried to sabotage his re-election bid. Even if Trump were to lose the election, it is not clear that China would end up with someone more palatable to deal with on trade matters. Does the Chinese government really want to negotiate over labor standards and human rights with President Warren, who betting markets now think has a better chance of becoming the Democratic nominee than Joe Biden (Chart 9)? While Republicans in Congress would be able to restrain a Democratic president on domestic issues, the president would still enjoy free rein over trade policy.   Brexit Uncertainty Adding To Investor Angst Two weeks before the Brexit vote on June 23, 2016, I wrote that “Just like my gut told me last August that Trump would do much better at the polls than almost anyone thought possible, I increasingly feel that come June 24th, the EU may find itself with one less member.”2 Chart 10Brexit Opposition Has Been Growing Soon after the shocking verdict, we argued that a hard Brexit would prove to be politically infeasible, meaning that the U.K. would either end up holding another referendum or be forced to negotiate some sort of customs union with the EU. Our view that a hard Brexit will not happen has not changed. Chart 10 shows that opposition to Brexit has only grown since that fateful day. Boris Johnson does not have enough votes in Westminster to force a hard Brexit. Another election would not change this outcome, given that it would almost certainly produce a hung parliament. In any case, it is not clear that Johnson actually wants a hard Brexit. The Times of London recently reported that the government’s own contingency plans for a hard Brexit, weirdly code-named “Operation Yellowhammer,” predicted a crippling logjam at British ports leading to shortages of fuel, food and medicine.3  Boris Johnson is all hat and no cattle. He will be forced to make a deal with the EU. Buy the pound on any dips. Sterling will probably be the best performing currency in the G7 over the next five years. Central Banks: Cut First, Ask Questions Later Chart 11Inflation Expectations Are Low Across The Globe Despite a few glimmers of good news, central banks are in no mood to take any chances. St. Louis Fed President James Bullard said it bluntly last week: “Our job is to get the yield curve uninverted.”4 If history is any guide, global growth will stabilize and begin to recover over the coming months. Inflation expectations are below target in most economies (Chart 11). Central banks know full well that if the current slowdown morphs into a full-blown recession, they will be out of monetary ammunition very quickly. In such a setting, it does not make sense to hold your punches. Much better to generate as much inflation as possible, and as soon as possible, so that real rates can be brought deeper into negative territory if economic circumstances later warrant it. What If The Medicine Works? The risk of easing monetary policy too much is that economies will eventually overheat, producing more inflation than is desirable. It is easy to forget that the aggregate unemployment rate in the G7 is now below its 2007 lows (Chart 12). True, inflation has yet to take off, but this may simply be because inflation is a lagging indicator (Chart 13). Chart 12Unemployment Rates Keep Trending Lower Chart 13Inflation Is A Lagging Indicator For all the talk about how the Phillips curve is dead, the empirical evidence suggests it is very much alive and well (Chart 14). Ironically, this means that lower interest rates today could set the stage for much higher rates in the future if hyperstimulative monetary policies ultimately generate a bout of inflation.  Chart 14The Phillips Curve Is Alive And Well Chart 15The Dollar Is A Countercyclical Currency   Investment Conclusions Like most economic forecasters, central banks tend to extrapolate recent trends too far into the future. Global growth has been weakening since early 2018 so it seems reasonable to assume that this trend will persist into next year. However, as we have documented, global industrial cycles tend to last about three years – 18 months of rising growth followed by 18 months of falling growth.5 If history is any guide, global growth will stabilize and begin to recover over the coming months. Should that occur, we will enter an environment where the lagged effects of easier monetary policy are hitting the economy just when the manufacturing cycle is taking a turn for the better. Stocks are likely to fare well in such a setting, while long-term bond yields will move higher. As a countercyclical currency, the dollar will also start to weaken anew (Chart 15). Granted, an intensification of the trade war or some other major adverse shock would upset this rosy forecast. Nevertheless, current market pricing offers a fairly large cushion against downside risks. Thanks to the drop in bond yields, the equity risk premium is quite high globally (Chart 16). Even if one were to assume that nominal dividend payments remain unchanged for the next ten years, the S&P 500 would still need to fall by more than 20% in real terms over the next decade for bonds to outperform stocks (Chart 17). Euro area stocks would need to drop by more than 42%. U.K. stocks would need to plummet by at least 60%! Chart 16AEquity Risk Premia Remain Quite High (I) Chart 16BEquity Risk Premia Remain Quite High (II) Chart 17AStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (I) Chart 17BStocks Need To Fall By A Considerable Amount For Bonds To Outperform Over A 10-Year Horizon (II) Investors should remain overweight stocks versus bonds over the next 12 months. We intend to upgrade EM and European equities once we see a bit more evidence that global growth has troughed.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1Please see Global Investment Strategy Weekly Report, “A Psychological Recession?” dated August 30, 2019. 2Please see Global Investment Strategy Weekly Report, “Worry About Brexit, Not Payrolls,” dated June 10, 2016. 3Rosamund Urwin and Caroline Wheeler, “Operation Chaos: Whitehall’s Secret No-Deal Brexit Preparations Leaked,” The Times, August 18, 2019. 4“Fed’s Bullard Sees ‘Robust Debate’ Over Half-Point Cut,” Bloomberg, August 23, 2019. 5Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Strategic Recommendations Closed Trades

Feature In investment, there are times when your view and your strategy should not be the same. Our view remains that the global economy is likely to avoid recession over the next 18 months, that the Fed will cut rates once or twice more as an “insurance” but not enter a full easing cycle, that global bond yields will rise, and that risk assets will outperform over the next 12 months. But the risks to that view have increased, and so we want to bolster the hedge against our view being wrong. We don’t see Recommended Allocation Chart 1GAA Portfolio Volatility Relative To Benchmark government bonds as an attractive hedge at this level of yield, and so are moving to a “barbell” strategy, with overweights in equities and cash, and an underweight in fixed income. This lowers the volatility of our recommended portfolio to close to that of the benchmark (Chart 1). First, the good news. Although the manufacturing sector globally continues to deteriorate, with many PMIs falling to below 50, services and consumption remain robust almost everywhere (Chart 2). With central banks easing monetary policy, and in some countries (Italy, the U.S., the U.K., maybe even Germany) governments loosening fiscal policy, financial conditions are improving, which will eventually support growth (Chart 3). Intra-cyclical manufacturing downturns typically last around 18 months, and this one is close to its sell-by date (Chart 4). Chart 2Manufacturing Weak, Services Fine So what has changed? First, manufacturing has continued to decline for longer than we expected. In the early summer, there were signs of a bottoming in Europe, but these are no longer evident. The diffusion index of the global manufacturing PMI (i.e. the percentage of countries with a rising versus falling PMI), which typically leads the PMI by six months, suggests the PMI has further to fall (Chart 5). Chart 3Easing Financial Conditions Will Help Chart 4Close To The Bottom?   Chart 5Further Downside For PMIs? Chart 6China's Reluctant Monetary Stimulus   The most likely cause of this is that China has been more reluctant to ramp up monetary stimulus than we expected. It has eased fiscal policy, but monetary policy has been tentative: despite a moderate increase in credit creation this year, M3 money supply growth has barely accelerated (Chart 6). This has been enough to stabilize Chinese growth, but has been insufficient to give the sort of boost to global growth that China provided in 2016. There are two reasons for China’s reluctance to stimulate. The authorities seemingly continue to prioritize debt deleveraging and clamping down on shadow banking. And, also, maybe they do not want to give a boost to the global economy that would help the U.S. avoid recession and increase the probability of President Trump’s being reelected. China has been more reluctant to ramp up monetary stimulus than we expected. The Trade War is an increasing risk. BCA’s geopolitical strategists continue to assign a 40% probability to a resolution by year-end,1 but it is becoming harder to see how (or, indeed, why) President Xi would offer concessions to the U.S. that would lead to a deal. Ultimately, if Chinese growth slows significantly and U.S. stocks fall sharply, China will boost monetary stimulus and President Trump will push for even a superficial trade agreement. But things will need to get worse first. Meanwhile, the rise in global political uncertainty – and the mercurial nature of Trump’s foreign and trade policies – are a risk for markets (Chart 7). Chart 7Global Political Risks Rising Chart 8Consumers (Mostly) Remain Confident   We are also concerned about how long consumption can remain robust in this environment. So far, consumer confidence has remained resilient in the U.S., though it has dipped a little in Europe and Japan (Chart 8). But, if corporate profits remain weak, companies will start to delay hiring decisions and begin to lay off workers. This would be the transmission mechanism for the manufacturing slowdown to spread into the broader economy. So far, fortunately, there are few signs it is happening: German unemployment is at a record low, and U.S. initial claims continue to run at or below last year’s level (Chart 9). Chart 9No Signs Of Weakening Labor Market Table 1GAA Recession Checklist     In the recession checklist we have published for the past two or more years, we are starting to have to tick off more warning signs (Table 1 and Chart 10). Chart 10Some Worrying Signs Chart 11Risk Of Recession No Longer Negligible   For example, the yield curve has inverted both for the 3-month/10 year and 2-year/10-year. Although the yield curve has been an almost infallible predictor of recession in the past 70 years, there are some reasons to argue that it may not be as good this time: for example, central bank purchases have artificially pulled down long-term rates. But inversion is probably a self-fulfilling prophesy. For example, in a recent Fed Senior Bank Loan Officers Survey, 40% of banks said they would tighten credit standards simply because of a moderate inversion of the yield curve. Formal models of recession 12 months ahead that incorporate the yield curve slope, put recession risk now at about 25% (Chart 11).   Chart 1218 Months Of Ups And Downs Given all this, we think it is appropriate to take some risk off. As far back as February 2018, we argued that “investors primarily concerned with capital preservation might look to dial down risk or hedge exposure now”.2 Given the ups and down of markets in the past 18 months, we suspect that those risk-averse investors would not have been unhappy with that advice (Chart 12), although they would also have missed some nice equity rallies over that time, if they had been nimble enough to time entry and exit points. Since a majority of the subscribers to this service are rather conservative, we are now extending that advice to all clients. On a 12-month time horizon, we raise cash to overweight. We are also reducing somewhat both our equity overweight and bond underweight. In this period of increased uncertainty, a portfolio closer than usual to benchmark makes sense. (BCA’s House View is a little more bullish, remaining neutral on cash and overweight equities on the 12-month horizon). Fixed Income: Absent recession, we see little room for rates to fall further. The U.S. 10-year Treasury yield (now 1.5%) should stay above its July 2016 historic low of 1.37%. The Fed is unlikely to cut rates by 100 basis points over the next 12 months, as futures imply. We would expect only two 25 bp rate cuts: in September and either October or December. Yields are likely eventually to move up over the next 12 months (particularly given that inflation continues to trend higher). But they may not move much for a while, and so we move from underweight to neutral on duration for now. Eventually, we see investors understanding that government bonds are no longer an attractive hedge at current yields. Even if German 10-year yields fell to -1.2% (probably around the lowest possible), one-year total return would only be 5% (Table 2). The U.S. looks a little better, though. One could imagine the yield falling to zero in the next recession, which would give a return of 16%. On credit, we remain neutral: it represents a low-beta play on equities. So far this year, both investment-grade and high-yield bonds have eked out a small positive excess return (Chart 13). Table 2Not Much Room For Positive Returns Chart 13Credit Returns Have Not Been Bad Chart 14Downside For Cyclicals?   