UK

Highlights After this week’s drama, the Brexit political process remains extremely complex, but the probability of a hard Brexit is still below 10%. No easy compromise will come through as Brexit suffers a fundamental contradiction: balancing the desire to maximize British sovereignty versus minimizing the pain of leaving the common market. While cross-party talks will prove unfruitful, an extension of the Article 50 deadline is very likely. A new referendum is the most probable solution to the current impasse, but it will likely require a new election. The pound is cheap, but volatility will stay elevated. Buying the pound versus the euro on politically induced drawdowns remains the optimal strategy to gain exposure. Long-term GBP/USD calls are also attractive. The dollar cyclical bull market is intact, but the greenback correction is likely to deepen, especially against growth-sensitive currencies, the AUD in particular. Feature Theresa May’s soft Brexit deal has suffered the largest defeat since 1924 for a bill submitted by a sitting government. The proposed EU Withdrawal Agreement was voted down by 432 members of Parliament, including a whopping 118 members of the Conservative Party. This suggests that both hard Brexit and Bremain Tories voted against May. What lies at the heart of this historic collapse? The fundamental problem is that a soft Brexit is incompatible with the principal demand of Brexit voters: Sovereignty. Any relationship entailing continued access to EU institutions and markets will require two elements that reduce sovereignty: Paying an access fee and accepting the acquis communautaire of the EU without having a say in how it is formulated.1   We do not see how this impasse will be overcome. The financial community’s preferred option – that Prime Minister May breaks ranks and appeals to the Labour Party for a super-soft “Norway Plus” option – is a fantasy. First, the Labour Party smells blood and will likely oppose any deal. Second, a Norway Plus option would entail the highest loss of sovereignty imaginable, given that the U.K. would essentially pay full EU membership fees with no ability to influence the regulatory policies that London would have to abide by. There is also a debate as to whether London would be able to constrict immigration from the EU under that option over the long term, a key demand of Brexiters.2  Members of Parliament may also be getting cold feet due to the shifting poll numbers, which have slowly but steadily increased the gap between those who think that Brexit was the right choice and those who think it was the wrong choice to just under double digits (Chart I-1). This gap reveals that the U.K. public is having second thoughts, no doubt influenced by the incoherent process itself, but also by the combination of geopolitical factors that have changed the appeal of “going it alone.” Chart I-1A Serious Case Of Bregret First, the EU is no longer mired in an epic migration crisis, as it was in the months before the referendum (Chart I-2). Second, terrorist attacks committed by home-grown Islamic State adherents have abated in continental Europe, whereas they seemed to be a monthly affair ahead of the June 2016 vote. Third, the U.K.’s main ally, the United States, which is often cited as a key post-Brexit partner, has elected a president who is unpopular in the U.K. (Chart I-3), putting the “special relationship” in doubt. Chart I-2The Refugee Crisis Is Over   Since the fateful referendum in 2016, the world has become less stable. As such, voters in the U.K. are no doubt wondering whether leaving the EU really would entail greater sovereignty – or whether “going it alone” would mean having to take the fait accompli of large powers such as the U.S., China, and Russia – whose values they share even less than those of their fellow Europeans across the Channel. Sovereignty, in other words, does not operate under Newtonian laws, but is rather relative to one’s vantage point.   In short, Brexit cannot be resolved merely with an extension of the negotiating period. Furthermore, our high-conviction view is that even if it were possible to pass the withdrawal agreement today by promising an even softer exit, the process will ultimately fail when, in two- or three-years’ time, Westminster pushes to vote on implementing such an arrangement. Investors should remember that there is another vote waiting after the transition period.  In the meantime, we see the following options as a way to resolve the current impasse (Diagram I-1): Article 50 extension: The EU is on record stating that it would agree to extend the Article 50 deadline, currently set at March 29. The EU can do so with a unanimous vote of the EU Council. If there is one thing that the Euro Area crisis has taught investors, it is that deadlines are set in policy and legislation, not in stone. London can extend Article 50 with a simple legislative act, amending the March 29 deadline set in the EU Withdrawal Act (passed in June 2018). The EU is on record stating that it would be simple to extend the current negotiating period until July, when a new European Parliament (EP) would sit in its first session. Any extension beyond July would require U.K. members of European parliament (MEPs) to sit in the legislative body, as the country would remain part of the EU. This would mean that the U.K. would have to hold EP elections. We think this is a minor technicality. But it would be highly embarrassing for PM May if she had to organize EP elections a few months from now, especially if it galvanized the Bremain movement to turn out en masse and send Europhile MEPs to Strasbourg. The bigger question is what the extra time would accomplish. Given the size of the loss for the government on its Brexit bill, we think that both Labour Party members and Bremain supporters have been emboldened and will hold out for either a new election or a new referendum, or in case of Labour Party members, both.    New referendum: A new referendum would require an Article 50 extension. The rules for referendums are set out in the Political Parties, Elections, And Referendums Act of 2000. Westminster would have to pass legislation, which would then have to be considered by the Electoral Commission. The process would very likely go beyond March. The easiest path to a new referendum is through a Labour Party victory in an early election. For PM May to reverse her longstanding policy and call a new referendum, we would need another round of negotiations to fail. As such, it is difficult to see PM May concede to a second referendum, at least not until late in 2019.   A new election: Even though the January 16 vote of no confidence against the government failed, PM May could decide that she needs an early election. Why would she take this route? Because it could give her a political mandate with which to pursue renewed negotiations with the EU and her version of soft Brexit. Under the terms of the Fixed Term Parliaments Act, May would need two-thirds of all MPs in the House of Commons to approve a new election. Current polls show that the election would be too close to call (Chart I-4). We think May would stand a good chance of renewing her mandate by painting Opposition Leader Jeremy Corbyn as too left-leaning and as indecisive on Brexit. Chart I-4An Election May Not Provide A Clear Answer One option not on the table is another leadership challenge to PM May. She already survived the challenge in December and is therefore safe from a new one for 12 months. These rules could of course be changed or PM May could simply resign, but we do not expect either option. Simply put, a change of leadership in the Conservative Party is unlikely as hard Brexit supporters cannot get a majority of Tory MPs to support them, while soft Brexit MPs continue to support May. Could a no-deal Brexit occur? Technically, yes. According to the EU Withdrawal Act, the U.K. will leave the EU on March 29. As such, with no further legislative acts, the U.K. could “sleepwalk” into a hard Brexit. However, we believe that the probability of this is under 10%. There is not even close to a majority in Westminster for a hard Brexit. We estimate that, at most, only 10% of 650 MPs in the House of Commons favor a hard Brexit. As such, the government would certainly win a large majority for a piece of legislation that extends the deadline. And, according to the European Court of Justice ruling in December, London could stop the Article 50 process unilaterally, without EU approval. If the probability of hard Brexit is below 10%, isn’t the pound a screaming buy at this point? After all, if the probability of a major dislocation in the economic relationship between the U.K. and the continent is so low, it also means the probability that the Bank of England maintains as easy a monetary policy as its current one is minimal. Our low-conviction answer to this question is yes, the pound is indeed attractive. The reason why buying the pound is a low-conviction view is that one of the three alternative scenarios listed above could have mixed implications for the British economy as well as U.K. assets and the pound: A new election that produces a Labour government. Corbyn’s legislative agenda is the most left-leaning that Europe has seen since François Mitterrand. He is also on record stating that he would pursue his own negotiations with Brussels. Corbyn’s government would therefore prolong the uncertainty of Brexit while enacting an ambitious left-wing agenda. Ultimately, he may reverse both of these positions: succumbing to pressure to call a new referendum while moderating his economic policy. However, as was the case with Mitterrand in the early 1980s, it would require a deep market riot to force him to do so, which means that closing one’s eyes and buying the pound at these levels is not for risk-averse investors. Bottom Line: The political battle for Brexit is far from over. The risk of a hard Brexit has receded considerably to a less than 10% probability, but volatility will continue due to the inherent conflict between the desire to maximize British sovereignty and the objective to minimize economic pain. While cross-party talks are unlikely to yield any decisive changes, an extension of the Article 50 deadline is likely. A new referendum is the most probable end game of this saga, but it will probably require a new election. While the pound is an attractive long-term play, GBP pairs will continue to suffer from politically induced volatility. Investment Implications In September, we argued that the geopolitical risk premium in the GBP was too low in the face of the uncertainty ahead. Moreover, we recognized that the pound was cheap on many long-term metrics, limiting its downside potential. As a result, instead of shorting GBP outright, we recommended investors buy GBP-volatility, a view that panned out well for us. We closed this recommendation in mid-November, when Cabinet Ministers McVey, Raab, and Vara resigned from the government. Since that time, GBP volatility has receded as investors have increasingly agreed with our assessment that the probability of a hard Brexit is very low. However, the political reality in London continues to suggest that the GBP will trade in a volatile fashion, even if its long-term attractiveness remains alive. Hence, we continue to recommend investors use dips in the GBP to slowly begin moving capital into sterling. Practically, we have expressed this view by selling EUR/GBP. EUR/GBP trades toward the top end of its historical distribution (Chart I-5) and is likely to sell off violently on any whiff that a resolution of any kind is coming. Furthermore, since British interest rates are higher than in the euro area, investors are paid to wait while shorting this cross. Chart I-5EUR/GBP Is A Coiled Spring The pound is particularly cheap against the U.S. dollar (Chart I-6). As a result, buying GBP/USD offers the most attractive long-term potential. However, the intermediate-term hurdles for this position are greater than those present in selling EUR/GBP. First, long cable offers a negative carry of 1.89%, thus buying GBP/USD means that investors are paying to take on a lot of volatility. Second, our negative intermediate-term outlook for the global economy implies a strong dollar over the coming six to nine months, creating risks for GBP/USD holders while helping the profile of selling EUR/GBP (Chart I-7). Finally, since Brexit risks are weighing on the euro as well as the pound, if a hard Brexit were indeed to materialize, GBP would suffer much deeper losses against the dollar than against the euro. Chart I-6Lot Of Value In Cable   Chart I-7Our Strong Dollar Theme Favors Shorting EUR/GBP To Play Rebounds In Sterling This inherent conflict in GBP/USD between potentially large long-term gains but heightened short-term risk suggests that the best way to play cable is to buy long-term call options on this pair. As Chart I-8 shows, the implied volatility on 2-year GBP/USD options is elevated, but has been much higher in the past. Additionally, the implied volatility on these long-term options is abnormally low relative to that offered by 3-month options (Chart I-8, bottom panel), suggesting they are comparatively cheap. Thus, since the long-term outlook for cable is much more attractive than the short-term one, favoring long-term options as a vehicle to gain exposure to GBP/USD makes sense. It is a risky bet only deserving of a small portfolio allocation. Chart I-8Long-Term Call Options On Cable Are Attractive Bottom Line: Only investors with either long-term horizons or a deep capacity to handle volatility should begin garnering some exposure to the pound. Selling EUR/GBP when the pound weakens in response to political shocks remains the best vehicle to do so. While buying cable offers more attractive long-term potential returns than selling EUR/GBP, it is a riskier bet over a six- to nine-month horizon. Nonetheless, investors wanting to get some pound exposure via buying GBP/USD should allocate funds to 2-year GBP/USD call options. Short-Term Risks For The Greenback As we argued last week, continued downside in global growth as well as U.S. interest rate markets having already priced in a year-long pause by the Fed together point to continued upside for the dollar. However, we also highlighted that the dollar currently possesses significant tactical downside, especially against commodity currencies. Five reasons underpin our cautious tactically view: First, the dollar is currently over-owned. Both net speculative positions in the dollar and sentiment toward the DXY are near bullish extremes (Chart I-9). The dollar is a momentum