Equities: To offset our overweight on equities, we continue with a low-beta country/regional tilt. We recommend an overweight on the U.S., and underweight on Emerging Markets. The key for upside to U.S. equities remains earnings. Analysts have a pessimistic forecast of only 2.5% EPS growth in 2019 for the S&P500. A rough proxy for earnings growth (nominal GDP growth of 4.5%, wage growth of 3.5% leading to some margin expansion, 2% buybacks) points to EPS growth of around 7-8%. Q3 earnings (where analysts forecast -2% year-on-year) are likely to surprise on the upside, as did Q1 and Q2, though the strong dollar and weak overseas growth are risks. In our next Quarterly, to be published on October 1, we may make some adjustments to further dial down risk, for example in our equity sector recommendations, which currently have a slight cyclical tilt. The relative performance of cyclicals has started to wobble, and the message from bond markets is that cyclicals have further to fall in relative terms (Chart 14). Investors will come to understand that government bonds are no longer an attractive hedge at current yields. Currencies: The trade-weighted dollar has broadly moved sideways in the past year (Chart 15), weakening against the yen, but strengthening against the euro and EM currencies. We remain neutral on the dollar. It will continue to be pulled by two opposing forces: weak global growth is a positive, but the Fed has more room to cut rates than the rest of the world and so interest rate differentials will shift against the dollar. The renminbi is likely to continue to weaken, as the Chinese use currency policy as the least painful offset against U.S. tariffs. The latest  set of tariffs suggests that the CNY needs to fall to around 7.5-7.6 to the USD to offset their impact but, if Trump implements all the tariffs he has threatened, it could fall as far as 8.0 (Chart 16). This would pull other EM currencies down further. GBP will continue to be buffeted by Brexit scenarios. A no-deal Brexit could bring it down to 1.00 against the USD, whereas Remain or a very soft Brexit would take it back to PPP, 1.43. The current level is a probability weighted average of the two. Chart 15Dollar Has Moved Broadly Sideways Chart 16CNY Could Fall Much Further     Commodities: The oil price has been hurt by a slowing of demand in developed economies (Chart 17). Supply, however, remains tight, and our energy strategists have cut their forecast for Brent this year only modestly to an average of $66 a barrel (from an earlier forecast of $70, and from a current spot price of $60).3 Industrial commodities continue to struggle because of China’s slowdown (Chart 18) and are unlikely to recover until China’s stimulus is beefed up. Gold remains a good insurance for investors worried about geopolitical risk, recession, and inflation.   Chart 17EM Oil Demand Has Been Weak   Chart 18Industrial Commodities Hurt By China       Garry Evans, Senior Vice President Chief Global Asset Allocation Strategist garry@bcaresearch.com 1      Please see Geopolitical Strategy Weekly, “Big Trouble In Greater China,” dated August 23, 2019, available at gps.bcareseach.com 2      Please see Global Asset Allocation, “GAA Monthly Portfolio Update,” dated February 1, 2018, available at gaa.bcaresearch.com. 3      Please see Commodity & Energy Strategy, “USD Strength Slows Oil Demand Growth; 2020 Brent Forecast Remains At $75/bbl,” dated August 22, 2019, available at ces.bcaresearch.com Recommended Asset Allocation  

Bank Credit Analyst

Highlights The U.S.-Sino trade war is taking a dangerous turn, but the U.S. should avoid a recession until 2022. Global growth will bottom in early 2020. The Fed is set to cut rates two to three times in the next year. Safe-haven bonds have more tactical upside, but will perform poorly on a cyclical basis. Long-term investors should use the next six to nine months to offload their corporate bonds. Equities will be volatile for the rest of 2019; a breakout is forecast for 2020. Long-term investors should favor stocks over bonds, and international stocks over U.S. ones. Feature The yield curve has become the punch line of late-night shows, triggered by the 2-/10-year yield curve inversion in early August. Recession fears have hit the front page. There are good reasons for the mounting concern. Historically, yield curve inversions have done an excellent job forecasting recession. The trade war between the U.S. and China is intensifying at an alarming speed. Moreover, global government bond yields are dipping to all-time lows. Additionally, the global ZEW and PMIs are depressed, while the global production of capital goods and machinery is contracting (Chart I-1). Despite this backdrop, the odds of a U.S. recession are overstated. Consumers in the U.S. and other advanced economies are healthy, the U.S. Federal Reserve and other major central banks are easing, and global financial conditions are supporting growth. We expect stocks to break out of their volatile period of consolidation early next year. Bond yields should rise later this year, but it is too early to stand in front of their downward trend. Finally, long-term investors should use any additional narrowing in credit spreads to lighten their exposure to corporates. U.S. Recession Odds Are Low The yield curve signal is not as dire as the headlines suggest. The inversion is incomplete; the curve is inverted up to the five-year mark and beyond that point, it steepens again. If the yield curve foreshadows a recession, then its slope would be negative across all maturities (Chart I-2). Chart I-1The List Of Worries Is Long   The consumer sector is doing well despite the global growth slowdown. Real retail sales, excluding motor vehicles, are growing at 4.4% and have quickly recovered from this past winter’s government shutdown. Meanwhile, retailers such as Walmart, Target, Home Depot and Lowe’s are reporting strong numbers. Three factors insulate consumer spending from global woes. First, household disposable income is expanding at a healthy 4.7% pace, courtesy of a tight labor market. Secondly, household balance sheets are robust. Household debt-servicing costs only represent 9.9% of disposable income, the lowest reading in more than four decades (Chart I-3, first panel). According to a December BIS paper, debt-servicing costs are one of the best forecasters of recessions.1 Additionally, household debt relative to GDP and to household assets is at 16- and 34-year lows, respectively (Chart I-3, second and third panel). Thirdly, the U.S. savings rate, which stands at 8.1%, already offers a cushion against adverse shocks and has limited upside. The corporate sector also displays some easily overlooked positives. So far, the PMIs and capex growth are still in mid-cycle slowdown territory. Meanwhile, debt loads have never provided an accurate recessionary signal. Since the end of the gold standard, recessions have always materialized after debt-servicing costs as a share of EBITDA rose two to four percentage points above their five-year moving average. We are nowhere near there (Chart I-4). Chart I-3Consumer Balance Sheets Are Very Robust Chart I-4Corporate Debt Is Not In Recessionary Territory   Nevertheless, we will remain vigilant on the capex trend. Corporate investment may not indicate a recession, but the escalating trade war with China will hurt capex intentions. Even if capex contracts, as in 2016, the economy can still avoid a recession. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. Housing is showing some positive signs after subtracting from GDP in the past six quarters. The NAHB Housing Market Index is recovering smartly from its plunge last year and homebuilder stocks have been outperforming the S&P 500 since October 2018 (Chart I-5). Meanwhile, the 139-basis point collapse in mortgage rates since November 2018 is finally impacting the economy. Mortgage demand is surging, according to the Fed’s Senior Loan Officers Survey. The MBA mortgage applications data corroborate this observation. As a result, both existing home sales and residential investment are trying to bottom (Chart I-6). Chart I-5Leading Indicators Of Residential Activity Are Improving Chart I-6Positive Signs For Residential Activity     The liquidity of the U.S. private sector is also strengthening. Deposit growth has reaccelerated after falling to near recessionary levels (Chart I-7) and the non-financial, private sector’s cash holdings are again increasing faster than debt. Furthermore, bank credit is expanding. Chart I-7The Private Sector Is Accumulating Liquidity Waiting For The Global Economy To Bottom Global growth should bottom by early 2020. Thus, while the U.S. economy should avoid a recession, any distinct re-acceleration will wait until next year. The factors that prompted slowdowns in global trade and manufacturing provide a mixed message. The trade war between the U.S. and China is intensifying. Chinese activity has not yet bottomed but policymakers will be increasingly forced to react. However, the global inventory down cycle is advanced, and in Europe, domestic activity indicators are holding up despite the continued deterioration in external and industrial conditions. Trade War The uncertainty created by the Sino-U.S. trade war is hurting global growth. On August 1, U.S. President Donald Trump announced a 10% tariff on the remaining $300 billion of Chinese exports to the U.S. The tariffs are phased in: $112 billions of goods will be taxed on September 1 while $160 billion will be hit on December 15. Unsurprisingly, a vicious circle of retaliation has been unleashed as China imposed a tariff ranging from 5% to 10% on U.S. goods last Friday, to which Trump immediately responded with a tariff hike from 25% to 30% on the $250 billion batch of goods and from 10% to 15% on the $300 billion batch slated to come into place September 1 and December 1. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. A resumption in talks between Beijing and Washington in September will offer little solace to investors. Even if President Trump is pressured by the stock market and the U.S. electoral calendar to settle for what Beijing is offering, it is not clear that President Xi Jinping will accept a deal. As BCA’s Chief Geopolitical Strategist Matt Gertken discusses in Section II, the two superpowers are locked in a multi-decade geopolitical rivalry and the Hong Kong protests and tensions over Taiwan could move the talks off track. China’s Challenges China’s economy has yet to bottom convincingly. So far, Chinese reflation has been weaker than anticipated. Given that stimulus has not been forceful, the uncertainty produced by the trade war and the illiquidity created by bloated balance sheets is still dragging down China’s marginal propensity to consume (Chart I-8). However, this propensity to spend has little downside, if the past 10 years are any indication. Chinese infrastructure and equipment investment needs to be revived. They are shouldering the bulk of the decline in economic activity and have slowed to an annual pace of 2.8% and -2.1%, respectively. Residential investment is expanding at a 9.4% annual rate (Chart I-9), but according to Arthur Budaghyan, BCA’s Chief Emerging Markets Strategist, even this sector’s strength could be an illusion. Chinese property developers are starting projects to raise funds via pre-sales. However, they are not completing nearly as many projects as they have started.2 Chart I-8A Falling Marginal Propensity To Spend Means More Stimulus Is Needed   We are not yet ready to give up on Chinese stimulus as the economy is on the verge of a deflationary spiral that could push debt-to-GDP abruptly higher. The following developments support this view: The statement following the July Politburo meeting showed a greater willingness to stimulate economic activity, as long as it does not add to the property bubble. Producer prices are again deflating. Contracting PPIs often unleash vicious circles as they push real rates higher and hurt investment, which foments additional price declines. Retail sales are slowing and the employment components of the manufacturing and non-manufacturing PMIs have fallen to 47.1 and 48.7, respectively. China’s economy needs to be insulated from the intensifying trade war with the U.S. or the deteriorating labor market will dampen consumer spending even more. We expect more tax cuts, more credit growth, and more issuance of local government special bonds to finance government spending, following China’s 70th anniversary celebrations on October 1. As Chart I-10 illustrates, an acceleration in total social financing will ultimately lift EM PMIs as well as Asian and European exports. Inventory Cycle The inventory cycle is very advanced. Inventories in the U.S., China and euro area are depleting (Chart I-11). Inventories cannot fall forever, especially when global monetary policy is increasingly accommodative and fiscal policy is loosened. Chart I-10More Chinese Stimulus Will Eventually Support Global Growth Chart I-11The Inventory Purge Is Advanced   Global activity can rebound if the inventory adjustment ends. Inventory fluctuations help drive the Kitchin cycle, a 36-40 month oscillation in activity. According to BCA’s Chief Global Strategist, Peter Berezin, the current slowdown is nearing 18 months, the typical length of a down oscillation in these cycles (Chart I-12).3 Europe     The manufacturing-heavy euro area will benefit when the global industrial cycle bottoms, but domestic tailwinds are also emerging. European deposits accumulation is quickening, driven by households (Chart I-13, top panel). Meanwhile, the European credit impulse has recovered thanks to the fall in both non-performing loans and borrowing costs (Chart I-13, bottom panel). Moreover, consumer spending is healthy as household balance sheets are improving and wage growth is accelerating to a 3.2% annual pace. Finally, last month we highlighted that the euro area fiscal thrust is set to increase by 0.7% of GDP this year.4 Fiscal easing appears set to expand as Germany and Italy study support packages. Finally, the Italian political uncertainty is receding as the Five Star Movement and the Democratic Party have agreed to form a coalition government. Chart I-12The Three-Year Cycle Is Also Advanced Chart I-13Some Ignored Improvements In Europe   At the moment, the biggest risk for Europe is the significant probability of a No-Deal Brexit. After the recent decision to prorogue Parliament, Matt Gertken raised his probability of a No-Deal Brexit to one third from 20%.Such an event would negatively impact Dutch, German and French exports, which could scuttle any improvement in Europe. Adding It Up The combined effects of more Chinese stimulus in the fourth quarter, an impending end to the global inventory drawdown, and an endogenous improvement in Europe, all should ultimately outweigh the negatives created by the U.S.-Sino trade war. Moreover, global financial conditions are easing (Chart I-14). Therefore, the fall in global bond yields should push the G-10 12-month credit impulse higher (Chart I-14, bottom panel). Lower oil prices should also help G-10 consumers. Early indicators support this assessment. BCA’s Global Leading Economic Indicator has been slowly bottoming, and according to its diffusion index, it will soon move higher (Chart I-15, top panel). Moreover, Singapore’s container throughput is tentatively stabilizing, while our Asian EM Diffusion Index is improving, albeit from depressed levels (Chart I-15, second panel). Finally, ethylene and propylene prices are rallying with accelerating momentum (Chart I-15, third and fourth panels). Chart I-14Easier Financial Conditions Favor Credit Growth Chart I-15Some Growth Indicators Are Stabilizing   Bottom Line: The U.S. economy will probably slow further in the coming months, but it will not enter into recession anytime soon. Neither debt nor consumers pose problems, the housing sector is turning the corner and the private sector’s liquidity position is strengthening. Meanwhile, global activity is trying to bottom, but any improvement will be delayed by the latest round of trade tensions. However, global policymakers are responding, thus global growth should improve by early 2020. Fed Policy: More Cuts Expected Chart I-16A Liquidity Crunch In The Interbank Market? Our base case is that the Fed will cut rates twice more in the coming nine months. In the tails of the probability distribution, three supplementary cuts are more likely than only one additional cut. Paradoxically, liquidity considerations support our Fed view. A recurring theme in our research is the improvement in global liquidity indicators such as excess money, deposit growth and our financial liquidity index.5 However, these indicators are not able to boost growth because of an important technical consideration. What might be classified as excess reserves by the Fed may not be free reserves. Higher Supplementary Leverage Ratios under Basel III rules require commercial banks to hold greater levels of excess reserves to meet their mandatory Tier 1 capital ratios. Since the Fed’s balance sheet runoff results in falling excess reserves, the decline in reserves may have already created some illiquidity in the interbank system. Global central banks have been divesting from the T-bill market, which is worsening the decline in excess reserves. They have parked their short-term funds at the New York Fed’s Foreign Repurchase Agreement Pool (Foreign Repo Pool) which limits the availability of reserves in the banking system (Chart I-16).6 These dynamics increase the cost of hedging the dollar for foreign buyers of U.S. assets. When reserves fall below thresholds implied by Basel III regulations, global banks lose their ability to use their balance sheets to conduct capital market transactions. Without this necessary wiggle room, they cannot arbitrage away wider cross-currency basis swap spreads and deviations of FX forward prices from covered interest rate parity. For foreign investors, the cost of hedging their FX exposure increases. Together with the flatness of the U.S. yield curve, hedged U.S. Treasurys currently yield less than German Bunds or JGBs (Table I-1). Chart I-17Declining Excess Reserves Hurt Risk Assets And Growth Lower excess reserves and higher hedging costs have been bullish for the USD and negative for the global economy. Instead of buying hedged Treasurys, foreigners purchase U.S. assets unhedged (agency and corporate bonds, not Treasurys). Thus, falling excess reserves have been correlated with a stronger dollar, softer global growth and weaker EM asset and FX prices (Chart I-17). This adverse environment has accentuated the downside in Treasury yields and flattened the yield curve (Chart I-17, bottom panel). Going forward, these problems should intensify. The Treasury will issue over US$800 billion of debt by year-end to replenish its cash balance and finance the bulging U.S. budget deficit. Primary dealers will continue to plug the void left by foreigners and will purchase the expanding issuance (Chart I-18). In the past year, primary dealers have already increased their repo-market borrowing by $300 billion to finance their inventories of securities. They will need to expand these borrowings, which will further lift the cost of hedging U.S. assets. Thus, foreign investors faced with $16 trillion of assets with negative yields will buy more U.S. assets on an unhedged basis. The dollar will rise and global growth conditions will deteriorate. The Fed will have to cut rates two to three more times, otherwise the dangerous feedback loop described above will take hold. These cuts are more than domestic economic conditions warrant. To bring back hedged foreign buying of Treasurys, the Fed will have to engineer a steeper yield curve and lower FX hedging costs. The end of the balance sheet runoff is a step in the right direction, but it will not be enough. The BCA Financial Stress Index and our Fed Monitor are consistent with this view (Chart I-19). Moreover, the intensifying trade war is hurting the outlook for growth, inflation expectations and the stock market. Chart I-18A Large Inventory Build Up By Primary Dealers Chart I-19Two To Three More Cuts Are Coming   Investment Implications Government Bonds We have revised our position on an imminent end to the bull market. We do expect bond yields to be higher in 12 months, but for now the global economy has too many risks to time a bottom in yields. The cyclical picture for bonds is bearish. Treasurys have outperformed cash by 8% in the past year, a performance normally associated with a fed fund rate that is 200 to 300 basis points below what markets anticipated 12 months ago (Chart I-20). In order for Treasurys to continue outperforming cash, the Fed must cut rates to zero next year. Nonetheless, a U.S. recession is not in the offing and the global economy should perk up by early 2020. At most, the Fed will validate current rate expectations of 96 basis points of cuts. Chart I-20The Fed Must Cut To Zero For Bonds To Further Outperform Cash Next Year Valuations are also consistent with Treasurys delivering negative returns in the next 12 months. According to the BCA Bond Valuation Index, Treasurys are extremely overvalued. Moreover, real 10-year yields are two standard deviations below the three-year moving average of real GDP growth, a proxy for potential GDP (Chart I-21). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. Technicals also point to poor 12-month prospective returns. The 13-week and 52-week rates of change in yields are consistent with tops in bond prices (Chart I-22). Positioning is also very stretched, as highlighted by the J.P. Morgan Duration Survey, the Bank of America Merrill Lynch Investors Survey, ETF flows, and government bonds futures and options holdings of asset managers. As a result, our Composite Technical Indicator is very overbought (Chart I-22, bottom panel). Chart I-21U.S. Bonds Are Very Expensive ... Chart I-22... And Very Overbought   The quickening pace of accumulation of securities on bank balance sheets also points to higher yields in 12 months (Chart I-23). As banks stockpile liquid assets, they accumulate more juice to fuel future lending. However, the rising cost of hedging FX exposure is bullish for the dollar. Hence, increasing Treasury holdings will not lift yields until the Fed cuts rates more aggressively. We are reluctant to recommend shorting / underweighting bonds. As Chart I-24 illustrates, mounting uncertainty over economic policy anchors U.S. yields. Last week’s round of tariff increases, along with the Brexit saga, suggests that the uncertainty has not yet peaked. Chart I-23A Coiled Spring Chart I-24Uncertainty Is Keeping Global Bonds Expensive   The collapse in German yields is also not finished. The fall in bund yields to -0.7% has dragged down rates worldwide as investors seek positive long-term returns. In response, the U.S. 10-year premium dropped to -1.1%. Historically, bunds end their rally when yields decline 120 basis points below their two-year moving average (Chart I-25). If history is a guide, German yields could bottom toward -1%, which is in line with Swiss 10-year yields. The 1995 experience also argues against an imminent end to the bond rally. In a recent Special Report, BCA’s U.S. Equity Strategy service highlighted the parallels between today’s environment and the aftermath of the December 1994 Tequila Crisis.7 In that episode, global growth troughed and the Fed cut rates three times before the U.S. ISM Manufacturing Index bottomed in January 1996. Only then did Treasury yields turn higher (Chart I-26). A similar scenario could easily unfold. Chart I-25More Downside For German Yields Chart I-26Bottom In Yields: Wait For The ISM To Turn And The Fed To Cut More   EM assets are vulnerable and could spark a last stampede into U.S. Treasurys. Investors of EM fixed-income products have not yet capitulated. EM assets perform poorly when global growth is weak, dollar funding is hard to come by and trade uncertainty is rising. Yet, yields on EM local-currency bonds have fallen, indicating little selling pressure. Rather than dispose of their EM holdings, investors have hedged their EM exposure by selling EM currencies. Therefore, EM bonds are rallying with EM currencies falling (Chart I-27), which is a rare occurrence. Recent cracks in EM high-yield bonds and the breakdown in EM currencies suggest investors will not ignore the trade war for much longer. The ensuing flight to safety should pull down Treasury yields. Chart I-27A Rare Occurrence BCA’s Cyclical Bond Indicator has yet to flash a buy signal, which will only happen when the indicator moves above its 9-month moving average (Chart I-28). Investors should wait to sell bonds until the Fed cuts rates by another 50 basis points, global and U.S. PMIs stabilize, and our cyclical indicator sends a sell signal. As a corollary, we remain positive on gold prices and expect the yellow metal to move to $1,600 in the coming months. Chart I-28BCA Cyclical Bond Indicator: Don't Sell Yet Corporate Bonds Chart I-29Corporate Bond Fundamentals Are Worsening The long-term outlook for corporate bonds is deteriorating enough that long-term investors should use any rally to lighten their exposures. However, on a six- to nine-month horizon, stresses will probably remain contained. A significant deterioration in corporate health will hurt this asset class’s long-term returns. Recent data revisions pushed GDP and productivity well below previous estimates. This curtailed corporate profitability, lifted debt-to-cash flow ratios, and hurt interest coverage measures. BCA’s Corporate Health Monitor is flashing its worst reading since the financial crisis. Moreover, the return on capital is at its lowest level in this cycle. Historically, these developments have pointed to higher default rates and spreads (Chart I-29). Worryingly, average interest coverage and profitability levels are distorted. Tech firms only account for 8% of the U.S. corporate bond universe, yet they represent 19% of cash flows generated by the U.S. corporate sector. Outside the tech sector, cash generation is poorer than suggested by our Corporate Health Monitor. This will amplify losses when the default cycle begins. The poor quality of bond issuance in the past 8 years will also hurt recovery rates when defaults rise. Since then, junk bonds constitute 10% of overall issuance, and BBB-rated bonds represent 42% of investment-grade issues. Historical averages are 9% and 27%, respectively. Additionally, covenants have been particularly light in the same period. Investors with horizons of one year or less still have a window to own corporate bonds. Moreover, since the deviation of corporate debt-servicing costs as a percentage of EBITDA remains well below historical trigger points, an imminent and durable jump in spreads is unlikely. Within the corporate universe, BCA’s U.S. Bond Strategy service currently favors high-yield to investment-grade bonds.8 Breakeven spreads in the junk space are much more rewarding than those offered by investment-grade issues (Chart I-30). Equities We expect the S&P 500 to remain volatile and below 3,000 for the rest of 2019. Early next year, an upside breakout will end this period of churn. The S&P will probably soon test the 2,700 level. Technically, the selling is not exhausted. The number of stocks above their 40-, 30- and 10-week moving averages have formed successively lower highs and are not yet oversold (Chart I-31). Furthermore, the Fed is unlikely to deliver a dovish surprise in September. Fed Chairman Jerome Powell’s recent speech at Jackson Hole suggests that the Fed needs to see more pain before moving ahead of the curve. Chart I-30Short-Term Investors Should Favor Junk Over Investment Grade Issues Chart I-31This Correction Can Run Further   Once stocks stabilize, the subsequent rebound will not lead to an immediate breakout this year. Yields will move up when growth picks up or if President Trump becomes less combative on trade. However, falling interest rates have been a crucial support for stock prices in 2019. As the 1995-1996 experience shows, when the ISM turned up, the S&P 500 did not gain much traction. Higher yields pushed down multiples even as earnings estimates strengthened. We are more positive on the outlook for stocks next year with BCA’s Monetary Indicator pointing to higher stock prices (see Section III). Moreover, bear markets materialize only when a recession is roughly six to nine months away (Chart I-32). The S&P still has time to rally because we do not anticipate a recession until early 2022. Chart I-32No Recession, No Bear Market Chart I-33Better Prospects For Non-U.S. Stocks Cyclical investors should move their equity holdings outside the U.S. International markets are comparatively cheap (Chart I-33, top panel). Moreover, a rebound in global growth early next year is congruent with U.S. underperformance. Finally, our earnings models forecast an end to the deterioration of European profit growth in September 2019, but not yet in the U.S. (Chart I-33, bottom two panels). Stocks should outperform bonds on a long-term basis. According to the BCA Valuation Index, U.S. stocks are extremely expensive (see Section III). Our valuation indicator would be as elevated as in 2000 if interest rates were not so depressed today. As Peter Berezin showed in BCA’s Global Investment Strategy service, based on current valuation levels, investors can expect 10-year returns of 3.0%, 4.5%, 11.9% and 7.4% for the U.S., euro area, Japan and EM equities, respectively.9 This is not appealing. Nonetheless, long-term equity expected returns are superior to bonds. If held to maturity, they will return 1.5%, -0.7%, and -0.3% annually in the U.S., Germany and Japan, respectively. Practically, long-term investors should favor the rest of the world over the U.S. Local-currency expected returns are higher outside the U.S., and the dollar will decline during the next 10 years. As our Foreign Exchange Strategy service recently highlighted, the dollar is very expensive on a long-term basis.10 Exchange rates strongly revert to their purchasing-parity equilibria in such investment horizons. The growing U.S. twin deficit and the strong desire of reserve managers to diversify out of the greenback will only exacerbate the dollar’s decline. Mathieu Savary Vice President The Bank Credit Analyst August 29, 2019 Next Report: September 26, 2019   II. Big Trouble In Greater China The chance of a U.S.