currency, hence the progressive deterioration in our favored momentum signal for the greenback – the crossover of the one-month and six-month moving averages – suggests that the dollar could soon experience a momentum-induced liquidation. Chart I-9If Our Dollar Momentum Signal Turns Negative, There Is No Shortage Of USD Sellers Second, the most recent BAML Investor survey not only showed that investors are more pessimistic on global growth than at any point in the past decade, but also that a trade war was highest on the list of concerns. Today, the probability of a truce in Sino-U.S. trade relations is growing. A declining trade-war risk should temporarily support assets levered to global growth and hurt the defensive U.S. dollar. Moreover, a consequence of the warm-up between Beijing and Washington has been a weakening USD/CNY. Historically, a strengthening RMB is associated with rebounding commodity currencies (Chart I-10). Chart I-10A Strong CNY Points To Stronger Commodity Currencies Third, global growth could also temporarily positively surprise beaten-down expectations. Today, the highly mean-reverting Citi Economic Surprise Index is very stretched to the downside, suggesting scope for a reversal (Chart I-11). With Chinese fiscal stimulus building up, and the recent pick-up in the six-month Chinese credit impulse, a temporary bout of positive economic surprises is a growing risk for dollar bulls. Chart I-11There Is Scope For Economic Surprises To Rebound Fourth, our China Investment Strategy service’s Market-Based China Growth Indicator has rebounded (Chart I-12). This further reinforces the risk that global growth could positively surprise abysmal expectations. Chart I-12Markets Signalling A Pause In The Economic Slowdown Fifth, gold prices have rebounded significantly, implying an improvement in the global liquidity backdrop (Chart I-13). Since tightening global liquidity was a contributor to the deterioration in non-U.S. growth, rebounding gold prices also confirm that the slowdown in international economic activity may take a breather. Chart I-13Gold As A Liquidity Gauge Altogether, these five factors suggest that the corrective episode in the countercyclical dollar may deepen. Because Chinese reflation and a truce in Sino-U.S. tensions lie at the crux of the potential for positive economic surprises, the growth-sensitive currencies like the AUD, the CAD and EM currencies should outperform, especially vis-à-vis the yen. In this environment, Scandinavian currencies should also rise versus the euro. EUR/CHF is set to benefit from this backdrop. For the time being, we continue to view any weakness in the dollar as a correction, not the end of the bull market. Ultimately, the respite in the Chinese economy is likely to prove transitory. The six-month credit impulse is improving, but the 12-month credit impulse is not, even when fiscal stimulus is taken into account (Chart I-14). Since the noise-to-signal ratio is much greater in the six-month impulse than in the 12-month one, we believe that only once the longer-term credit impulse rebounds will Chinese economic activity form a durable bottom. Moreover, Chinese exports are beginning to suffer from a payback period after having been artificially supported by front-running ahead of the trade sanctions. As things stand today, the recent weakness in Chinese export growth looks set to worsen (Chart I-15). This will cause yet another shock to Chinese growth, one likely to percolate to domestic demand. Once it does, global industrial activity should soften again, creating a strong support for the dollar. Chart I-14China's 12-Month Credit Impulse Doesn't Point To An Imminent Economic Turnaround... Chart I-15 ...And Exports Are Set To Become A Significant Drag Bottom Line: Cyclically, fundamentals remain supportive for the greenback. However, the tactical picture shows that the dollar should correct further, especially against growth-sensitive currencies like the AUD, which could rally to 0.75. This view is because the dollar’s momentum is deteriorating sharply, the yuan is rising on the back of a growing likelihood of a trade truce, global economic surprises have room to brighten, China is implementing some reflationary efforts, and global liquidity is improving at the margin.   Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com   Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Footnotes 1 The acquis communautaire refers to the collection of accumulated legislation, legal acts, and judicial decisions that constitute the body of the EU law. 2 Proponents of the Norway Plus option point out that Article 112(1) of the European Economic Area (EEA) Agreement allows for restriction of movement of people within the area. However, these restrictions are intended to be used in times of “serious economic, societal or environmental difficulties.” It certainly appears to be an option for London to restrict EU migration, but it is not clear whether Europe would agree for this to be a permanent solution. Liechtenstein has been using Article 112 to impose quantitative limitations on immigration for decades, but that is because its tiny geographical area is recognized as a “specific situation” that justifies such restrictions. Currencies U.S. Dollar Chart II-1USD Technicals 1 Chart II-2USD Technicals 2 Recent data in the U.S. has been mixed: Core inflation came in line with expectations at 2.2%. Meanwhile, initial jobless claims outperformed expectations, coming it at 216 thousand. Finally, the ISM Non-manufacturing survey also surprised negatively, coming in at 57.6. DXY has been flat since the beginning of the year. After falling through the end of 2018 and the start of 2019, the dollar has staged a small recovery, managing to be flat year to date. We believe that while the greenback could experience tactical weaknesses in the coming three months, our cyclical outlook for the dollar remains positive. After all, the Fed will be able to deliver more hikes than the markets currently anticipates, and global growth remains soggy. Report Links: So Donald Trump Cares About Stocks, Eh? - January 9, 2019 Waiting For A Real Deal - December 7, 2018 2019 Key Views: The Xs And The Currency Market - December 7, 2018 The Euro Chart II-3EUR Technicals 1 Chart II-4EUR Technicals 2 Recent data in the euro are has been negative: Industrial production yearly growth surprised negatively, coming in at a 3.3% contraction. Moreover, headline inflation also underperformed expectations, coming in at 1.6%. Finally, the Markit Composite PMI also surprised to the downside, coming in at 51.1. EUR/USD has been flat since the beginning of the year. We are positive on EUR/USD on a tactical basis, given that China could be experiencing a temporary rebound, and given that the fall in the dollar and bond yields at the end of 2018 improved financial conditions around the world. These factors should be positive for the euro over the next 3-months. Report Links: 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Six Questions From The Road - November 16, 2018 Evaluating The ECB’s Options In December - November 6, 2018 The Yen Chart II-5JPY Technicals 1 Chart II-6JPY Technicals 2 Recent data in Japan has been mixed: Domestic Goods prices yearly growth underperformed expectations, coming in at a 1.5%. Moreover, overall household spending also underperformed expectations, coming in at a 0.6% contraction. However, bank lending yearly growth outperformed expectations, coming in at 2.4%. USD/JPY has fell at the beginning of the year but then managed to recover a bit. We are bearish on the yen on a tactical basis, given that the easing of financial conditions that started in late 2018 should continue to help risk assets. Consequently, safe havens like the yen should remain under pressure on a 3-month horizon. Report Links: Yen Fireworks - January 4, 2019 2019 Key Views: The Xs And The Currency Market - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 British Pound Chart II-7GBP Technicals 1 Chart II-8GBP Technicals 2 Recent data in the U.K. has been mixed: Core inflation came in above expectations, coming in at 1.9%. However, industrial production surprised negatively, coming in at a 1.5% contraction. Finally, retail price growth also surprised to the downside, coming in at 2.7%. GBP/USD has risen by 2% since the beginning of the year. The low probability of a hard Brexit will support the pound, however, as the British political situation remain extremely fluid, GBP will continue to experience elevated volatility. Nonetheless, we believe that the best vehicle to play the strength in the pound is to short EUR/GBP. This cross is now trading at the upper range of its historical distribution, and therefore, any good news coming out of Britain could make it sell off violently. Report Links: Six Questions From The Road - November 16, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Australian Dollar Chart II-9AUD Technicals 1 Chart II-10AUD Technicals 2 Recent data in Australia has been mixed: Retail sales month-on-month growth outperformed expectations, coming in at 0.4%. However, the trade balance for November also surprised negatively, coming in at 1.925 million. Finally, building permits month-on-month growth also surprised to the downside, coming in at -9.1%. AUD/USD has risen by 2.6% since the beginning of the year. We are positive on the AUD on a tactical basis, given that the current fall in the dollar and yields have eased monetary conditions and have provided a reflationary force helping risk assets. Moreover, the warming in Sino-U.S. relations and the recent strength in the yuan is adding another tailwind behind growth sensitive currencies like the Aussie. That being said, we are still bearish on the AUD on a cyclical timeframe, as the dual forces of Chinese deleveraging and Fed tightening should resume later this year. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Policy Divergences Are Still The Name Of The Game - August 14, 2018 New Zealand Dollar Chart II-11NZD Technicals 1 Chart II-12NZD Technicals 2 Recent data in New Zealand has been negative: Gross domestic product yearly growth came in below expectations, coming in at 2.6%. Moreover, electronic card retail sales month on month growth declined further from last month to -2.3%. NZD/USD has risen by 1.1% since the beginning of the year. While we are positive on the kiwi on a 3-month basis, as Chinese growth has started to rebound temporarily and global financial conditions have eased, we nonetheless prefer the AUD to the kiwi over this timeframe. That being said, the NZD will most likely depreciate against the dollar on a cyclical timeframe, as both the Fed and China reinitiate their tightening campaigns. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 In Fall, Leaves Turn Red, The Dollar Turns Green - October 12, 2018 Canadian Dollar Chart II-13CAD Technicals 1 Chart II-14CAD Technicals 2 Recent data in Canada has been positive: Seasonally adjusted housing starts growth came in above expectations, coming in at 213 thousand. Moreover, the unemployment rate surprised positively, coming in at 5.6%. Finally, the net change in employment also surprised to the upside, coming in at 9.3 thousand. USD/CAD has plunged by 2.5% since the beginning of the year. We are bullish on the CAD on a tactical basis, as oil prices should continue to rise on the back of tighter supply from OPEC. Moreover, the fall in yields which had led to easier financial conditions should continue to put upward pressure on commodity currencies like the Canadian dollar, a currency that very much enjoy falling risk-asset volatility. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Swiss Franc Chart II-15CHF Technicals 1 Chart II-16CHF Technicals 2 Recent data in Switzerland has been mixed: Headline inflation underperformed expectations, coming in at 0.7%. Moreover, the KOF leading indicator also surprised to the downside, coming in at 96.3. However, the SVME Purchasing Manager’s Index outperformed expectations, coming in at 57.8. EUR/CHF has risen 0.5% since the beginning of the year. We are bullish on EUR/CHF as global financial conditions are easing. Moreover, disappointing Swiss inflation and economic data highlight that the SNB remain unable to achieve its target. To achieve growing prices, Switzerland will need a weaker currency. Therefore, the SNB will pull all the necessary levers to put a natural floor under this cross. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Norwegian Krone Chart II-17NOK Technicals 1 Chart II-18NOK Technicals 2 Recent data in Norway has been positive: Headline inflation outperformed expectations, coming in at 3.5%. Moreover, core inflation also surprised positively, coming in at 2.1%. Finally, retail sales growth also surprised to the upside, coming in at 0.9%. USD/NOK has fallen by 1.3% since the beginning of the year. We are bearish on USD/NOK on a tactical time horizon, as global financial conditions are easing while oil prices are also rising. Report Links: Waiting For A Real Deal - December 7, 2018 Updating Our Intermediate Timing Models - November 2, 2018 Clashing Forces: The Fed And EM Financial Conditions - October 19, 2018 Swedish Krona Chart II-19SEK Technicals 1 Chart II-20SEK Technicals 2 Recent data in Sweden has been mixed: Consumer confidence underperformed expectations, coming in at 96.4. However, retail sales month-on-month growth outperformed expectations, coming in at 0.8%. Finally, headline inflation came in line with expectations, coming in at 2%. USD/SEK has risen by 1.6% since the beginning of the year. On a long-term basis, we like the SEK. Not only is the krona exceptionally cheap, but also, strong inflationary pressures in Sweden should eventually force the Riksbank to tighten monetary policy. Despite these structural positives for the SEK, the cyclical outlook is much more tenuous as this currency historically responds most poorly among G10 currencies to dollar strength. Report Links: Updating Our Intermediate Timing Models - November 2, 2018 Updating Our Long-Term FX Fair Value Models - June 22, 2018 Updating Our Intermediate Timing Models - May 18, 2018 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights The U.S. economy is slowing in a completely predictable manner. With inflationary pressures largely dormant, the Fed can afford to stay on hold for the next few FOMC meetings. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. A bearish stance towards U.S. Treasurys is warranted over a 12-month horizon. As long as the Fed is hiking rates in response to above-trend GDP growth rather than accelerating inflation, risk assets will fare well. Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Brexit fears are overdone. Stay long the pound versus the euro. We were stopped out of our short AUD/JPY trade for a gain of 10%. Feature A Predictable Slowdown Investors are misunderstanding the nature of the current slowdown in the United States and much of the world. Completely predictable slowdowns, such as this one, rarely morph into recessions. Real U.S. GDP rose at a blistering 3.8% average annualized pace in Q2 and Q3 of 2018. There is no way that sort of growth rate could have been sustained. Financial conditions also tightened sharply in Q4, which has inevitably weighed on growth. Given the stock market rout, it is actually surprising that the economy has not weakened more than it has. The New York Fed GDP Nowcast points to growth of 2.5% in Q4 of 2018 and 2.1% in Q1 of 2019. This is still above the Fed’s long-term estimate of potential GDP growth of 1.9%. Most of the slowdown has been concentrated in the manufacturing sector, but even there, the bloodletting may be ending. The latest Philadelphia Fed survey — arguably the most important of the regional Fed manufacturing reports — showed an uptick in activity, with the new orders component hitting the highest level since last July. Despite the tightening in financial conditions, bank lending to the business sector has accelerated over the past three months (Chart 1). The Conference Board’s Leading Credit Index remains in expansionary territory (Chart 2). While business capex intention surveys have come off their highs, they still point to robust spending plans over the next few quarters (Chart 3). Chart 1Credit Is Still Flowing To U.S. Businesses Chart 2Little Sign Of A Looming Credit Crunch Chart 3Capex Plans Still Solid The labor market remains healthy, as evidenced by ongoing strong payroll growth and low initial unemployment claims. Faster wage growth is boosting consumer spending. Holiday sales rose by 5.1% from a year earlier according to the Mastercard SpendingPulse report, the fastest growth in six years. The Redbook same-store index tells a similar story (Chart 4). Chart 4Same-Store Sales Are Robust The housing market struggled for much of 2018, but the recent stabilization in mortgage rates should help matters (Chart 5). Notably, mortgage applications for purchase have surged to their highest levels since 2010 (Chart 6). Homebuilder confidence improved in January, mirroring the rally in homebuilder shares (Chart 7). We are long homebuilders versus the S&P 500, a trade that is up 5.3% since we recommended it on November 1, 2018. Chart 5aThe U.S. Housing Sector Will Stabilize (I) Chart 5BThe U.S. Housing Sector Will Stabilize (II) Chart 6A Positive Signal For U.S. Housing Chart 7U.S. Homebuilder Stocks Have Been Outperforming Recently U.S. Government Shutdown: A Near-Term Hit To Growth The government shutdown poses a near-term risk to the U.S. economy. If it lasts until the end of March, it will shave about 1.7% off Q1 GDP based on White House estimates. While this represents a potentially significant hit to the economy, the effect is likely to be completely reversed once the shutdown ends. Moreover, the drag to growth from the shutdown pales in comparison to the overall stance of fiscal policy. According to the IMF, the cyclically-adjusted budget deficit is set to reach 5.7% of GDP this year, up from 3.2% of GDP in 2015. There is also a reasonable chance that any deal to end the shutdown will involve a commitment to increase spending beyond currently budgeted levels. This would increase the overall amount of fiscal stimulus the economy is receiving. Taking The Pulse Of Global Growth The slowdown in growth has been deeper and more protracted outside the United States. Nevertheless, rays of sunshine are emerging. Our global Leading Economic Indicator diffusion index, which measures the proportion of countries with rising LEIs compared to those with falling LEIs, has bottomed. The diffusion index leads the global LEI by a few months (Chart 8). Chart 8The Uptick In The LEI Diffusion Index Suggests Global Growth Could Stabilize As is increasingly the case, the fate of the Chinese economy will be critical in determining when global growth begins to reaccelerate. The latest Chinese activity data has been disappointing, with this week’s downright awful export figures being the latest example. That said, credit growth may be starting to stabilize, as evidenced by stronger-than-expected loan growth for December. With credit growth now running only slightly above nominal GDP growth, the need for the authorities to maintain their deleveraging campaign has diminished. In an encouraging sign, the Market-Based China Growth Indicator developed by our China Investment Strategy service has been moving higher (Chart 9). Chart 9Encouraging Sign For The Chinese Economy A revival in Chinese growth would aid trade-sensitive economies such as Japan and Germany. The former saw a decline in economic momentum in the second half of 2018, exacerbated by typhoons and an earthquake in Hokkaido. With the consumption tax set to increase from 8% to 10% in October, the Bank of Japan will need to maintain its yield curve control regime at least until 2020. This could weigh on the yen. With that in mind, we tightened the stop on our short AUD/JPY trade two weeks ago and subsequently exited the position with a gain of 10%. The German economy has taken it on the chin recently. Real GDP contracted in the third quarter and barely grew in the fourth quarter. The economy should rebound in 2019 as external demand improves. The drag on growth from the decline in automobile assemblies following the introduction of new emission standards should also turn into a modest tailwind as production resumes. In addition, fiscal policy is set to turn more stimulative, while robust wage growth, lower oil prices, and rising home prices should support consumption. Elsewhere in Europe, the Italian economy should recover as bond yields come down from their highs and confidence improves following the resolution of the impasse with the EU over budget targets. The modest easing in Italy’s fiscal policy of about 0.5% of GDP in 2019 should also benefit growth. It is too early to quantify the effect on the French economy from the “yellow vest” protests. France is no stranger to protests of this sort, so our guess is that the impact on the economy will be minimal. President Macron’s pledge to loosen fiscal policy in hopes of placating the protestors should also support demand. Brexit: A “No Deal” Outcome Looks Less Likely The Brexit saga could end in one of three ways: 1) A “no deal” where the U.K. leaves the EU with no alternative in place; 2) A “soft Brexit” involving an agreement to form a permanent customs union or some sort of “Norway plus” arrangement; 3) A decision to reverse the results of the original referendum and stay in the EU. In thinking about which of these three outcomes is most likely, one should keep the following in mind: Any course of action that the U.K. takes must have the support of the British parliament. A no deal outcome does not have parliament’s support. Not even close. Thus, it will not happen. This leaves options 2 and 3. This publication has argued since the day after the Brexit vote that the European establishment, following the example of the Irish and Danish referendums over various EU treaties, will keep insisting on do-overs until it gets the result it wants. If one referendum is good, two is even better – it’s twice as much democracy! The betting markets seem to be coming around to our view. As we go to press, PredictIt shows a one-in-three chance that a new referendum will be called by March 31 (Chart 10). Polling trends suggest that if another referendum were held, the remain side would probably prevail (Chart 11). Chart 11U.K.: A Change Of Heart? In some sense though, it does not matter for investors whether the original referendum is reversed or a soft-Brexit deal is reached. Either outcome would be welcomed by markets. We continue to advocate buying GBP/EUR. My colleague Dhaval Joshi, BCA’s Chief European strategist, also recommends that equity investors purchase the FTSE 250 index, which comprises from the 101st to the 350th largest companies listed on the London Stock Exchange. Unlike its large-cap counterpart, the FTSE 100, the FTSE 250 index is more geared to what happens in the U.K. than in the rest of the world. Investment Conclusions Global inflation remains subdued, which gives central banks the luxury of taking a wait-and-see approach to tightening monetary policy. Growth in the U.S. and the rest of the world should stabilize by mid-year. This will enable the Fed to resume raising rates in June. Given that the market is no longer pricing in any Fed hikes, a bearish stance towards U.S. Treasurys is warranted over a 12-month horizon (Chart 12). Outside of Japan, bond yields will also rise in the major developed economies. Chart 12Treasurys Will Underperform If The Fed Hikes Rates By More Than Expected We downgraded global equities in June as our leading indicators began to point to slower growth ahead, but upgraded them back to overweight after stocks plunged following the December FOMC meeting. The rally over the past three weeks has reversed deeply oversold conditions and our tactical MacroQuant model is once again flagging some near-term risk to stocks. Nevertheless, if the global economy avoids a recession this year, as we expect, equities should fare well over a 12-month horizon. The MSCI All-Country World index is trading at a modest 13.6-times forward earnings (Chart 13). Profit estimates have been revised down meaningfully, suggesting that the bar for upward earnings surprises is now quite low. Chart 13A Lot Of Bad News Already Discounted? Risk assets can tolerate higher rates as long as tighter monetary policy is the result of stronger growth. What risk assets cannot withstand is a stagflationary environment where growth is slowing but the Fed is hiking rates in order to bring down inflation. That is not the situation today, but could be the situation next year. Bottom line: Investors should overweight global equities and spread product for now, but monitor inflation trends closely for signs of when to get out. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights Buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit. For equity investors the best play is a FTSE Small Company Index ETF and/or U.K. REITS. Beaten-down banks, industrials and materials can continue their recent countertrend outperformances. This necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Go overweight industrials versus utilities as a tactical trade. Feature Chart of the WeekWere It Not For Brexit, U.K. Interest Rates Would be 1 Percent Higher Please join me for a webcast today at 10.00 AM EST (3.00 PM GMT, 4.00 PM CET, 11.00 PM HKT) when I will be elaborating on some of the ideas in this report as well as other major investment themes. For those of you who cannot participate live, the webcast will also be available as a playback. Were it not for the psychodrama called Brexit, the pound would be trading at $1.50 rather than at $1.28. We can say this with utmost confidence because ‘cable’ is very closely tracking the difference in 2-year interest rates in the U.K. versus the U.S. Absent the Brexit shenanigans, U.K. interest rates would be around 1 percent closer to those in the U.S., implying that pound/dollar would be around 15 percent higher ( Chart I-2 and Chart I-3 ). Chart I-2Absent The Brexit Discount On U.K. Interest Rates... Chart I-3...The Pound Would Be At $1.50 Explaining Brexit’s Impact On U.K. Interest Rates And The Pound The difference in U.K. versus U.S. interest rates usually tracks the difference in their inflation rates, in effect equalizing real interest rates in the two economies. But the Brexit referendum in 2016 forced the Bank of England into an ‘emergency monetary policy’ mode, whereby interest rates were left depressed relative to the inflation fundamentals, and U.K. real interest rates collapsed. Applying the BoE’s pre-Brexit reaction function to the current inflation dynamics, U.K. interest rates – and therefore the pound – would be in a completely different ballpark. After all, U.K. and U.S. core inflation rates and unemployment rates are virtually identical ( Chart of the Week  ). It follows that the pound’s trajectory will be higher in any negotiated Brexit – or indeed ‘no Brexit’ – which avoids a complete and overnight no-deal divorce. The simple reason is that a transition period lasting several years that continues to give the U.K. access to the EU single market will allow the BoE to revert to its pre-Brexit monetary policy reaction function. But any workable alternative to a no-deal Brexit must satisfy two conditions: the way forward must be acceptable to the EU27; and it must command a majority in the U.K. parliament. From the perspective of investors, what this way forward turns out to be – Common Market 2.0, permanent customs union, second referendum, or general election – does not really matter. What matters is that a parliamentary majority exists for a course of action that avoids no-deal. The investment strategy is to buy the pound as soon as the U.K. parliament coalesces a majority around an action plan to counter a no-deal Brexit . In this event, do not buy the FTSE100. Whenever the pound strengthens, the weaker translation of the FTSE100 companies’ dollar-denominated earnings tends to weigh down this large-cap index. A better play is the FTSE250 mid-cap index ( Chart I-4 ), but for equity investors t he best play is a FTSE Small Company Index ETF and/or U.K. REITS ( Chart I-5 ). Chart I-4A Negotiated Brexit Would Favour The FTSE250... Chart I-5...And U.K. Small Companies Europeans Are Celebrating Lower Oil Europeans will be celebrating the near halving of the crude oil price from its $86 high just three months ago. The simple reason is that Europeans are net importers of energy, and the amount of energy they consume tends to be price inelastic. After all, Europeans have to do the school run and stay warm in winter, irrespective of the oil price. Hence, when energy prices soar as they did for most of 2018, it squeezes European real spending. Conversely, when energy prices plunge as they have more recently, it boosts real spending ( Chart I-6 ). A second transmission mechanism is via credit creation: higher inflation, through its implication for tighter monetary policy, lifts bond yields and depresses credit impulses; lower inflation does the opposite, it depresses bond yields and lifts credit impulses. The upshot is that higher oil weighed on European