-China trade agreement by November 2020 is still only 40% – but an upgrade may be around the corner. Trump is on the verge of a tactical trade retreat due to fears of economic slowdown and a loss in 2020. Xi Jinping is now the known unknown. His aggressive foreign policy is a major risk even if Trump softens. Political divisions in Greater China – Hong Kong unrest and Taiwan elections – could harm the trade talks. Maintain tactical caution but remain cyclically overweight global equities.   “I am the chosen one. Somebody had to do it. So I’m taking on China. I’m taking on China on trade. And you know what, we’re winning.” – U.S. President Donald J. Trump, August 21, 2019 On August 1, United States President Donald Trump declared that he would raise a new tariff of 10% on the remaining $300 billion worth of imports from China not already subject to his administration’s sweeping 25% tariff. Then, on August 13, with the S&P 500 index down a mere 2.4%, Trump announced that he would partially delay the tariff, separating it into two tranches that will take effect on September 1 and December 15 (Chart II-1). Chart II-1Trump's Latest Tariff Salvo Six days later Trump’s Commerce Department renewed the 90-day temporary general license for U.S. companies to do business with embattled Chinese telecom company Huawei, which has ties to the Chinese state and is viewed as a threat to U.S. network security. The same pattern played out on August 23 when President Trump responded to China’s retaliatory tariffs by declaring he would raise tariffs to 30% on the first half of imports and 15% on the remainder by December 15. Within a single weekend he softened his rhetoric and said he still wanted a deal. Trump’s tendency to take two steps forward with coercive measures and then one step back to control the damage is by now familiar to global investors. Yet this backpedaling reveals that like other politicians he is concerned about reelection. After all, there is a clear chain of consequence leading from trade war to bear market to recession to a Democrat taking the White House in November 2020. Trump’s approval rating is already similar to that of presidents who fell short of re-election amid recession (Chart II-2) – an actual recession would consign him to history. Will Trump Stage A Tactical Retreat On Trade? Yes. Trump’s predicament suggests that he will have to adjust his policies. Global trade, capital spending, and sentiment have deteriorated significantly since the last escalation-and-delay episode with China in May and June. Beijing’s economic stimulus measures disappointed expectations, exacerbating the global slowdown (Chart II-3). This leaves him less room for maneuver going forward. The fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. Even “Fortress America” – consumer-driven and relatively insulated from global trade – has seen manufacturing, private investment, and business sentiment weaken. GDP growth is slowing and has been revised downward for 2018 despite a surge in budget deficit projections to above $1 trillion dollars (Chart II-4). Chart II-3China's Gradual Stimulus Yet To Revive Global Economy Chart II-4Trump's Economy Grew Slower Than Thought Despite Fiscal Stimulus   The U.S. Treasury yield curve inversion is deepening. While we at BCA would point out reasons that this may not be a reliable signal of imminent recession, Trump cannot afford to ignore it. He is sensitive to the widening talk of “recession” in American airwaves and is openly contemplating stimulus options (Chart II-5). His approval rating has lost momentum, partly due to his perceived mishandling of a domestic terrorist attack motivated by racist anti-immigrant sentiment in El Paso, Texas, but negative financial and economic news have likely also played a part (Chart II-6). Chart II-5Trump Fears Growing Talk Of Recession In short, the fourth quarter of 2019 may be Trump’s last chance to save the business cycle and his presidency. The core predicament for Trump continues to be the divergence in American and Chinese policy. In the U.S., the stimulating effect of Trump’s Tax Cut and Jobs Act is wearing off just as the deflationary effect of his trade policy begins to bite. In China, the lingering effects of Xi’s all-but-defunct deleveraging campaign are combining with the trade war, and slowing trend growth, to produce a drag on domestic demand and global trade. The result is a rising dollar, which increases the trade deficit – the opposite of what Trump wants and needs (Chart II-7). Chart II-7Trump's Fiscal Policy Undid His Trade Policy   The United States is insulated from global trade, but only to a point – it cannot escape a global recession should one develop (Chart II-8). With global and U.S. equities vulnerable to additional volatility in the near term, Trump will have to make at least a tactical retreat on his trade policy over the rest of the year. First and foremost this would mean: Chart II-8If Total Trade War Causes A Global Relapse, The U.S. Economy Cannot Escape Expediting a trade deal with Japan – this should get done before a China deal, possibly as early as September. Ratifying the U.S.-Mexico-Canada “NAFTA 2.0” agreement – this requires support from moderate Democrats in Congress. The window for passage is closing fast but not yet closed. Removing the threat to slap tariffs on European car and car part imports in mid-November. There is some momentum given Europe’s need to boost growth and recent progress on U.S. beef exports to the EU. Lastly, if financial and economic pressure are sustained, Trump will be forced to soften his stance on China. The problem for global risk assets – in the very near term – is that Trump’s tactical retreat has not fully materialized yet. The new tariff on China is still slated to take effect on September 1. This tariff hike or other disagreements could result in a cancellation of talks or failure to make any progress.11 Even if Trump does pivot on trade, China’s position has hardened. It is no longer clear that Beijing will accept a deal that is transparently designed to boost Trump’s reelection chances. Thus, the biggest question in the trade talks is no longer Trump, but Xi. Is Xi prepared to receive Trump kindly if the latter comes crawling back? How will he handle rising political risk in Hong Kong SAR and Taiwan island,12 and will the outcome derail the trade talks? The biggest question in the trade talks is no longer Trump, but Xi. Bottom Line: Global economic growth is fragile and President Trump has only rhetorically retracted his latest salvo against China. Nevertheless, the clear signal is that he is sensitive to the financial and economic constraints that affect his presidential run next year – and therefore investors should expect U.S. trade policy to turn less market-negative on the margin in the coming months. This is positive for the cyclical view on global risk assets. But the risk to the view is China: whether Trump will take a conciliatory turn and whether Xi will reciprocate. Can Xi Jinping Accept A Deal? Yes. It is extremely difficult for Xi Jinping to offer concessions in the short term. He is facing another tariff hike, U.S. military shows of force, persistent social unrest in Hong Kong, and a critical election in Taiwan. Certainly, he will not risk any sign of weakness ahead of the 70th anniversary of the People’s Republic of China on October 1, which will be a nationalist rally in defiance of imperialist western powers. After that, however, there is potential for Xi to be receptive to any Trump pivot on trade. China’s strategy in the trade talks has generally been to offer limited concessions and wait for Trump to resign himself to them. Concessions thus far are not negligible, but they can easily be picked apart. They consist largely of preexisting trends (large commodity purchases); minor adjustments (e.g. to car tariffs and foreign ownership rules); unverifiable promises (on foreign investment, technological transfer, and intellectual property); or reversible strategic cooperation (partial enforcement of North Korean and Iranian sanctions) (Table II-1). Many of these concessions have been postponed as a result of Trump’s punitive measures. It is unlikely that Beijing will offer much more under today’s adverse circumstances. The exception is cooperation on North Korea, which should improve. So the contours of a deal are generally known. This is what Trump will have to accept if he seeks to calm markets and restore confidence in the economy ahead of his election. But this slate of concessions is ultimately acceptable for the U.S. Chart II-9China's Ultimate Economic Constraint China’s demands are that Trump roll back all his tariffs, that purchases of U.S. goods must be reasonable in scale, and that any agreement be balanced and conducted with mutual respect. Of these three, the tariffs and the “respect” pose the most trouble. Trade balance: Washington and Beijing can agree on the terms of specific purchases. China can increase select imports substantially – it remains a cash-rich nation with a state sector that can be commanded to buy American goods. Tariff rollback: This is tougher but can be done. The U.S. will insist on some tariffs – or the threat of tech sanctions – as an enforcement mechanism to ensure that Beijing implements the structural concessions necessary for an agreement. But China might accept a deal in which tariffs were mostly rolled back – say to the original 25% tariff on $50 billion worth of goods. This would likely offset the degree of yuan appreciation to be expected from the likely currency addendum to any agreement. Balance and respect: This qualitative demand is the sticking point. Fundamentally, China cannot reward Trump for his aggressive and unilateral protectionist measures. This would be to set a precedent for future American presidents that sweeping tariffs on national security grounds are a legitimate way of coercing China into making economic structural reforms. Moreover if the U.S. wants to improve the trade balance, China thinks, it cannot embargo Chinese high-tech imports but must actually increase its high-tech exports. Clearly this is a major impasse in the talks. The last point, mutual respect, is the likeliest deal-breaker. It may ultimately hinge on strategic events outside of the realm of trade. But before discussing it further, it is important to recognize that China is not invincible – it has a pain threshold. Deterioration in China’s labor market is of utmost seriousness to any Chinese leader (Chart II-9). And the economy is still struggling to revive. Xi’s reform and deleveraging campaign of 2017-18 has largely been postponed but the lingering effects are weighing on growth and the property sector remains under tight regulation. Moreover the removal of implicit guarantees, and rare toleration of creative destruction (Chart II-10), have left banks and corporations afraid to take on new risks. The state’s reflationary measures, including a big boost to local government spending, have so far been merely sufficient for domestic stability. Chart II-10Creative Destruction In China These problems can be addressed by additional policy easing. But the domestic political crackdown and the break with the U.S. have shaken manufacturers and private entrepreneurs to the bone, suppressing animal spirits and reducing the demand for loans. Ultimately a short-term trade deal to ease this economic stress would make sense for Xi Jinping, even though he knows that U.S. protectionism and the conflict over technological acquisition will persist beyond 2020 and beyond Trump. The threat of a sharp and destabilizing divorce from the U.S. is a real and present danger to the long-term stability of China’s economy and the Communist regime. Xi is a strongman leader, but is he really ready for Mao Zedong-style austerity? Is he not more like former President Jiang Zemin (ruled 1993-2003), who imposed some austerity while prizing domestic economic and political stability above all? To this question we now turn. Bottom Line: China has become the wild card in the trade war. Trump’s need to prevent a recession is known. Beijing has a higher pain threshold and could walk away from the deal to punish Trump (upsetting the global economy and diminishing Trump’s reelection prospects). This would set the precedent for future American presidents that China will not bow to gunboat diplomacy. Will Xi Jinping Overplay His Hand? Be Afraid. For decades China’s main foreign policy principle has been to “lie low and bide its time,” to paraphrase former leader Deng Xiaoping. In the current context this means maintaining a willingness to engage with the U.S. whenever it engages sincerely. This approach implies making the above concessions to minimize the immediate threat to stability from the trade war, while biding time in the longer run rivalry against the United States. Such an approach would also imply assisting the diplomatic process on the Korean peninsula, avoiding a military crackdown in Hong Kong, and refraining from aggressive military intimidation ahead of Taiwan’s election in January. Chart II-11China's Vast Market Its Most Persuasive Tool After all, there is no better way for the Communist Party to undercut dissidents in Hong Kong and Taiwan than to strike a deal with the United States. This would demonstrate that Xi is a pragmatic leader who is still committed to “reform and opening up.” It would help generate an economic rebound that would bring other countries deeper into Beijing’s orbit (Chart II-11). China’s vast domestic market is ultimately its greatest strength in its contest with the United States. In short, conventional Chinese policy suggests that Xi should perpetuate the long success story since 1978 by striking another deal with another Republican president. The catch is that Xi Jinping is not conventional. Since coming to power in 2012, Xi has eschewed the subtle strategies of Sun Tzu and Deng Xiaoping in favor of a more ambitious approach: that of declaring China’s arrival as a major power and leveraging its economic and military heft to pursue foreign policy and commercial interests aggressively. Xi’s reassertion of Communist rule and state-guided technological acquisition is the biggest factor behind the new U.S. political consensus – entirely aside from Trump – that China is foe rather than friend. There are several empirical reasons to think that Xi might overplay his hand: Xi failed to make substantive concessions with President Barack Obama’s administration on North Korea, the South China Sea, and cyber security, resulting in Obama’s decision to harden U.S. policy toward both China and North Korea in 2015 – a trend that predates Trump. Xi formally removed presidential term limits from China’s constitution even though he could have attracted less negative attention from the West by ruling from behind the scenes after his term in office, like Deng Xiaoping or Jiang Zemin. China has mostly played for time in negotiations with the Trump administration, as mentioned, and this aggravated tensions. Deep revisions to the draft agreement, and the  extent of tariff rollback which was supposedly 90% complete, broke the negotiations in May, sparking this summer’s standoff. Aggressive policies in territorial disputes have alienated even China’s potential allies. This includes regional states whose current ruling parties have courted China in recent years, in some cases obsequiously – South Korea, the Philippines, and Vietnam. The East and South China Seas remain a genuine source of “black swans” – unpredictable, low-probability, high-impact events – due to their status as critical sea lanes for the major Asian economies. China continues to militarize the islands there and aggressively prosecute its maritime-territorial disputes. We calculate that $6.4 trillion worth of goods flowed through this bottleneck in the year ending April 2019, 8% of which consists of energy goods from the Middle East that are vital to China and its East Asian neighbors, none of whom can stomach Chinese domination of this geographic space (Diagram II-1). Even if Washington abandoned the region, Japan, South Korea, and Taiwan would see Chinese control as a threat to their security. Ultimately, however, China’s adventures in its neighboring seas are a matter of choice. Not so for Greater China – in Hong Kong and Taiwan, political risk is rapidly mounting in a way that enflames the U.S.-China strategic distrust and threatens to prevent a trade agreement. Hong Kong: The Dust Has Not Settled Mass protests in Hong Kong have lost some momentum, based on the size of the largest rally in August versus June. But do not be fooled: the political crisis is deepening. A plurality of Hong Kongers now harbors negative feelings toward mainland Chinese people as well as the government in Beijing – a trend that is spiking amid today’s protests but began with the Great Recession and has roots in the deeper socioeconomic malaise of this capitalist enclave (Chart II-12A & II-12B).   A majority also lacks confidence in the political arrangement that ensures some autonomy from Beijing – known as “One Country, Two Systems” (Chart II-13). This is a particularly worrisome sign since this is the fundamental basis for stable political relations with Beijing. With clashes continuing between protesters and police, students calling for a boycott of school this fall, and Beijing rotating troops into the city and openly drilling its security forces in Shenzhen for a potential intervention, Hong Kong’s unrest is not yet laid to rest and could flare up again ahead of China’s sensitive National Day celebration. U.S. tariffs and sanctions are already in effect, reducing the ability of the U.S. to deter China from using force if it believes instability has gone too far. And as President Trump has warned – and would be true of any U.S. administration – a violent crackdown on civilian demonstrators would greatly reduce the political viability of a trade deal in the United States. Taiwan: The Black Swan Arrives Since Taiwan’s 2016 election, we have argued that it is a potential source of “black swans.” Mass protests in Hong Kong may have taken the cake. But these protests are now affecting the Taiwanese election dynamic and potentially the U.S.-China trade talks. Chart II-14U.S. Approves Big New Arms Sale To Taiwan On August 20, the United States Department of Defense informed Congress that it is proceeding with an $8 billion sale of F-16 fighter jets and other military arms and equipment to Taiwan – the largest sale in 22 years and the largest aircraft sale since 1992 (Chart II-14). This sale is not yet complete and delivered, but ultimately will be – the question is the timing. Arms sales to Taiwan are a perennial source of tension between the United States and China – and China is increasingly assertive in using economic sanctions to get its way over such issues, as it showed in the lead up to South Korea’s election in 2017. This sale is not a military “game changer” – the U.S. did not send over fifth-generation F-35s, for instance – but China will respond vehemently. It is threatening to impose sanctions on American companies like Lockheed Martin and General Electric for their part in the deal. The sale does not in itself preclude the chance of a trade agreement but it contributes to a rise in strategic tensions that ultimately could. Chart II-15A 'Fourth Taiwan Strait Crisis' Would Have A Seismic Equity Impact The context is Taiwan’s hugely important election in January. Four years ago, President Tsai Ing-wen and her pro-independence Democratic Progressive Party swept to power on the back of a popular protest movement – the “Sunflower Movement” – that opposed deeper cross-strait economic integration. It dangerously resembled the kind of anti-Communist “color revolutions” that motivate Xi Jinping’s hardline policies. Tsai shocked the world when she called Trump personally to congratulate him after his election, which violated diplomatic protocol given that Taiwan is a territory of China and not an independent nation-state. Since then Trump has largely avoided provoking the Taiwan issue so as not to strike at a core Chinese interest and obliterate the chance of a trade deal. But the U.S. has always argued that the provision of defensive arms to Taiwan is a condition of the U.S.-China détente – and Trump is so far moving forward with the sale. How will Xi Jinping react if the sale goes through? In 1995-96, China’s use of missile tests to try to intimidate Taiwan produced the opposite effect – driving voters into the arms of Lee Teng-hui, the candidate Beijing opposed. This was the occasion of the Third Taiwan Strait Crisis, in which U.S. President Bill Clinton sent two aircraft carriers to the region, one that sailed through the Taiwan Strait. The negative effect on markets at that time was local, whereas anything resembling this level of tensions would today be a seismic global risk-off (Chart II-15). Since the 1990s, leaders in Beijing have avoided direct military coercion ahead of elections. But Xi Jinping has hardened his stance on Taiwan throughout his term. He has dabbled with such coercion in his use of military drills that encircle Taiwan in recent years. While one must assume that he will use economic sanctions rather than outright military threats – as he did with South Korea – saber-rattling cannot be ruled out. The pressure on him is rising. Prior to the Hong Kong unrest, Taiwan’s elections looked likely to return the pro-mainland Kuomintang (KMT) to power and remove the incumbent President Tsai – a boon for Beijing. That outlook has changed and Tsai now has a fighting chance of staying in power (Chart II-16). The prospect of four more years of Tsai would not be too problematic for Beijing if not for the fact that the U.S. political establishment is now firmly in agreement on challenging China. But even if Tsai loses, Taiwan’s outlook is troublesome. And this makes Xi’s decision-making harder to predict. Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. It is not that Tsai or her party will necessarily prevail. The manufacturing slowdown will take a toll and third-party candidates, particularly Ko Wen-je, would likely split Tsai’s vote. Moreover her Democratic Progressives still tie the KMT in opinion polling (Chart II-17). The Taiwanese people are primarily concerned about maintaining the strong economy and cross-strait peace and stability, which her reelection could jeopardize (Chart II-18). Tsai could very well lose, or she could be a lame duck presiding over the KMT in the legislature.   Rather, the problem for Xi Jinping is that the Taiwanese people clearly sympathize with the protesters in Hong Kong (Chart II-19). They fear that their own governance system faces the same fate as Hong Kong’s, with the Communist Party encroaching on traditional political liberties over time.   While Hong Kong ultimately has zero choice as to whether to accept Beijing’s supremacy, Taiwan has much greater autonomy – and the military support of outside forces. It is not a foregone conclusion that Taiwan must suffer the same political dependency as Hong Kong. Indeed, Taiwan has a long history of exercising the democratic vote and has even dabbled into the realm of popular referendums. In short, Taiwan has a lot more dry powder for a political crisis in the long run than Hong Kong. But the Hong Kong events have accentuated this fact, for two key reasons: First, Taiwanese people identify increasingly as exclusively Taiwanese, rather than as both Taiwanese and Chinese (Chart II-20). The incidents in Hong Kong reveal that this sentiment is tied to immediate political relations and therefore deterioration would encourage further alienation from the mainland. Second, while a strong majority of Taiwanese wish to maintain the political status quo to avoid conflict with the mainland, a substantial subset – approaching one-fourth – supports eventual or immediate independence (Chart II-21).   This means that relations with the mainland will eventually deteriorate even if the KMT wins the election. The KMT itself must respond to popular demand not to cozy up too much with Beijing, which is how it fell from power in 2016. Meanwhile, under KMT rule, Taiwan’s progressive-leaning youth are likely to set about reviving their protest movement in the subsequent years and imitating their Hong Kong peers, especially if the KMT warms up relations too fast with the mainland. Ultimately these points suggest that Xi Jinping will strive to avoid a violent crackdown in Hong Kong. A crackdown would be the surest way for him to harm the KMT in the Taiwanese election and to hasten the rebuilding of U.S.-Taiwan security ties. Call The President The best argument for Xi to lie low and avoid a larger crisis in Greater China is that it would unify the West and its allies against China. So far Xi’s foreign policy has not been so aggressive as to lead to diplomatic isolation. Europe is maintaining a studied neutrality due to its own differences with the United States; Asian neighbors are wary of provoking Chinese sanctions or military threats. A humanitarian crisis in Hong Kong or a “Fourth Taiwan Strait Crisis” would change that. For markets, the best-case scenario is that Xi Jinping exercises restraint. This would help Hong Kong protests lose steam, North Korean diplomacy get back on track, and Taiwanese independence sentiment simmer down. China would be more likely to halt U.S. tariffs and tech sanctions, settle a short-term trade agreement, and delay the upgrade in U.S.-Taiwan defense relations. China would still face adverse long-term political trends in both the U.S. and Taiwan, but an immediate crisis would be averted. The worst-case scenario is that Xi indulges his ambition. Hong Kong protests could explode, relations with Taiwan would deteriorate, and U.S.-China relations would move more rapidly in their downward spiral. Trade talks could collapse. Xi Jinping would face the possibility of a unified Western front, instability within Greater China, and a global recession. This might get rid of Donald Trump, but it would not get rid of the U.S. Congress, Navy, or Department of Defense. The choice seems pretty clear. Xi, like Trump, faces constraints that should motivate a tactical retreat from confrontation, at least after October 1. While this does not necessarily mean a settled trade agreement, it does suggest at least a ceasefire or truce. Our GeoRisk indicators show that market-based political risk in Taiwan – and less so South Korea – moves in keeping with global economic policy uncertainty. The underlying U.S.-China strategic confrontation and trade war are driving both (Chart II-22). A deterioration in this region has global consequences. Chart II-22U.S.-China Strategic Conflict Fuels Global Economic Uncertainty And Taiwanese Geopolitical Risk In Tandem Xi is a markedly aggressive “strongman” Chinese leader who has not been afraid to model his leadership on that of Chairman Mao. He could still overplay his hand. This is why we maintain that the odds of a U.S.-China trade agreement remain 40%, though we are prepared to upgrade that probability if Trump and Xi make pro-market decisions. Investment Implications On the three-month tactical horizon, BCA’s Geopolitical Strategy is paring back our tactical safe-haven trades: we are closing our “Doomsday Basket” of long gold and Swiss bonds for a gain of 13.6%, while maintaining our simple gold portfolio hedge going forward.  Trump has not yet decisively staged his tactical retreat on trade policy, while rising political risk in Greater China increases uncertainty over Xi Jinping’s next moves. On the cyclical horizon, the above suggests that there is a light at the end of the tunnel – if both Trump and Xi recognize their political constraints. This means that there is still a political and geopolitical basis to reinforce BCA’s House View to remain optimistic on global and U.S. equities over the next 12 months, with the potential for non-U.S. equities to recover and bond yields to reverse their deep dive.   Matt Gertken Vice President Geopolitical Strategy   III. Indicators And Reference Charts The S&P 500 correction is likely to deepen a bit further. A move toward 2700 remains our base case scenario. Short-term oscillators have not yet reached capitulation levels and the Sino-U.S. trade war remains a source of risks, especially as the Chinese side is unlikely to provide any strong concessions until October. However, we still do not expect a deeper correction to unfold. In other words, equities remain stuck in a trading range for the remainder of the year. Our Revealed Preference Indicator (RPI) continues to shun stocks. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive readings from the policy and valuation measures. Conversely, if strong market momentum is not supported by valuations and policy, investors should lean against the market trend. Global growth remains the biggest problem for stocks. Until the global economy finds a floor, the outlook for profits will be poor and our RPI will argue against buying equities. Beyond this year, the outlook remains constructive of stocks. Our Willingness-to-Pay (WTP) indicator for the U.S. and Japan is markedly improving. However, it continues to deteriorate in Europe. The WTP indicator tracks flows, and thus provides information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. The WTP therefore argues that investors are still looking to buy the dips in the U.S. and in Japan, which limits the downside in those markets. Yields have collapsed, money growth has picked up, and global central banks are cutting rates in unison. As a result, our Monetary Indicator points to the most accommodative global monetary backdrop since early 2015. Moreover, our Composite Technical Indicator is improving and continues to flash a buy signal. In 2015, it was deteriorating after having hit overbought territory. Therefore, unlike four years ago, equities are more likely to avoid the gravitational pull created by their overvaluation, especially as our BCA Composite Valuation index is in fact improving thanks to lower bond yields.  According to our model, 10-year Treasurys have not been this expensive since late 2012. Back then, this level of overvaluation warned of an impending Treasury selloff. Moreover, our technical indicator is now deeply overbought. So are various rate-of-change measures for bond prices. While none of those indicators can tell you if yields will move up in the next few weeks, they do argue that the risk/reward of holding bonds over the coming year is extremely poor. That being said, we are closely monitoring the recent breakdown in the advanced/decline line of commodities, which might herald another down-leg in commodity prices, and therefore, in bond yields as well. On a PPP basis, the U.S. dollar is only growing ever more expensive. Additionally, despite the dollar’s recent strength, our Composite Technical Indicator has lost enough momentum that the negative divergence we flagged last month remains in place. It is worrisome for dollar bulls that despite growing uncertainty and a deteriorating global economy, the euro is not breaking down. If the dollar’s Technical Indicator deteriorates further and falls below zero, the momentum-continuation behavior of the greenback will likely kick in. The USD would suffer markedly were this to happen. EQUITIES: Chart III-1U.S. Equity Indicators Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators   Chart III-4Revealed Preference Indicator Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance   FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields Chart III-1210-Year Treasury Yield ComponentsChart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets   CURRENCIES: Chart III-16U.S. Dollar And PPP Chart III-17U.S. Dollar And Indicator Chart III-18U.S. Dollar Fundamentals Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals   COMMODITIES: Chart III-23Broad Commodity Indicators Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning   ECONOMY: Chart III-28U.S. And Global Macro Backdrop Chart III-29U.S. Macro Snapshot Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging   Chart III-36U.S. Financial Conditions Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China   Mathieu Savary Vice President The Bank Credit Analyst   Footnotes 1       Claudio Borio , Mathias Drehmann, Dora Xia, "The financial cycle and recession risk," BIS Quarterly Review, December 2018. 2       Please see Emerging Markets Strategy Special Report "China’s Property Market: Making Sense Of Divergences," dated May 9, 2019, available at ems.bcaresearch.com 3       Please see Global Investment Strategy Weekly Report, “Three Cycles,” dated July 26, 2019, available at gis.bcaresearch.com 4       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 5       Please see The Bank Credit Analyst Section I, “August 2019,” dated July 25, 2019, available at bca.bcaresearch.com 6       For an explanation of the mechanics of the FRP, please see NY Fed’s website: https://www.newyorkfed.org/aboutthefed/fedpoint/fed20 7       Please see U.S. Equity Strategy Special Report "Sector Performance And Fed “Mid-Cycle Adjustments”: For Better Or For Worse," dated August 19, 2019, available at uses.bcaresearch.com 8       Please see U.S. Bond Strategy Weekly Report "The Trump Interruption," dated August 13, 2019, available at usbs.bcaresearch.com 9       Please see Global Investment Strategy Special Report, “TINA To The Rescue?,” dated August 23, 2019, available at gis.bcaresearch.com 10     Please see Foreign Exchange Strategy Special Report, “A Fresh Look At Purchasing Power Parity,” dated August 23, 2019, available at fes.bcaresearch.com 11     Negotiations between Trump and Xi are slated for September in Washington. There is a prospect for Trump to hold another summit with Communist Party General Secretary Xi Jinping on the sidelines of the United Nations General Assembly in New York in late September and at the APEC summit in Chile in mid-November. 12     Hong Kong is a Special Administrative Region of the People’s Republic of China, while Taiwan is recognized as a province or territory. EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Special Report

Feature Feature ChartNo 'Secular Stagnation' In Japan! Bond yields have plummeted to all-time lows and inflation has continued to undershoot the 2 percent target which central bankers tell us is ‘price stability’. This configuration has led to renewed fears that the European and global economies are entering a so-called ‘secular stagnation’. We strongly disagree with this line of thinking. Near-zero bond yields and inflation are categorically not portents of a long-term drought in economic progress. Quite the opposite. Chart I-2Japan Has Experienced Near-Zero Inflation For Decades Japan has experienced near-zero bond yields and inflation for decades (Chart I-2). Yet since the late 1990s, the growth in Japan’s real GDP per head has outperformed every other major economy1 (Feature Chart). Granted, the Japanese government has been running persistent deficits, but this is to counterbalance private sector de-levering. Total indebtedness as a share of GDP has not been rising. In the post credit boom era, Japan’s economic progress has come entirely from productivity improvements. The ability to learn, experiment, and innovate boosts the quality and/or quantity of output from a fixed set of inputs. Unlike the unsustainable growth that is fuelled by credit booms and asset bubbles, real growth that comes from productivity improvements marks genuine and sustainable economic progress. In Europe, Switzerland tells a similar tale. Swiss bond yields and inflation have been near zero for decades, but they have not defined a secular stagnation. Real GDP per head and living standards have steadily advanced, even from an already high base. In the post credit boom era, Japan’s economic progress has come entirely from productivity improvements.  But the best counterexample comes from economic history. At the height of the British Empire in 1914, British consumer prices were little different to where they stood at the end of the English Civil War in 1651 – meaning that Britain experienced near-zero inflation and low bond yields for almost three centuries (Chart I-3). Did these define a secular stagnation? No, quite the opposite. For Britain, this was a golden epoch in which it emerged as the world’s preeminent economy. Chart I-3Britain Experienced Near-Zero Inflation For Centuries The Real Reason For Near-Zero Inflation And Bond Yields The fear-mongering about a secular stagnation misses the real reason for today’s sub-2 percent inflation and record low bond yields. Central banks have wrongly defined price stability. Central banks have wrongly defined price stability because they think of it in terms of the economics and mathematics in which they have expertise. Their models tell them that they can nail inflation to one decimal place – two point zero. But price stability has as much to do with biology and psychology. Biologists will tell you that the human brain cannot distinguish inflation rates between -1 and 2 percent, a range we indistinguishably perceive as ‘price stability’. If biology teaches us that we cannot distinguish between -1 and 2 percent inflation, then central banks have a huge problem. It is impossible for a central bank to change our inflation expectations within that range, because the entire range just feels the same to us. Therefore, our behaviour in terms of wage demands and willingness to borrow will also stay unchanged. And if our economic behaviour is unchanged, what is the transmission mechanism to fine tune inflation within the -1 to 2 percent range? Central banks have wrongly defined price stability.  Therefore, price stability is actually like a ‘quantum state’. You’re in the state or you’re out of the state, but once you’re in the state you cannot then fine tune inflation to an arbitrary number like two point zero. In fact, average inflation over, say, five years will gravitate to the mid-point of the price stability state, 0.5 percent, which is a long way below the central bank’s arbitrary target of 2 percent (Chart I-4). This forces the central bank into drastic and prolonged monetary policy easing – which depresses bond yields (Chart I-5). Chart I-4Central Banks Have Wrongly Defined Price Stability... Chart I-5...Forcing Them To Depress Bond Yields Monetary Policies Will Ultimately Converge As structural credit booms have sequentially ended, economies have one by one entered the state of price stability. First it was Japan; then it was Switzerland; more recently it has been the euro area and the United States. It follows that the 5-year annualised inflation rates have also sequentially tumbled to the mid-point of the price stability state, around 0.5 percent. By which point, inflation is so far below the misplaced 2 percent target, that the central bank’s drastic and prolonged monetary policy easing has depressed the 5-year bond yield to near zero. Japan reached this point in the late 1990s, Switzerland in the early 2010s, and the euro area in the late 2010s. Begging the question: why has the 5-year inflation rate in the U.S. not tumbled towards 0.5 percent too?  The answer is that actually, it has. On a like-for-like basis, 5-year inflation rates are way below the 2 percent target in all the major jurisdictions. You see, the Americans measure inflation differently to the Europeans. In the U.S., the consumer price basket includes owner-occupied housing costs at a substantial weighting, while in Europe it is completely excluded. Using the same definition of inflation as in Europe, the U.S. 5-year inflation rate is not at 1.5 percent, it is at a feeble 0.6 percent (Chart I-6). Chart I-6On a Like-For-Like Basis, U.S. 5-Year Inflation Is A Feeble 0.6 Percent Crucially, on a like-for-like basis, 5-year inflation rates are way below the 2 percent target in all the major jurisdictions: the U.S., euro area, and Japan. This leads us to believe that the current chasm in monetary policies is unsustainable. Even including owner-occupied housing in the consumer price basket, as the U.S. does, the long run boost to annual inflation is only about 0.2 percent (Chart I-7). Meaning that it is only a matter of time before U.S. structural inflation and bond yields converge with those in the euro area. Chart I-7Owner-Occupied Housing Boosts Inflation, But In The Long Run By Only 0.2 Percent In the meantime, the chasm between monetary policies has become a major geopolitical risk. This is because it has depressed the euro versus the dollar by at least 10 percent – based on the ECB’s own competitiveness indicators. The exchange rate distortion stemming from polarised monetary policies is the culprit for the euro area’s huge trade surplus with the United States (Chart I-8). On this point, President Trump is spot on to complain that the Fed’s policy stance relative to other central banks is severely handicapping U.S. manufacturers. As the president tries to counter this handicap with tariffs, real or threatened, the Fed is being forced to lean against the risks to growth and inflation. Chart I-8Blame Polarised Monetary Policies For The Euro Area’s Huge Trade Surplus With The U.S. What Does All Of This Mean? One way or another, the dollar will come under structural pressure in the coming years as the current chasm in monetary policies proves to be unjustified. However, in the near term, we prefer to express this not via the euro, but via the yen. The corollary is that U.S bond yields will eventually converge with their European counterparts. But to reiterate, a world with near-zero inflation is categorically not a portent of secular stagnation. It is just the true state of price stability as the human brain perceives it, rather than the over-precise two point zero that central banks have arbitrarily picked. In turn, ultra-low bond yields stem from the monetary policy response to this massive undershoot of true price stability from central bank defined price stability.   All of this raises a fascinating question: if bond yields are lower than is truly required, why hasn’t it created a new inflation? The answer is that it has, but the new inflation is not in the real economy. The reason is that the world has just been through a structural credit boom, remains heavily indebted, and is still unwinding some of the credit excesses. In this world, as Japan has illustrated in recent decades, productivity growth must drive economic progress. Instead, the new inflation is in equity and other risk-asset prices. At ultra-low bond yields the prospect of bond capital gains diminishes versus potential losses, making bonds as risky as equities. This removes the need for an excess return on equities and other risk-assets versus bonds, meaning that the valuation of risk-assets inflates exponentially (Chart I-9). So long as bond yields remain depressed, this new inflation in risk-asset valuations is well justified and supported.2  But be very careful if the global 10-year bond yield rises above 2 percent.3   Dhaval Joshi, Chief European Investment Strategist dhaval@bcaresearch.com Footnotes 1 Based on real GDP per working age (15-64) population, but also broadly true for real GDP per total population. 2 Please see the European Investment Strategy Weekly Report “Risk: The Great Misunderstanding Of Finance”, October 25 2018, available at eis.bcaresearch.com. 3 The global 10-year bond yield is the simple average of 10-year government bond yields in the U.S., euro area (or France as a proxy), and China.