growth in 2018 while lower oil should boost growth in early 2019. Chart I-6Inflation Is Likely To Plunge, Boosting Real Incomes Compelling proof comes from the oscillations in the euro area economy. For several years, these growth oscillations have perfectly and inversely tracked oscillations in the oil price ( Chart I-7 ). The economic implication is that the recent collapse in energy prices should engineer some sort of growth rebound in the euro area. The investment implication is that such a growth rebound will support the classically cyclical equity sectors – banks, industrials and materials – because of their very high operational leverage to economic growth. Chart I-7Euro Area Growth Oscillations Inversely Track Oil Price Oscillations Profit is a small number created from the difference between two large numbers: sales minus the cost of generating those sales. But the dominant cost – the wage bill – tends to be quite sticky. Hence, if a company’s sales are highly sensitive to the economy, the power of operational leverage means that a small change in GDP can have a dramatically large proportional impact on profit. This is a simple principle, but it turns out to be an excellent explanation for the Eurostoxx50 earnings per share (eps) cycle. Because the index is dominated by the classically economic-sensitive sectors, Eurostoxx50 eps growth has a very high operational leverage to changes in euro area GDP growth, potentially as high as 50 times over short periods such as six months ( Chart I-8 ). In contrast the less cyclical S&P500 has an operational leverage to economic growth of less than 10 ( Chart I-9 ). Chart I-8Eurostoxx50 Profits Growth Is Highly Geared To Economic Growth Chart I-9S&P500 Profits Growth Is Less Geared To Economic Growth On the expectation that euro area growth will rebound modestly in early 2019, the beaten-down banks, industrials and materials can continue their recent countertrend outperformances. And this necessarily means that the cyclical-heavy Eurostoxx50 can continue its recent countertrend outperformance versus the S&P500. Explaining The ‘Unexplainable’ Moves In Markets During the recent Christmas holiday period, financial markets experienced sharp moves with no explainable catalyst. Such reversals leave many strategists and analysts scratching their heads in bewilderment, wondering: what was the catalyst for that reversal? The answer is there was no fundamental catalyst; the market reversed because liquidity dried up . But to explain why liquidity dried up and markets ‘unexplainably’ reversed, we first need to understand what creates market liquidity in the first place. Market liquidity is the ability to convert cash into an investment quickly and in volume without affecting its price. But for an investor to convert a large amount of cash into an investment without affecting its price, another investor must be willing to do the exact opposite – convert a large amount of the investment into cash at the given price. Therefore, market liquidity comes from a disagreement about the attractiveness of an investment at that given price. Investors disagree about the attractiveness of an investment at a given price because investors with different time horizons interpret the same facts and information very differently. Hence, a market remains stable when it possesses investors with many different time horizons. The reason is that when a day-trader experiences a ‘six-sigma’ price move, an investor with a longer investment horizon, for example 65 days, will step in and stabilize the market. The longer-term investor will do so because, within his investment horizon, the day-trader’s six-sigma price move is not unusual. As long as another investor has a longer trading horizon than the investor experiencing an extreme event, the market will stabilize itself. Therefore, the market’s liquidity and stability are maximized when its participants possess a variation of investment horizons, say, both the 1 day horizon and the 65 day horizon. The corollary is that the market’s liquidity and stability disappear when its participants no longer possesses this healthy variation in horizons. In technical terms, this occurs when the market’s 65-day fractal dimension collapses to its lower bound. Without a shadow of a doubt, this is what happened to the S&P500 on Christmas Eve and triggered a 5 percent market rebound on Boxing Day ( Chart I-10 ). And this is now what is happening to the relative performance of industrials versus utilities, which is also in the process of a similar liquidity-triggered rebound ( Chart I-11 ). Chart I-10A Liquidity Shortage Triggered A Sharp Rebound In The S&P500   Chart I-11Expect A Liquidity-Triggered Rebound In Industrials Versus Utilities   Fractal Trading System* This week we note that the strong rally in the Indian rupee versus the Pakistan rupee has reached a point where an imminent liquidity shortage could trigger a countertrend move. Go short the Indian rupee versus the Pakistan rupee with a profit target of 3 percent, and a symmetrical stop-loss. For any investment, excessive trend following and groupthink can reach a natural point of instability, at which point the established trend is highly likely to break down with or without an external catalyst. An early warning sign is the investment’s fractal dimension approaching its natural lower bound. Encouragingly, this trigger has consistently identified countertrend moves of various magnitudes across all asset classes. Chart I-12 The post-June 9, 2016 fractal trading model rules are: When the fractal dimension approaches the lower limit after an investment has been in an established trend it is a potential trigger for a liquidity-triggered trend reversal. Therefore, open a countertrend position. The profit target is a one-third reversal of the preceding 13-week move. Apply a symmetrical stop-loss. Close the position at the profit target or stop-loss. Otherwise close the position after 13 weeks. Use the position size multiple to control risk. The position size will be smaller for more risky positions. * For more details please see the European Investment Strategy Special Report “Fractals, Liquidity & A Trading Model,” dated December 11, 2014, available at eis.bcaresearch.com   Dhaval Joshi , Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com Fractal Trading System Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1Indicators To Watch - Bond Yields Chart II-2Indicators To Watch - Bond Yields Chart II-3Indicators To Watch - Bond Yields Chart II-4Indicators To Watch - Bond Yields Interest Rate Chart II-5Indicators To Watch - Interest Rate Expectations Chart II-6Indicators To Watch - Interest Rate Expectations Chart II-7Indicators To Watch - Interest Rate Expectations Chart II-8Indicators To Watch - Interest Rate Expectations  

Bank Credit Analyst

Highlights Investors ran for cover in December as they succumbed to a litany of worries regarding the outlook. The key question is whether the pessimism is overdone or an extended equity bear market is underway. Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. There are some tentative signs that the two U.S. weak spots, housing and capital spending, are bottoming out. However, our global leading economic indicators continue to herald a soft first half of 2019 outside of the U.S. The dollar thus has more upside in the near term. The political risks facing investors have not diminished either. In particular, we expect turbulence related to the U.S./China trade war to extend well beyond the 3-month “truce” period. The returns to stocks, corporate bonds and commodities historically have not been particularly attractive on average when the U.S. yield curve is this flat. Nonetheless, the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies back to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. The upgrade to stocks in the developed markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now, but be prepared to upgrade sometime in 2019. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil prices have overshot to the downside. Supply is adjusting and, given robust energy demand in 2019, we still expect prices to rise to $82. Feature Investors ran for cover in December as they succumbed to concerns regarding the U.S./China trade war, corporate leverage, global growth, rising U.S. interest rates and the shift toward quantitative tightening. Some equity indexes, such as the Russell 2000, reached bear market territory, having lost more than 20%. Losses have been even worse outside the U.S. Earnings revisions have plunged into the “net downgrade” zone. Implied volatility has spiked and corporate bond spreads are surging (Chart I-1). The key question is whether the pessimism is overdone or an extended equity bear market is underway. Chart I-1A Flight To Quality We laid out our economic view in detail in the BCA Outlook 2019 report, published in late November. Not enough has changed on the global economic front in the three weeks since then that would justify such a violent shift in investor sentiment. That said, our favorite global leading economic indicators continue to erode (Chart I-2). The only ray of hope is that the diffusion index constructed from our Global Leading Economic Indicator appears to have bottomed. Nonetheless, the actual LEI will keep falling until the diffusion index shifts into positive territory.   Chart I-2Global Leading Indicators Still Weak For China, a key source of investor angst, the latest retail sales and industrial production reports reinforced that economic momentum continues to recede. We will not be convinced that growth is bottoming until we see an upturn in our credit impulse indicator (Chart I-3). Its continued decline in November suggests that the outlook for emerging market assets and commodity prices is poor for at least the next quarter. Global industrial output appears headed for a mild contraction. The manufacturing troubles are centered in the emerging Asian economies, but Europe and Japan are also feeling the negative effects. Chart I-3China: No Bottom Yet In the U.S., November’s bounce in housing starts and permits is a hopeful sign that the soft patch in this sector is ending. However, it is not clear how the devastating wildfires on the west coast have affected the housing data (Chart I-4). The downdraft in capital goods orders may also be drawing to a close, based on the latest reading from the Fed’s survey of capital spending intentions. The U.S. leading economic indicator dipped slightly in November, but remains consistent with above-trend real GDP growth in the months ahead. Chart I-4U.S.: Some Hopeful Signs The bottom line is that our outlook for growth has not been significantly altered. We see little risk of a U.S. recession in 2019. The global economy continues to weaken, but we expect enough policy stimulus out of China to stabilize growth in that economy in the second half of the year. We highlighted in the BCA Outlook 2019 that, while the risks appeared elevated, we would consider shifting back to overweight in stocks if they cheapened sufficiently. Valuation has indeed improved in recent weeks and sentiment has turned more cautious. Global growth will likely continue to decelerate in the first half of 2019, but markets have largely discounted this outcome. In other words, the shift toward pessimism in financial markets appears overdone. The fact that the Fed has signaled a move away from regular quarter-point rate hikes adds to our confidence in playing what will likely be the last upleg in risk assets in this cycle. Fed: Rate Hikes No Longer On Autopilot The Fed lifted rates by a quarter point in December and signaled that any additional tightening will be data-dependent. The FOMC also trimmed the expected peak in the funds rate and its estimate of the long-run, or neutral, level. Policymakers were likely swayed by some disappointing U.S. economic data, the pullback in core PCE inflation, and the sharp tightening in financial conditions (Chart I-5). Chart I-5Financial Conditions Have Tightened Monetary conditions are not tight by historical yardsticks, such as the level of real interest rates. The problem is that investors fear that the neutral level of the fed funds rate, the so-called R-star, remains very depressed. If true, it could mean that the Fed is already outright restrictive, which would signal that the monetary backdrop has turned hostile for risk assets. The OIS curve signals that the consensus believes that the Fed is pretty much done the tightening cycle (Chart I-6) Chart I-6Investors Believe The Fed Is Done! We believe that R-star is higher than the current policy setting and is rising, as the growth headwinds related to the Great Financial Crisis fade with the passage of time. The problem is that nobody knows the level of the neutral rate. Thus, we need to watch for signs that the fed funds rate has surpassed that level, such as an inverted yield curve. The 10-year/3-month T-bill spread is still in positive territory, but barely so. Meanwhile, our R-star indicator is also flashing yellow as it sits on the zero line (Chart I-7). It is a composite of monetary indicators that in the past have been useful in signaling that monetary policy had become outright restrictive, leading to slower growth and trouble for risk assets. The lead time of this indicator relative to economic activity and risk asset prices has been quite variable historically, but a breakdown below zero would send a powerful bearish signal for risk assets if confirmed by an inverted yield curve. Chart I-7Worrying Signs Of Tight Money The Implications Of Four Fed Scenarios It is not surprising that investors are struggling with a number of different possible scenarios on how the R-star/Fed policy nexus will play out. We can perhaps boil down discussion of the Fed and the implications for financial markets to a matrix of four main outcomes, based on combinations related to the level of R-Star (high or low) and the pace of Fed rate hikes in 2019 (pause or continue increasing rates by 25 basis points per quarter). Policy Mistake #1: R-star is still very low, but policymakers do not realize this and the FOMC continues to tighten into restrictive territory in 2019. By definition, the economy begins to suffer in this scenario, inflation and inflation expectations decline and long-bond yields are flat-to-lower. The yield curve inverts. However, current real rates are still so low that the fed funds rate cannot be very far above R-Star, which means it would represent only a small policy mistake. As long as the Fed recognizes the economic slowdown early enough and truncates the rate hike cycle, then