There will be no U.S. Bond Strategy report next week. Our regular publication schedule will resume on September 10th, with our Portfolio Allocation Summary for September. Highlights Fed: Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it. Expect another 25 basis point rate cut in September. Duration: Stronger economic data will eventually lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. Yield Curve & Recessions: An inverted yield curve signals that the market views monetary policy as restrictive. Restrictive policy should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. Feature Chart 1Markets Want More Easing And The Fed Should Accommodate Bond investors had their hands full last week, as comments from Fed officials produced an unusually wide range of views. The hawks were most vocal early in the week as Boston Fed President Eric Rosengren, Kansas City Fed President Esther George and Philadelphia Fed President Patrick Harker all made the case for leaving rates at current levels, even as the market continues to price-in another 25 basis point rate cut in September, followed by an additional 50 basis points of cuts between October and February (Chart 1). Fed Chairman Jerome Powell, however, did not try to shift market expectations one way or the other during his Jackson Hole speech on Friday. This suggests that he is probably comfortable with current bond market pricing. In our opinion, we will see another 25 basis point rate cut in September and the Fed is justified in doing so. The Fed Can’t Fight The Markets, And It Shouldn’t Chart 2Keep Financial Conditions Supportive In the current environment, monetary policy exerts its greatest influence on the economy via its impact on broad financial conditions. Easier financial conditions lead to stronger growth and higher inflation in the future (Chart 2), and the Fed must ensure that financial conditions remain accommodative during the current global slowdown. This means that the Fed’s most important job is to ensure that investors perceive Fed policy as supportive for equities and corporate credit. In other words, unless Chairman Powell wants to slow the economy, he must bow down to the markets and deliver enough monetary easing to keep broad financial conditions accommodative. The minutes from the July FOMC meeting, released last week, suggest that the Fed understands this dynamic and will act as appropriate. In their discussion of financial market developments, participants observed that financial conditions remained supportive of economic growth, with borrowing rates low and stock prices near all-time highs. Participants observed that current financial conditions appeared to be premised importantly on expectations that the Federal Reserve would ease policy to help offset the drag on economic growth stemming from the weaker global outlook and uncertainties associated with international trade as well as to provide some insurance to address various downside risks. Chart 3No Sign Of Rising Inflation Expectations... Simply, if the market expects another rate cut in September, the Fed would be wise to deliver. Otherwise, broad financial conditions could tighten sharply, making it more difficult for economic growth to recover. It is not always the case that the Fed should act to ensure that financial conditions remain accommodative. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations.1 However, neither of those conditions are in place today. The cost of inflation compensation priced into long-maturity TIPS has collapsed, and it is well below the 2.3% - 2.5% range that would be consistent with well-anchored inflation expectations near the Fed’s target (Chart 3). Survey measures of long-dated inflation expectations have been more stable, but are not threatening to move significantly higher (Chart 3, bottom panel). Equally, financial asset valuations are nowhere near “bubbly” (Chart 4). The risk premium priced into corporate bonds after accounting for expected default losses is above levels seen early last year, while the S&P 500’s 12-month forward Price/Earnings ratio is below its early-2018 peak. If inflation expectations were breaking out to the upside, or financial asset valuations were stretched, then the case could be made for the Fed to fight back against the market’s easing expectations. Further, the 2-year/10-year Treasury slope recently inverted and the broad trade-weighted dollar continues to appreciate (Chart 5). Both of these factors suggest that the market views Fed policy as insufficiently accommodative. St. Louis Fed President James Bullard bluntly summed up the situation in an interview last week, saying that it is “our job to get the yield curve to be un-inverted”. Chart 4...Or Excessive Financial ##br##Asset Valuation Chart 5The Case For More Accommodative Monetary Policy We agree with this sentiment. Absent inflationary pressures or excessive financial asset valuations, the Fed must maintain an accommodative policy stance. This means cutting rates if the market demands it, in an effort to un-invert the yield curve. The Economy Must Lead Chart 6Still Waiting For A Rebound In Global Growth But the Fed can’t un-invert the yield curve all on its own. The Fed can pull down the short-end of the curve, but it needs to economy to cooperate if it wants to boost long-end yields. In fact, if the global economic data improve, then the market will no longer require Fed rate cuts to keep financial conditions accommodative. If the economic data improve a lot, then the market might even be able to live with rate hikes and still maintain supportive broad financial conditions. We haven’t yet seen much evidence of improvement in the global economic data, but we remain confident that a rebound will take hold before the end of the year.2 Flash PMI data for August were released last week and showed a drop in the U.S. figure to below the 50 boom/bust line (Chart 6). The Flash data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. In contrast with the weaker PMI data, Leading Economic Indicators (LEI) are showing some signs of strength. Although both the U.S. and Global (excluding U.S.) LEIs remain at below-average levels relative to their trailing 12-month trends (Chart 7), the Global (ex. U.S.) index bottomed several months ago and the U.S. index ticked higher last month. Troughs in the LEIs tend to precede troughs in both the Global PMIs and bond yields.  Chart 7Leading Economic Indicators Suggest The Rebound Might Be Soon Bottom Line: The Fed must keep financial conditions accommodative, and this means satisfying the bond market’s expectations for further rate cuts. Eventually, stronger economic data will lead long-dated bond yields higher, un-inverting the yield curve and allowing the Fed to stop its mini easing cycle. Investors should keep portfolio duration close to benchmark, but stand ready to reduce duration at the first signs of stronger global economic data. The Inverted Yield Curve And Recession Risk We have received a lot of client questions on the topic of using the yield curve to forecast recessions. In this week’s report we explain our views about how the inverted yield curve should be interpreted. In short, we think an inverted yield curve should be viewed as a necessary pre-condition for recession, but not one that helps much with timing the next downturn. The Flash PMI data showed small gains in the Eurozone and Japan, though both of those PMIs also remain below 50. We start by recognizing that many variables have strong track records at forecasting recession, and those variables can be grouped into two broad categories: Financial market indicators (including the yield curve, stock market, oil price, etc…) Economic indicators (including initial jobless claims, unemployment rate, housing starts, etc…) In general, financial market indicators give more advance warning of recession but they are also prone to sending false signals. Economic indicators, on the other hand, are less prone to false signals, but often provide little (if any) advance notice. With this in mind, we turn to Chart 8. The top panel of which shows the New York Fed’s popular Recession Probability Indicator, an indicator derived purely from the 3-month/10-year Treasury slope. We also calculate the same model using the 2-year/10-year slope, but the results are not materially different. Chart 8Recession Probability Indicators The top panel of Chart 8 shows the strengths and weaknesses of using financial market data to forecast a recession. The New York Fed’s model started to rise about 3 years prior to the last recession and 5 years prior to the 2001 recession. The model also fluctuated up and down several times in the late 1990s, suggesting that recession risk was lower in 1998 than in 1996 even though the recession was actually 2 years closer. In general, the model clearly illustrates that the yield curve flattens as the economic recovery ages, but also that the yield curve can provide a recession signal far in advance of the actual recession. The model’s signal can also reverse if the yield curve re-steepens. The bottom panel of Chart 8 shows the New York Fed’s yield curve-based Recession Probability Indicator alongside our own recession indicator, one that is based on several different variables (including the yield curve). Our model is designed to give less lead time than a pure yield curve model, but also fewer false signals. Once again, the late-1990s are instructive. The yield curve-only model was sending a recession signal of varying magnitudes for 5 years before our multi-factor model shot higher in 2001. What can we conclude from looking at these different recession models? Essentially, we should view an inverted yield curve as a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. Policy could remain restrictive for several years before the recession takes hold, or policy could move from restrictive to accommodative and the yield curve’s recession signal could vanish. Incorporating The Term Premium, Is This Time Different? Some publications at BCA have made the case that the yield curve’s recession signal is distorted in this cycle because of the deeply negative term premium. While this could be true in theory, in practice, we think it would be unwise to dismiss what the yield curve is telling us about the current stance of monetary policy. Chart 9Uncertainty Around The Term Premium Bond yields consist of two components, short rate expectations and a term premium. The yield curve’s power as a recession indicator comes from the rate expectations component. Assuming a constant term premium, an inverted yield curve means that the bond market expects the overnight rate to fall in the future. This is more likely to happen in a recession. However, if the term premium were deeply negative at the long-end of the yield curve, then an inverted yield curve might simply reflect the negative term premium and not an expectation that the fed funds rate will decline. In theory, this could be the case if, for example, the equity hedging value of Treasury bonds is perceived to be much higher now than in the past. In that case, investors might be willing to pay to take duration risk in order to gain the perceived diversification benefits. That is a plausible story. The problem is that we cannot verify it in the data because bond term premia cannot be accurately estimated. For example, one popular term premium estimate, the New York Fed’s Adrian, Crump and Moench (ACM) estimate, placed the 10-year zero coupon term premium at -84 bps on July 22. On that same date, the spot 10-year Treasury yield was 2.06%. This implies that the market’s 10-year average fed funds rate expectation was (206 bps – (-84 bps)) = 2.9%. In other words, the ACM estimate tells us that on July 22 the market expected the fed funds rate to average 2.9% over the next 10 years. This seems highly implausible, given that the New York Fed’s Survey of Market Participants, taken that same day, shows that the median market participant expected the fed funds rate to average 2% over the next 10 years (Chart 9). According to that median survey response, the 10-year term premium was +6 bps on July 22, not -84 bps! The point is not that survey measures of term premia are preferable to more sophisticated models of the ACM variety. We simply wish to point out that term premia estimates are highly uncertain, and the actual term premium on any given day is impossible to pin down. Once we recognize this fact, then we should at least be skeptical of claims that a negative term premium is distorting the recession signal from the yield curve. Given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value. Bottom Line: The proper interpretation of an inverted yield curve is that it is a signal that the market views monetary policy as restrictive. Restrictive monetary policy is a necessary pre-condition for recession, but it does not help us much with timing. It is conceivable that a deeply negative term premium is currently distorting the yield curve’s signal about the stance of monetary policy. But given the uncertainty surrounding term premium estimates, we are inclined to simply take the yield curve’s signal at face value.   Ryan Swift, U.S. Bond Strategist rswift@bcaresearch.com Footnotes 1 We have made the case that inflation expectations and financial conditions are the two most important factors to monitor when tracking Fed policy. For further details please see U.S. Bond Strategy Weekly Report, “The New Battleground For Monetary Policy”, dated March 26, 2019, available at usbs.bcaresearch.com 2  We elaborated on the reasons to expect a rebound in global growth in the U.S. Bond Strategy / Global Fixed Income Strategy Weekly Report, “Where’s The Positive Carry In Bond Markets?” dated August 20, 2019, available at usbs.bcaresearch.com Fixed Income Sector Performance Recommended Portfolio Specification

Highlights Sovereign bond yields have cratered over the last few months, … : Over the last three months, 10-year yields in the U.S., France, Germany, Switzerland and Australia have fallen by 71, 64, 53, 54, and 67 basis points, respectively. … and the Treasury curve has experienced a significant bull flattening, … : Month-to-date total returns for the Barclays Bloomberg Long, Intermediate and 1-3-Year Treasury Indexes are 9.2%, 1.6% and 1.1%, respectively. … indicating that the bond market thinks more rate cuts are in store: The textbook interpretation of an inverted curve is that monetary policy is too tight and needs to be loosened, but technical factors have amplified the flattening pressure. Is the bond market reacting to weakening growth prospects, or uber-dovish central banks?: The answer has implications well beyond the fixed-income universe. It could mean the difference between an economic slowdown and a market melt-up. Feature BCA researchers convened last week for our monthly View Meeting, much of which was given over to the global decline in sovereign bond yields. Does their plunge owe more to weakening growth prospects or central banks’ synchronized dovish pivot? There have surely been elements of both; after all, central banks wouldn’t be so dovish if they weren’t concerned about the growth outlook. It is clear to our fixed-income strategists that the yield move has overshot the data, however, and they mainly attribute the overshoot to monetary policy. No central bank wants a stronger currency while confronting a demand deficiency aggravated by trade tensions and a global manufacturing slowdown. The New York Times Business section put the prevailing policy winds into living color in a nearly full-page, four-column graphic spotlighting the 32 central banks that have cut their policy rate so far this year.1 The pell-mell rush to cut rates is emblematic of a global scramble for competitiveness. No central bank wants its economy to be caught without a buffer while other economies are busily reinforcing theirs. The Message From The Bond Market Trade tensions are a legitimate threat to global economic growth already challenged by a downswing in the global manufacturing cycle. A recession is a possibility, but it is hardly a foregone conclusion. We agree with our fixed-income colleagues that the yield selloff has overrun the economic fundamentals. Last week’s preliminary European manufacturing PMIs suggested that manufacturing may finally be stabilizing, and there is still no evidence that the manufacturing downturn has infected the services sector (Chart 1). A recession is hardly a foregone conclusion. 10-year Treasury yields have been falling sharply since their 3.25% peak in early November, and the current leg down is the third in a series of sharp declines (Chart 2, top panel). Global sovereign yields have followed the same pattern (Chart 2, bottom panel), but the latest plunge is as much a reflection of ubiquitous easing biases as it is of new concerns about economic weakness. That may sound like a minor point, of interest only to macro specialists, but it has import for all investors. If the yield decline isn’t signaling new softness, then easier financial conditions will be free to act as a tailwind for risk assets. Chart 1Services Are Holding Up ... Chart 2A Brief Inversion ... But Yields Are Freefalling Neither investment-grade (Chart 3, top panel) nor high-yield corporate bond spreads evince any particular concern about the economy (Chart 3, bottom panel). Although they’ve ticked up, they remain near the bottom of their post-crisis range, and are nowhere near the levels they reached in 2011-12, during the federal budget showdown/U.S. downgrade and the flare-up of the Eurozone crisis, or in 2015-16, during the last manufacturing recession. With banks still easing lending standards for corporate and industrial borrowers (Chart 4), spreads won’t undergo a systematic widening. Borrowers do not default as long as there is a lender willing to roll over their maturing obligations, so tighter credit standards are a precondition for spread-widening cycles. Chart 3No Sign Of Stress Among Corporate Borrowers ... Chart 4... And Banks Aren't Applying Any Pressure The Message From The Housing Market Chart 5Lower Rates Have Yet To Impact Housing ... We have been disappointed by residential investment’s muted response to the significant year-to-date decline in mortgage rates (Chart 5, bottom panel). The trajectory of starts and permits (Chart 5, top panel) hasn’t changed, new and existing home sales haven’t perked up (Chart 5, second panel), and mortgage purchase applications (Chart 5, third panel) appear not to have heard the news that rates are much lower. We thought that the swift fall in mortgage rates would promote more residential investment than it has to date. There is a difference, however, between disappointing growth and a full-on contraction. With affordability remaining high relative to history (Chart 6), and apartment rents exceeding monthly mortgage payments in several locales (Chart 7), housing demand should remain well supported. There are no excesses in the housing market in terms of inventory or oncoming supply that would make housing a source of economic or financial instability. Inventory relative to the number of households is bumping around its all-time lows (Chart 8), and cumulative household formations have easily outstripped housing starts since the crisis broke (Chart 9). Structural factors like a lack of supply geared to first-time and first-move-up buyers, and the ravenous appetite of pools of capital purchasing single-family homes for rent, are squeezing out some would-be buyers, but housing is not about to induce a recession. There are plenty of things for investors to be concerned about, but the housing market isn’t one of them. Chart 6... Though They Have Placed Homeownership In Easier Reach Chart 8... Inventories Are At Record Lows, ... The View From Broad And Wall We concede that stocks are not behaving as if all is well. Big daily swings are not a feature of healthy markets, and eight of this month’s sixteen sessions have registered moves of at least 1%. The second quarter’s 3% year-over-year earnings growth is three percentage points better than the consensus expected when earnings season kicked off, however, and despite the single-day moves, the S&P 500 has spent all but the first day of the month in a well-defined range between 2,825 and 2,945 (Chart 10). The market may be jumpy from one day to the next, but investors have not been concerned enough to engage in sustained selling. The equity market’s verdict on housing is more optimistic than ours. Inspired by earnings reports, the S&P 1500 Homebuilders Index have broken out to a new 52-week high (Chart 11). Retailers were the stars of last week’s earnings releases, with Lowe’s, Nordstrom and Target posting double-digit percentage gains after reporting numbers that failed to live up to investors’ worst fears. Equities are validating the view that the U.S. consumer is alive and kicking. Chart 11Homebuilder Stocks Have Broken Out The GDP Outlook Chart 12Capex Intentions: Elevated But Slipping If consumers are well positioned, the U.S. economy should be, too. Consumption accounts for two-thirds of the U.S. economy, with investment and government spending equally dividing the other third. Federal expenditures amount to about 40% of government spending, and between this year’s fiscal thrust and next year’s hotly contested presidential election, D.C. can be counted upon to do its part for the economy. At the state and local level, healthy household income should support state sales and income tax receipts, while still-rising home prices will provide the property taxes to keep municipal coffers full. That leaves fixed asset investment as the economy’s Achilles heel. We are confident, as noted above, that residential investment will not decline enough to pose a problem for the economy, but corporate investment is in the crosshairs of the uncertainty surrounding the multiple trade squabbles. The NFIB survey and the regional Fed surveys indicate that capital expenditure plans are rolling over, even if they remain at a fairly high level (Chart 12). Our base case remains that investment will not fall enough to offset robust consumption and trend-level government spending, but a marked worsening in trade tensions could erode business confidence enough to drag the economy below stall speed. Busted Thesis In our mutual-fund days, we followed one rule without exception. If our thesis for owning a stock was disproved, we got rid of the stock without a backward glance. We no longer manage money, but our clients do, and we try to set a good example, especially in the inevitable instances when things go wrong. We are closing out our agency mREIT recommendation on the ground that we got the rates call underpinning it very wrong. Things went wrong with our agency mortgage REIT recommendation right from the get-go. In retrospect, we should have waited until the FOMC meeting dust settled before putting on a curve-dependent position. We are closing it out now, though, because we recommended the group in anticipation of a steeper yield curve. Given that we think it will take some time for investors to become convinced that a recession is not imminent, and given that mechanical factors may push yields even lower, we do not expect sustained curve steepening for several months. Although we only held it for four weeks, the recommendation left a mark. Through Thursday’s close, our defined subset of agency mREITs lost 11%, while the S&P 500 is down 3.1% and the Barclays High Yield Index is flat. We’re taking our medicine and moving on, but we will take another look at the group when the curve eventually does begin to steepen. Investment Implications Even if recession fears are overblown, as we and a majority of our colleagues believe, it will likely take some time for investors to overcome their concerns. That leads us to believe that equities may be unable to make new highs in the near term, and that Treasury yields have more downside risk than upside risk in the next few months, as rising convexity2 compels investors following asset-liability management strategies to seek out long-maturity bonds. The yield point may sound complex and esoteric, but our Global Fixed Income Strategy team increasingly believes it’s a key to understanding the negative-yield phenomenon and is researching the issue for an upcoming Special Report. Monetary accommodation is not a silver bullet. If the economy has already flipped from expansion to contraction, modest rate cuts parceled out at a deliberate pace will be insufficient to turn things around, and equities and spread product will suffer. If the expansion remains intact, however, rate cuts will help shore up the economy at the margin and quite possibly fuel a new phase of the bull markets in risk assets. Our money is on the latter, and we expect that this bull cycle has one more burst in it that will allow it to sprint to the finish line like the majority of its predecessors. Doug Peta, CFA Chief U.S. Investment Strategist dougp@bcaresearch.com   Footnotes 1 Smialek, Jeanna and Russell, Karl, “Rates Are Falling Again. That May Be Dangerous.” New York Times, August 17, 2019, p. B1. 2 Duration measures a bond’s sensitivity to changes in interest rates. Convexity measures duration’s sensitivity to changes in interest rates, which increases as rates fall. Investors like life insurers and pension funds, who match the duration of their investment portfolios with the duration of their liabilities, are forced to increase the duration of their bond holdings at an increasing rate as interest rates fall.