there is a good chance that a recession would be avoided. Investors would initially fear a recession, however, which means that risk assets would be hit hard in absolute terms and relative to bonds and cash until recession fears fade. The direction of the dollar is perhaps trickiest part because there are so many potential cross currents. To keep things simple we will assume that global growth follows our base-case view and remains lackluster in the first half of 2019, followed by a modest re-acceleration. We believe the dollar would likely rally a little as the Fed continues tightening, but then would fall back as the FOMC is forced to turn dovish in the face of a U.S. growth scare. Policy Mistake #2: R-Star is high and rising but the Fed fails to hike rates fast enough to keep up. The economy accelerates in this scenario because monetary policy remains stimulative through 2019, at a time when the 2018 fiscal stimulus will still be providing a demand tailwind. Core PCE inflation moves above 2% and long-term inflation expectations shift up, signaling to investors that the Fed has fallen behind the inflation curve. Risk assets rip for a while and the yield curve bear-steepens as the 10-year Treasury yield moves gradually higher at first. Belatedly, the FOMC realizes it has underestimated the neutral rate and signals a hawkish policy shift. A 50-basis point rate hike at one FOMC meeting causes risk assets to buckle on the back of surging Treasury yields. The yield curve begins to bear-flatten. Eventually the curve inverts and the economy enters recession. The dollar weakens at first because higher inflation lowers U.S. real interest rates relative to the rest of the world. Global growth prospects would initially get a boost from the acceleration in U.S. growth, which is also dollar-bearish. However, in the end the dollar would likely rise as global financial markets turn risk-off. Fed Gets It Right (1): R-star is high and rising. The Fed continues to tighten in line with the increase in the neutral rate. Treasurys sell off hard and the yield curve shifts higher, but remains fairly flat (parallel shift). The curve could mildly invert temporarily, but market worries about a recession eventually recede as economic momentum remains robust, allowing the curve to subsequently trade in the 0-50 basis point range. As discussed below, risk assets tend to outperform Treasurys and cash when the yield curve is in this range, but not by much. The Treasury market would suffer significant losses. This is the most dollar-bullish of the four scenarios, given our global growth view (tepid) and the fact that the market is not even priced for a full quarter-point rate hike in 2019. Fed Gets It Right (2): R-Star is actually still quite low, but the Fed correctly sees recent economic data disappointments and the tightening in financial conditions as signs that policy is close to neutral. The Fed pauses the rate hike cycle, followed by a slower and more data-dependent pace of tightening. The yield curve stays fairly flat and flirts with inversion as investors try to figure out if the Fed has overdone it. Risk assets are volatile and deliver little return over cash. Treasurys rally a bit as the chance of any further rate hikes is priced out of the market, but the rally is limited unless the economy falls into recession (which is not part of this scenario because we are assuming the Fed “gets it right”). The dollar fluctuates, but delivers no real trend since U.S. yield differentials versus the rest of the world do not change much. As we go to press, financial markets are moving in a way that is consistent the Policy Mistake #1; the consensus appears to believe that the Fed has already lifted the fed funds rate too far, causing financial conditions to tighten. But if U.S. real GDP growth remains above-trend as we expect, then the market view could eventually transition to a belief in Mistake #2; the Fed falls behind the inflation curve. The curve would re-steepen and risk assets could have one last hurrah before the Fed gets hawkish again and the 2020 recession arrives. The transition from Mistake #1 to Mistake #2 is essentially our base-case outlook. Nonetheless, obviously the risks around this central scenario are high, especially given how late it is in the U.S. economic and policy cycle. Asset Returns And The Yield Curve Our 2018 late-cycle investing theme focussed on historical asset return and policy dynamics after the U.S. unemployment rate fell below the full-employment level in past cycles. We found that risk assets tend to run into trouble once the U.S. S&P 500 operating margin peaks. As we highlighted in the BCA Outlook 2019, our margin proxies are still not heralding that a peak is at hand. Given the recent investor obsession with the U.S. yield curve, this month we look at historical asset returns at different levels of the 10-year/3-month T-bill yield curve slope: Phase I, when the slope is above 50 basis points; Phase II, when the curve is between 0 and 50 basis points; and Phase III, when the curve is inverted (Table I-1). The data are presented as (not annualized) monthly average returns. It may be surprising that risk asset returns are for the most part positive even in when the curve is inverted. However, keep in mind that we are focussing on the curve, not on recession periods. The curve can be inverted for a long time before the subsequent recession occurs. Risk asset returns often remain positive during this period. The broad conclusions are as follows: Unsurprisingly, risk assets perform their best, in absolute terms and relative to government bonds and cash, in Phase I when the yield curve is steep. Returns tend to deteriorate as the curve flattens. This includes equities, corporate bonds and commodities. Small caps underperform large caps when the curve is between 0 and 50 basis points, but the reverse is true when the curve is flatter or steeper than that range. The ratio of cyclical stocks to defensives has not revealed a consistent pattern with respect to the yield curve, although this may reflect the short historical period available. Value stocks shine versus growth when the curve is inverted. Hedge fund and private equity returns have not varied greatly across the three yield curve environments. Structured product, such as CMBS and ABS, have enjoyed their best performance when the curve is inverted. Timberland and Farmland have also rewarded investors during Phase III. We suspected that asset returns when the curve is in the 0-50 basis point range would vary importantly with the direction of the curve. In Table I-I we split Phase II into two parts: when the curve is steepening after being inverted, and when the curve is flattening after being steep. In other words, when the consensus is either transitioning from quite bullish to very bearish, or vice-versa. Risk assets such as equities (U.S. and Global) and U.S. investment-grade corporate bonds indeed perform much better in absolute terms when the curve is flat but is steepening rather than flattening. The same is true for U.S. structured product. In terms of excess returns relative to government issues, both U.S. IG and HY corporates have tended to underperform when the curve is in the 0-50 basis point range. Surprisingly, the underperformance is worse when the curve is steepening than when it is flattening. This appears to reflect an anomalous period in early 2006 when the curve was flattening but corporate bonds enjoyed strong excess returns. Emerging market equities show very strong returns in all three curve phases. This reflects the inclusion of the pre-2000 period in the mean calculations, a time when EM equities were much less correlated with U.S. financial conditions. EM equity returns have been significantly lower on average since 2000 when the curve is in the 0-50 basis point range (and especially when the curve is flattening) The bottom line is that risk assets can still reward investors with positive returns during periods when the yield curve is flat. However, it is a dangerous time, especially when the global economy is up to its eyeballs in debt. This month’s Special Report beginning on page 17 argues that, although regulation has made the global financial system more resilient to shocks compared to the pre-Lehman years, the number of potentially destabilizing shocks has increased. Moreover, the trade war and Brexit risks make the investment backdrop all the more precarious. No Quick End To The Trade War The honeymoon following the trade ceasefire between the U.S. and China, agreed at the G20 summit in early December, did not last long. The arrest of the chief financial officer of Chinese telecom maker Huawei and continuing hawkish tweets from the U.S. president dampened hopes that a trade agreement can be negotiated by March. Even news that China intended to cut tariffs on U.S. auto imports did not help much. We highlighted in the BCA Outlook 2019 that negotiations will prove to be protracted and testy. It will take a lot more than some token market-opening action on the part of China to placate the U.S. Our geopolitical team emphasizes that “trade war” is a misnomer for a broader strategic conflict that is centered on the military-industrial balance rather than the trade balance.1 For example, while China is rapidly catching up to the U.S. in research and development spending, it is only spending about half as much as the U.S. relative to its overall economy (Chart I-8). While the U.S. can accept China’s eventually surpassing it in economic output, it cannot accept China’s technological superiority. This would translate into military and strategic supremacy over time. Chart I-8R&D Expenditure By Country U.S. demands will also be hard for China to swallow. Most importantly, the U.S. is requesting that China rein in its hacking and spying, shift its direct investment to less tech-sensitive sectors, adjust its “Made in China” targets to allow for more foreign competition, and lower foreign investment equity restrictions. These stumbling blocks will make it difficult to strike a deal on trade. We continue to believe that a final trade deal between the U.S. and China will not arrive in the 90-day timeframe of the ceasefire. Thus, global risk assets will be subject to swings in sentiment regarding the likelihood of a trade deal well beyond March. Meanwhile, as previously discussed, Chinese policy stimulus has not yet become aggressive enough to spark animal spirits in the private sector. The Chinese authorities are proceeding cautiously so as to avoid adding significantly to private- and public-sector’s debt mountain. This month’s Special Report also discusses the risks that the surge in debt over the past decade poses for the global financial system, including escalating risk in China’s shadow banking system. Brexit Pain Continues Politics surrounding the torturous Brexit process will also remain a source of volatility for global markets in 2019. Prime Minister May survived a leadership challenge, but this is hardly confidence-inspiring. The question is whether any deal can get through Westminster. The votes appear to be in place for the softest of soft Brexits, the so-called Norway+ option, if May convinces the Labour Party to break ranks. Such a deal would entail Common Market access, but at the cost of having to essentially pay for full EU membership with no ability to influence the regulatory policies that London would have to abide by. The alternative is to call for a new election (which may usher the even less pro-Brexit Labour Party into power), or to delay Brexit for a more substantive period of time, or simply to buckle under the pressure and call for a second referendum. We disagree that the failure of the Tories to endorse May’s proposed agreement means that the “no deal Brexit,” or the “Brexit cliff,” is nigh. Such an outcome is in nobody’s interest and both May and the EU can offer delays to ensure that it does not happen. Whatever happens, one thing is clear; the median voter is turning forcefully towards Bremain (Chart I-9). It will soon become untenable to delay the second referendum. The bottom line is that, while a soft Brexit is the most likely outcome, the path from here to the end result will be punishing. We do not recommend Brexit-related bets on the pound, despite the fact that it is cheap. Chart I-9A Shift Toward Bremain 2019: A Tale Of Two Halves For EM, Commodities And The Dollar One of our key themes in the BCA Outlook 2019 is that the growth divergence between China and the U.S. will persist at least for the first half of 2019. The result will be weak EM asset prices and currencies, little upside for base metals and a strong U.S. dollar. We expect the Chinese authorities will do enough to stabilize growth by mid-year, providing the impetus for a playable bounce in EM and commodity prices in the second half of 2019, coinciding with a peak in the U.S. dollar. Nonetheless, the dollar still has some upside potential in broad trade-weighted terms in the first half of 2019. Our Central Bank Monitors continue to show a greater need for policy tightening in the U.S. than in the rest of the major countries. The dollar has usually strengthened when this has been the case historically. In particular, the ECB’s Central Bank Monitor has slipped back into “easy money required” territory, reflecting moderating economic momentum and still-depressed consumer price inflation (Chart I-10). Chart I-10Our CB Monitors Support A Stronger Dollar The ECB announced the well-anticipated end of its asset purchase program in December. The central bank will now focus on forward guidance as its main policy tool outside of setting short-term interest rates. Lending via targeted LTROs will also be considered under certain circumstances. Policymakers retained the latest forward guidance after the December MPC meeting, that rates are on hold “through the summer of 2019”. The latest reading from our ECB Monitor suggests that the central bank could be on hold for longer than that. We expect Eurozone growth to improve somewhat through the year, but we still believe that interest rate differentials will move further in favor of the dollar relative to the euro and the other major currencies. Periods of slow global growth also tend to favor the greenback. The bottom line is that, while a correction is possible in the very near term, investors with at least a six-month horizon should remain long the dollar. Investment Conclusions: Our outlook for the U.S. and global economies has not changed since we published our 2019 Outlook. The risks facing investors have not diminished either, especially given the precarious nature of late-cycle investing and the uncertainty regarding the neutral level of the fed funds rate. Historically, the returns to stocks, corporate bonds and commodities have not been particularly attractive on average when the yield curve is this flat. Nonetheless, we believe that the risk/reward balance has improved enough as prices fell over the past month to justify upgrading equities in the advanced economies to overweight. Move to a neutral level of cash, and keep bonds underweight on a 6-12 month investment horizon. Despite our more positive view on equities, we remain cautious on credit. Spreads have widened recently to more attractive levels, but we remain concerned about the high leverage of U.S. corporates, whose debt/assets ratio is on average higher now than in 2009. Signs of strain are already showing in the junk bond market, with new issuance having largely dried up since early December. If this continues, borrowers may struggle to refinance maturing debt in early 2019.  Credit is an asset class that is likely to perform particularly poorly in the next recession. Our upgrade to stocks in the advanced markets does not carry over to emerging markets. The backdrop will remain hostile to EM assets until China pulls out the big policy stimulus guns and the dollar peaks. Stay clear of EM assets and neutral on base metals for now. Global government bonds could rally a little more in the near term if the risk-off phase continues. Nonetheless, with little chance of any more rate hikes discounted in the U.S. yield curve, the risks for U.S. and global yields are tilted to the upside. Bond investors with a 6-12 month horizon should ride out the near-term volatility with a short-duration position. Oil markets are still in the process of re-adjusting to an extraordinary policy reversal by the Trump Administration on its Iranian oil-export sanctions in November, as last-minute waivers were granted to Iran’s largest oil importers. We believe that oil prices have overshot to the downside. Following OPEC 2.0’s decision to cut 1.2mm b/d of production to re-balance markets in the first half of the year, we continue to expect prices to recover on the back of solid global energy demand. Canada also mandated energy firms to trim production. Our energy experts expect oil prices to reach $82/bbl in 2019. We also like gold as long as the fed funds rate remains below its neutral level. Mark McClellan Senior Vice President The Bank Credit Analyst December 21, 2018 Next Report: January 31, 2019 II. (Part II) The Long Shadow Of The Financial Crisis This is the second of a two-part Special Report on the structural changes that have occurred as a result of the Great Recession and financial crisis. We look at three issues: asset correlation, the safety of the financial system, and the level of global debt. First, correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. Some believe that the underlying level of correlation among risk assets has shifted permanently higher for two main reasons: (1) trading factors such as the increased use of exchange-traded funds and algorithms; and (2) the risk-on/risk-off environment in which trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. We have sympathy for the second explanation. The equity risk premium (ERP) was forced higher on a sustained basis by the financial crisis, driven by fears that the advanced economies had entered a ‘secular stagnation’. Elevated correlation among risk assets was a result of a higher-than-normal ERP. The ERP should decline as fears of secular stagnation fade, leading to a lower average level of risk asset correlation than has been the case over the last decade. Second, regulators have been working hard to ensure that the financial crisis never happens again. But is the financial system really any safer today? Undoubtedly, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. The propensity for contagion among banks has diminished and there has been a dramatic decline in the volume of complex structured credit securities. The bad news is that the level of global debt has increased at an alarming pace. The third part of this report highlights that elevated levels of debt could cause instability in the global financial system. Choking debt levels boost the vulnerability to negative shocks. The number and probability of potential shocks appear to have increased since 2007, including extreme weather events, sovereign debt crises, large-scale migration, populism, water crises and cyber & data attacks. The lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide any fiscal relief in the event of a negative shock. Moreover, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend more in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. The Great Recession and Financial Crisis cast a long shadow that will affect economies, policy and financial markets for years to come. Rather than reviewing the roots of the crisis, the first of our two-part series examined the areas where we believe structural change has occurred related to the economy or financial markets. We covered the changing structure of the corporate bond market, the inflation outlook, central bank policymaking and equilibrium bond yields. We highlighted that the financial crisis transformed the corporate bond market in several ways that heighten the risk for quality spreads in the next downturn. We made the case that the prolonged inflation undershoot is sowing the seeds of an overshoot in the coming years, in part related to central bank policymakers that are doomed to fight the last war. Finally, we argued that the forces behind the structural and cyclical bull market in bonds reached an inflection point in 2016/2017. In Part II, we examine the theory that the financial crisis has permanently lifted market correlations among risk assets. Next, we look at whether regulatory changes implemented as a result of the financial crisis have made the global financial system safer. Finally, we highlight the implications of the continued rise in global leverage over the past decade in the context of BCA’s Debt Supercycle theme. The bottom line is that the global financial system still faces substantial risks, despite a more highly regulated banking system. (1) Are Risk Asset Correlations Permanently Higher? Correlations among financial assets shifted dramatically during the financial crisis and the after-effects lingered for years. For example, risk assets became more highly correlated, suggesting little differentiation within or across asset classes. Chart II-1 presents a proxy for U.S. equity market correlations, using a sample of current S&P 100 companies. The average correlation was depressed in the 1990s and 2000s relative to the 1980s. It spiked in 2007 and fluctuated at extremely high levels for several years, before moving erratically lower. It has jumped recently and is roughly in the middle of the post-1980s range. Chart II-1Two Factors Driving Correlation Correlations will undoubtedly ebb and flow in the coming years and will spike again in the next recession. But a key question is whether correlations will oscillate around a higher average level than in the 1990s and 2000s. The consensus seems to believe that the underlying level of correlation among risk assets has indeed shifted higher on a structural basis for two main reasons: Market Structure Changes: Many investors point to trading factors such as the increased use of index products (exchange-traded funds for example), and high-frequency/algorithmic trading as likely culprits. Macro “theme” investing has reportedly become more popular and is often implemented through algorithms. The result is an increase in stock market volatility and a tendency for risk-asset prices to move up and down based on momentum because they are all being traded as a group. These factors would likely be evident today even if the financial crisis never happened, but the popularity of algorithm trading may have been encouraged by the fact that the macro backdrop was so uncertain for years after Lehman collapsed. Risk On/Off Trading Environment: Trading has become more binary in nature, due to the sharp rise in policy uncertainty, risk aversion and risk premiums in the aftermath of the Great Recession. Even after the recession ended, the headwinds to growth were formidable and many felt that the sustainability of the recovery hinged largely on the success or failure of unorthodox monetary policies. The general feeling was that either the policies would “work”, the output gap would gradually close and risk assets would perform well, or it would fail and risk assets would be dragged down by a return to recession. Thus, markets traded on an extreme “risk-on/risk-off” basis, as sentiment swung wildly with each new piece of economic and earnings data. While the market structure thesis has merit on the surface, the impact should only be short term in nature. It is difficult to see how a change in the intra-day microstructure of the market could have such a fundamental, wide-ranging and permanent impact on market prices. Previous research suggests that any impact on market correlation beyond the very short term is likely to be small. For the sake of brevity, we won’t present the evidence here, but instead refer readers to two BCA Special Reports.2 The risk on/off trading environment thesis is a more plausible explanation. However, we find it more useful to think about it in terms of the equity risk premium (ERP). A higher ERP causes investors to revalue cash flows from all firms, which, in turn, causes structural shifts in the correlation among stocks. A lower ERP results in less homogenization of the present value of future cash flows, and raises the effect of differentiation among business models. A rise in the ERP could occur for different reasons, but the most obvious are an increase in the perceived riskiness of firms, a shift in investor risk aversion, or both. Shifts in the ERP are sometimes structural in nature, but there is also a strong cyclical element in that persistent equity declines historically have had the effect of temporarily raising the ERP and correlations. A simple model based on the ERP and volatility explains a lot of the historical variation in equity correlation, including the elevated levels observed in the years after 2007 (Chart II-2).3 The shift lower in correlations after 2012 reflects both a lower equity risk premium and a dramatic decline in downside volatility. Chart II-2Simple Model Explains Correlation It is tempting to believe that the lingering shell-shock related to the financial crisis means that the underlying equity risk premium has shifted permanently higher. The ERP is still elevated by historical standards, but this is more reflective of extraordinarily low bond yields than an elevated forward earnings yield. Investors evidently believe that the U.S. and other developed economies are stuck in a “secular stagnation”, which will require low interest rates for many years just to keep economic growth near its trend pace. In other words, the equilibrium interest rate, or R-star, is still very low. The ERP and correlations among risk assets will undoubtedly spike again in the next recession. Nonetheless, in the absence of recession, we expect fears regarding secular stagnation to fade further. If the advanced economies hold up as short-term interest rates and bond yields rise, then concerns that R-star is extremely low will dissipate and expectations regarding equilibrium bond yields will shift higher. The ERP will move lower as bond yields, rather than the earnings yield, do most of the adjustment. The underlying correlations among risk asset prices should correspondingly recede. This includes correlations among a wide variety of risk assets, such as corporate bonds and commodities. While this describes our base case outlook, there is a non-trivial risk that the next recession arrives soon and is deep. This would underscore the view that R-star is indeed very low and the economy needs constant monetary stimulus just to keep it out of recession (i.e. the secular stagnation thesis). The ERP and correlations would stay elevated on average in that scenario. What About The Stock/Bond Correlation? Chart II-3 shows the rolling correlation between monthly changes in the 10-year Treasury bond yield and the S&P 500. The correlation was generally negative between the late-1960s and the early-2000s. Bond yields tended to rise whenever the S&P 500 was falling. Over the past two decades, however, bond yields have generally declined when the stock market has swooned. Chart II-3Structural Shifts In The Stock/Bond Correlation Inflation expectations can help explain the shift in stock/bond correlation. Expectations became unmoored after 1970, which meant that inflationary shocks became the primary driver of bond yields. Strong growth became associated with rising inflation and inflation expectations, and the view that central banks had fallen behind the curve. Bond yields surged as markets discounted aggressive tightening designed to choke off inflation. And, given that inflation lags the cycle and had a lot of persistence, central banks were not in a position to ease policy at the first hint of a growth slowdown. This was obviously a poor backdrop for stocks. When inflation expectations became well anchored again around the late 1990s, investors no longer feared that central banks would have to aggressively stomp on growth whenever actual inflation edged higher. Central banks also had more latitude to react quickly by cutting rates at the first sign of slower economic growth. Fluctuations in growth became the primary driver of bond yields, allowing stock prices to rise and fall along with yields. The correlation has therefore been positive most of the time since 2003. Bottom Line: A negative correlation between stocks and bond yields reared its ugly head in the last quarter of 2018. The equity correction reflected several factors, but the previous surge in bond yields and hawkish Fed comments appeared to spook markets. Investors became nervous that the fed funds rate had already entered restrictive territory, at a time when the global economy was cooling off. We expect more of these episodes as the Fed normalizes short-term interest rates over the next couple of years. Nonetheless, we see no evidence that inflation expectations have become unmoored. This implies that the stock-bond correlation will generally be positive most of the time over the medium term. In addition, the average level of correlation among risk assets has probably not been permanently raised, although spikes during recessions or growth scares will inevitably occur. (2) Is The Global Financial System Really Safer Today? The roots of the great financial crisis and recession involved a global banking and shadow banking system that encouraged leverage and risk-taking in ways that were hard for investors and regulators to assess. Complex and opaque financial instruments helped to hide risk, at a time when regulators were “asleep at the switch”. In many countries, credit grew at a much faster pace than GDP and capital buffers were dangerously low. Banking sector compensation skewed the system toward short-term gains over long-term sustainable returns. Lax lending standards and a heavy reliance on short-term wholesale markets to fund trading and lending activity contributed to cascading defaults and a complete seizure in parts of the money and fixed income markets. A vital question is whether the financial system is any less vulnerable today to contagion and seizure. The short answer is that the financial system is better prepared for a shock, but the problem is that the number of potential sources of instability have increased since 2007. Since the financial crisis, regulators have been working hard to ensure that the financial crisis never happens again. Reforms have come under four key headings: Capital: Regulators raised the minimum capital requirement for banks, added a buffer requirement, and implemented a surcharge on systemically important banks. Liquidity: Regulators implemented a Liquidity Coverage Ratio (LCR) and a Net Stable Funding Ratio (NSFR) in order to ensure that banks have sufficient short-term funds to avoid liquidity shortages and bank runs.4 Risk Management: Banks are being forced to develop systems to better monitor risk, and are subject to periodic stress tests. Resolution Planning: Banks have also been asked to detail options for resolution that, hopefully, should reduce systemic risk should a major financial institution become insolvent. Global systemically-important banks, in particular, will require sufficient loss-absorbing capacity. A major study by the Bank for International Settlements,5 along with other recent studies, found that systemic risk in the global financial system has diminished markedly as a result of the new regulations. On the whole, banks have improved balance sheet and funding resilience, and have significantly reduced their involvement in complex financial activities. Lending standards have tightened almost across the board relative to pre-crisis levels, particularly for residential mortgages. Additional capital and liquid assets provide a much wider buffer today against adverse shocks, allowing most banks to pass recent stress tests (Chart II-4). Financial institutions have generally re-positioned toward retail and commercial banking and wealth management, and away from more complex and capital-intensive activities (Chart II-5). The median share of trading assets in total assets for individual G-SIBs has declined from around 20% to 12% over 2009-16. Moreover, the propensity for contagion among banks has diminished. The BIS notes that assessing all the complex interactions in the global financial system is extremely difficult. Nonetheless, a positive sign is that banks are focusing more on their home markets since the crisis, and that direct connections between banks through lending and derivatives exposures have declined. The BIS highlights that aggregate foreign bank claims have declined by 16% since the crisis, driven particularly by banks from the advanced economies most affected by the crisis, especially from some European countries (Chart II-6). It is also positive that European banks have made some headway in diminishing over-capacity, although problems still exist in Italy. Finally, and importantly, there has been a distinct shift toward more stable sources of funding, such as deposits, away from fickle wholesale markets (Charts II-7 and II-8). Chart II-6Less Cross Border Lending (Until Recently)   Outside of banking, many other regulatory changes have been implemented to make the system safer. One important example is that rules were adjusted to reduce the risk of runs on money market funds. What About Shadow Banking? Of course, more could be done to further indemnify the financial system. Concentration in the global banking system has not diminished, and it appears that the problem of “too big to fail” has not been solved. And then there is the shadow banking sector, which played a major role in the financial crisis by providing banks a way of moving risk to off-balance sheet entities and securities, and thereby hiding the inherent risks. Shadow banking is defined as credit provision that occurs outside of the banking system, but involves the key features of bank lending including leverage, and liquidity and maturity transformation. Complex structured credit securities, such as Collateralized Debt Obligations, allowed this type of transformation to mushroom in ways that were difficult for regulators and investors to understand. A recent study by the Group of Thirty6 concluded that securitization has dropped to a small fraction of its pre-crisis level, and that growing non-bank credit intermediation since the Great Recession has primarily been in forms that do not appear to raise financial stability concerns. Much of the credit creation has been in non-financial corporate bonds, which is a more stable and less risky form of credit extension than bank lending. Other types of lending have increased, such as corporate credit to pension funds and insurance companies, but this does not involve maturity transformation, according to the Group of Thirty. There has been a dramatic decline in the volume of complex structured credit securities such as collateralized debt obligations, asset-backed commercial paper, and structured investment vehicles since 2007 (Chart II-9). While the situation must be monitored, the Group of Thirty study concludes that the financial system in the advanced economies appears to be less vulnerable to bouts of self-reinforcing forced selling, such as occurred during the 2008 crisis. Chart II-9Less Private-Sector Securitization One exception is the U.S. leveraged loan market, which has swelled to $1.13 trillion and about half has been pooled into Collateralized Loan Obligations. As with U.S. high-yield bonds, the situation is fine as long as profitability remains favorable. But in the next recession, lax lending standards today will contribute to painful losses in leveraged loans. The Bad News That’s the good news. The bad news is that, while the financial system might have become less complex and opaque, the level of debt has increased at an alarming rate in both the private and public sectors in many countries. Elevated levels of debt could cause instability in the global financial system, especially as global bond yields return to more normal levels by historical standards. We discuss other pressure points such as Emerging Markets and China in the next section, although the latter deserves a few comments before we leave the subject of shadow banking. The Group of Thirty notes that 30% of Chinese credit is provided by a broad array of poorly regulated shadow banking entities and activities, including trust funds, wealth management products, and “entrusted loans.” Links between these entities and banks are unclear, and sometimes involve informal commitments to provide credit or liquidity support. The study takes some comfort that most of Chinese debt takes place between Chinese domestic state-owned banks and state-owned companies or local government financing vehicles. Foreign investors have limited involvement, thus reducing potential direct contagion outside of China in the event of a financial event. Still, the potential for contagion internationally via global sentiment and/or the economic fallout is high. The other bad news is that, while regulators in the advanced economies have managed to improve the ability of financial institutions to weather shocks, potential risks to the financial system have increased in number and in probability of occurrence. The Global Risk Institute (GRI) recently published a detailed comparison of potential shocks today relative to 2007.7 The report sees twice the number of risks versus 2007 that are identified as “current” (i.e. could occur at any time) and of “high impact”. The most pressing risks today include extreme weather events, asset bubbles, sovereign debt crises, large-scale involuntary migration, water crises and cyber & data attacks. Any of these could trigger a broad financial crisis if the shock is sufficiently intense, despite improved regulation. The GRI study also eventuates how the risks will evolve over the next 11 years. Readers should see the study for details, but it is interesting that the experts foresee cyber dependency rising to the top of the risk pile by 2030. The increase is driven by the importance of data ownership, the increasing role of algorithms and control systems, and the $1.2 trillion projected cost of cyber, data and infrastructure attacks. Our computer systems are not prepared for the advances of technology, such as quantum computing. Climate change moves to the number two risk spot in its base-case outlook. Space limitations precluded a discussion of the rise of populism in this report, but the GRI sees the political tensions related to income inequality as the number three threat to the global financial system by 2030. Bottom Line: Regulators have managed to substantially reduce the amount of hidden risk and the potential for contagion between financial institutions and across countries since 2007. Banks have a larger buffer against stocks. Unfortunately, the number and probability of potential shocks to the financial system appear to have increased since 2007. (3) Implications Of The Global Debt Overhang The End of the Debt Supercycle is a key BCA theme influencing our macro view of the economic and market outlook for the coming years. For several decades, the willingness of both lenders and borrowers to embrace credit was a lubricant for economic growth and rising asset prices and, importantly, underpinned the effectiveness of monetary policy. During times of economic and/or financial stress, it was relatively easy for the Federal Reserve and other central banks to improve the situation by engineering a new credit up-cycle. However, since the 2007-09 meltdown, even zero (or negative) policy rates have been unable to trigger a strong revival in private credit growth in the major developed economies, except in a few cases. The end of the Debt Supercycle has severely impaired the key transmission channel between changes in monetary policy and economic activity. The combination of high debt burdens and economic uncertainty has curbed borrowers’ appetite for credit while increased regulatory pressures and those same uncertainties have made lenders less willing to extend loans. This has severely eroded the effectiveness of lower interest in boosting credit demand and supply, forcing central banks to rely increasingly on manipulating asset prices and exchange rates. On a positive note, the plunge in interest rates has lowered debt servicing costs to historically low levels. Yet, it is the level, rather than the cost, of debt that seems to have been an impediment to the credit cycle, contributing to a lethargic economic expansion. The Bank for International Settlements (BIS) publishes an excellent dataset of credit trends across a broad swath of developing and emerging economies. Some broad conclusions come from an examination of the data (Charts II-10 and II-11):8 Chart II-10Advanced Economies: Some Deleveraging Chart II-11EM: Deleveraging Has Not Even Started Private debt growth has only recently accelerated for the advanced economies as a whole. There are only a handful of developed economies where private debt-to-GDP ratios have moved up meaningfully in the past few years. These are countries that avoided a real estate/banking bust and where property prices have continued to rise (e.g. Canada and Australia). The high level of real estate prices and household debt currently is a major source of concern to the authorities in those few countries. Even where some significant consumer deleveraging has occurred (e.g. the U.S., Spain and Ireland), debt-to-income ratios remain very high by historical standards. In many cases, a stabilization or decline in private debt burdens has been offset by a continued rise in public debt, keeping overall leverage close to peak levels. This is a key legacy of the financial crisis; many governments were forced to offset the loss of demand from private sector deleveraging by running larger and persistent budget deficits. Weak private demand accounts for close to 50% of the rise in public debt on average according to the IMF. Global debt of all types (public and private) has soared from 207% of GDP in 2007 to 246% today. The Debt Supercycle did not end everywhere at the same time. It peaked in Japan more than 20 years ago and has not yet reached a decisive bottom. The 2007-09 meltdown marked the turning point for the U.S. and Europe, but it has not even started in the emerging world. The financial crisis accelerated the accumulation of debt in the latter as investors shifted capital away from the struggling advanced economies to (seemingly less risky) emerging markets. Both EM private- and public-sector debt ratios have continued to move up at an alarming pace. The lesson from Japan is that deleveraging cycles following the bursting of a major credit bubble can last a very long time indeed. One key area where there has been significant deleveraging is the U.S. household sector (Chart II-12). The ratio of household debt to income has fallen below its long-term trend, suggesting that the deleveraging process is well advanced. However, one could argue that the ratio will undershoot the trend for an extended period in a mirror image of the previous overshoot. Or, it may be that the trend has changed; it could now be flat or even down. Chart II-12U.S. Household Deleveraging... What is clear is that U.S. attitudes toward saving and spending have changed dramatically since the Great Financial Crisis (GFC) (Chart II-13). Like the Great Depression of the 1930s that turned more than one generation off of debt, the 2008/09 crisis appears to have been a watershed event that marked a structural shift in U.S. consumer attitudes toward credit-financed spending. The Debt Supercycle is over for this sector. Chart II-13...As Attitudes To Debt Change Developing Countries: Debt And Economic Fundamentals BCA’s long-held caution on emerging economies and markets is rooted in concern about deteriorating fundamentals. Trade wars and a tightening Fed are negative for EM assets, but the main headwinds facing this asset class are structural. Excessive debt is a ticking time bomb for many of these countries. EM dollar-denominated debt is now as high as it was in the late 1990s as a share of both GDP and exports (Chart II-14). Moreover, the declining long-term growth potential for emerging economies as a group makes it more difficult for them to service the debt. The structural downtrend in EM labor force and productivity growth underscores that trend GDP growth has collapsed over the past three decades (Chart II-14, bottom panel). Chart II-14EM: High Debt And Slow Growth... The 2019 Key Views9 report from our Emerging Markets Strategy team highlights that excessive capital inflows over the past decade have contributed to over-investment and mal-investment. Much of the borrowing was used to fund unprofitable projects, as highlighted by the plunge in productivity growth, profit margins and return on assets in the EM space relative to pre-Lehman levels (Chart II-15) Decelerating global growth in 2018 has exposed these poor fundamentals. Chart II-15...Along With Deteriorating Profitability As we highlighted in the BCA Outlook 2019, emerging financial markets may enjoy a rally in the second half of 2019 on the back of Chinese policy stimulus. However, this will only represent a ‘sugar high’. The debt overhang in emerging market economies is unlikely to end benignly because a painful period of corporate restructuring, bank recapitalization and structural reforms are required in order to boost productivity and thereby improve these countries’ ability to service their debt mountains. China’s Debt Problem Space limitations preclude a full discussion of the complex debt situation in China and the risks it poses for the global financial system. Waves of stimulus have caused total debt to soar from 140% of GDP in 2008 to 260% of GDP at present (Chart II-16). Since most of the new credit has been used to finance fixed-asset investment, China has ended up with a severe overcapacity problem. The rate of return on assets in the state-owned corporate sector has fallen below borrowing costs (Chart II-17). Chinese banks are currently being told that they must lend more money to support the economy, while ensuring that their loans do not sour. This has become an impossible feat. Chart II-16China's Overinvestment... Chart II-17Has Undermined The Return On Assets The previous section highlighted that much of the debt has been created in the opaque shadow banking system, where vast amounts of hidden risk have likely accumulated. Whether or not the central government is willing and/or able to cover a wave of defaults and recapitalize the banking system in the event of a negative shock is hotly debated, both within and outside of BCA. But even if a financial crisis can be avoided, bringing an end to the unsustainable credit boom will undoubtedly have significant consequences for the Chinese economy and the emerging economies that trade with it. Interest Costs To Rise Globally, many are concerned about rising interest costs as interest rates normalize over the coming years. In Appendix Charts II-19 to II-21, we provide interest-cost simulations for selected government, corporate and household sectors under three interest-rate scenarios. The good news is that the starting point for interest rates is still low, and that it takes years for the stock of outstanding debt to adjust to higher market rates. Even if rates rise by another 100 basis points, interest burdens will increase but will generally remain low by historical standards. It would take a surge of 300 basis points across the yield curve to really ‘move the needle’ in terms of interest expense. This does not imply that the global debt situation is sustainable or that a financial crisis can be easily avoided. The next economic downturn will probably not be the direct result of rising interest costs. Nonetheless, elevated government, household and/or corporate leverage has several important long-term negative implications: Limits To Counter-Cyclical Fiscal Policy: Government indebtedness will limit the use of counter-cyclical fiscal policy during the next economic downturn. Chart II-18 highlights that structural budget deficits and government debt levels are higher today compared to previous years that preceded recessions. The risk is especially high for emerging economies and some advanced economies (such as Italy) where investors will be unwilling to lend at a reasonable rate due to default fears. Even in countries where the market still appears willing to lend to the government at a low interest rate, political constraints may limit the room to maneuver as voters and fiscally-conservative politicians revolt against a surge in budget deficits. This will almost certainly be the case in the U.S., where the 2018 tax cuts mean that the federal budget deficit is likely to be around 6% of GDP in the coming years even in the absence of recession. A recession would push it close to a whopping 10%. Even in countries where fiscal stimulus is possible, the end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend and take on more debt. Growth Headwinds: The debt situation condemns the global economy to a slower pace of trend growth in part because of weaker capital spending. From one perspective this is a good thing, because spending financed by the excessive use of credit is unsustainable. Still, deleveraging has much further to go at the global level, which means that spending will have to be constrained relative to income growth. The IMF estimates that deleveraging in the private sector for the advanced economies is only a third of historical precedents at this point in the cycle. The IMF also found that debt overhangs have historically been associated with lower GDP growth even in the absence of a financial crisis. Sooner or later, overleveraged sectors have to retrench. Vulnerability To Negative Shocks: If adjustment is postponed, debt reaches levels that make the economy highly vulnerable to negative shocks as defaults rise and lenders demand a higher return or withdraw funding altogether. IMF work shows that economic downturns are more costly in terms of lost GDP when it is driven or accompanied by a financial crisis. This is particularly the case for emerging markets. Bottom Line: Although credit growth has been subdued in most major advanced economies, there has been little deleveraging overall and debt-to-GDP is still rising at the global level. Elevated debt levels are far from benign, even if it appears to be easily financed at the moment. It acts as dead weight on economic activity and makes the world economy vulnerable to negative shocks. It steals growth from the future and, in the event of such a shock, the lack of a fiscal buffer in most countries means that it will be difficult or impossible to provide fiscal relief. The end of the Debt Supercycle means that the monetary and fiscal authorities will find it difficult to encourage the private sector to spend in most cases. For EM, deleveraging has not even started and more financial fireworks seem inevitable in the context of a strong dollar and rising global yields. China may avoid a crisis, but the adjustment to a less credit-driven economy is already proving to be a painful process. Mark McClellan Senior Vice President The Bank Credit Analyst APPENDIX Chart II-19Corporate Interest Cost Scenarios   Chart II-20Government Interest Cost Scenarios   Chart II-21U.S. Household Sector Interest Cost Scenarios   III. Indicators And Reference Charts Our tactical upgrade of equities to overweight this month goes against most of our proprietary indicators. Our Willingness-to-Pay (WTP) indicators for the U.S., Japan and Europe are all heading lower. The WTP indicators track flows, and thus provide information on what investors are actually doing, as opposed to sentiment indexes that track how investors are feeling. Investors are clearly moving funds away from the equity market at the moment. Our Revealed Preference Indicator (RPI) for stocks continues to issue a ‘sell’ signal. The RPI combines the idea of market momentum with valuation and policy measures. It provides a powerful bullish signal if positive market momentum lines up with constructive signals from the policy and valuation measures. Conversely, if constructive market momentum is not supported by valuation and policy, investors should lean against the market trend. Momentum remains out of sync with valuation and policy, supporting the view that caution is still warranted. The U.S. net earnings revisions ratio has dropped into negative territory. The earnings surprises index has also declined, although it remains above 60%. Finally, our Composite Technical Equity Indicator has broken below the zero line and its 9-month exponential moving average, sending a negative technical signal. On the positive side, our Monetary Indicator has hooked up, although it is still in negative territory for equities. From a contrary perspective, the fact that equity sentiment has turned bearish is positive for stocks. In fact, this is the main reason why we upgraded stocks this month. While it is late in the U.S. economic expansion and the Fed is tightening, sentiment regarding U.S. and global growth has become overly pessimistic. Thus, we are playing a late-cycle bounce in stocks. For bonds, the term premium moved further into negative territory in December, which is unsustainable from a long-term perspective. Long-term inflation expectations are also too low to be consistent with the Fed meeting its 2% target over the medium term. These facts suggest that bond yields have not peaked for the cycle, although at the moment they have not yet worked off oversold conditions according to our technical indicator. The U.S. dollar is overbought and very expensive on a PPP basis. Nonetheless, we believe it will become more expensive in the first half of 2019, before its structural downtrend resumes in broad trade-weighted terms. EQUITIES: Chart III-1U.S. Equity Indicators   Chart III-2Willingness To Pay For Risk Chart III-3U.S. Equity Sentiment Indicators Chart III-4Revealed Preference Indicator   Chart III-5U.S. Stock Market Valuation Chart III-6U.S. Earnings Chart III-7Global Stock Market And Earnings: Relative Performance Chart III-8Global Stock Market And Earnings: Relative Performance FIXED INCOME: Chart III-9U.S. Treasurys And Valuations Chart III-10Yield Curve Slopes Chart III-11Selected U.S. Bond Yields   Chart III-1210-Year Treasury Yield Components Chart III-13U.S. Corporate Bonds And Health Monitor Chart III-14Global Bonds: Developed Markets Chart III-15Global Bonds: Emerging Markets CURRENCIES: Chart III-16U.S. Dollar And PPP   Chart III-17U.S. Dollar And Indicator   Chart III-18U.S. Dollar Fundamentals   Chart III-19Japanese Yen Technicals Chart III-20Euro Technicals Chart III-21Euro/Yen Technicals Chart III-22Euro/Pound Technicals COMMODITIES: Chart III-23Broad Commodity Indicators   Chart III-24Commodity Prices Chart III-25Commodity Prices Chart III-26Commodity Sentiment Chart III-27Speculative Positioning ECONOMY: Chart III-28U.S. And Global Macro Backdrop   Chart III-29U.S. Macro Snapshot   Chart III-30U.S. Growth Outlook Chart III-31U.S. Cyclical Spending Chart III-32U.S. Labor Market Chart III-33U.S. Consumption Chart III-34U.S. Housing Chart III-35U.S. Debt And Deleveraging Chart III-36U.S. Financial Conditions   Chart III-37Global Economic Snapshot: Europe Chart III-38Global Economic Snapshot: China Mark McClellan Senior Vice President The Bank Credit Analyst   1      For more details, please see BCA Geopolitical Strategy Special Report "U.S.-China: The Tech War And Reform Agenda," dated December 12, 2018, available at gps.bcaresearch.com 2      Please see BCA U.S. Investment Strategy Special Report "The Bane Of Investors’ Existence: Why Is Correlation High And When Will It Fall?" dated January 4, 2012, available at usis.bcaresearch.com. Also see BCA Global ETF Strategy Special Report "The Passive Menace," dated September 13, 2017, available at etf.bcaresearch.com 3       We use only below average returns in the calculation of volatility (downside volatility) because we are more concerned with the risk of equity market declines for the purposes of this model. 4       The LCR requires a large bank to hold enough high-quality liquid assets to cover the net cash outflows the bank would expect to occur over a 30-day stress scenario. The NSFR complements the LCR by requiring an amount of stable funding that is tailored to the liquidity risk of a bank’s assets and liabilities, based on a one-year time horizon. 5       Structural Changes in Banking After the Crisis. CGFS Papers No.60. Bank for International Settlements, January 2018. 6       Shadow Banking and Capital Markets Risks and Opportunities. Group of Thirty. Washington, D.C., November 2016. 7       Back to the Future: 2007 to 2030. Are New Financial Risks Foreshadowing a Systemic Risk Event? Global Risk Institute. 8       For more details on public and private debt trends, please see BCA Special Report "The End Of The Debt Supercycle: An Update," dated May 11, 2016, available at bca.bcaresearch.com 9       Please see BCA Emerging Markets Strategy Weekly Report "2019 Key Views: Will The EM Lost Decade End With A Bang Or A Whimper?" dated December 6, 2018, available at ems.bcaresearch.com EQUITIES:FIXED INCOME:CURRENCIES:COMMODITIES:ECONOMY:

Special Report

Dear Client, We are sending you our last issue of the year, which contains a lighter fare than usual, highlighting 10 charts we find important. The first three charts tackle questions of Chinese growth, global activity and the outlook for the Federal Reserve. The other seven relate directly to the currency market. We will resume our regular publishing schedule on January 4th, 2019. The Foreign Exchange Strategy team would like to thank you for your continued readership and wish you and yours a joyful holiday season as well as a healthy, happy and prosperous 2019.   Warm Regards, Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Feature 1) Chinese Growth Outlook Since the 19th National Congress of the Communist Party of China, Beijing has been focused on controlling debt growth. The Chinese leadership is worried that too much debt will lead to the dreaded middle-income trap, whereby a country’s development stalls once it achieves middle-income status. Because of Beijing’s laser focus on debt, Chinese growth, especially in the industrial sector, has slowed. Yet in the second half of 2018, Chinese policymakers have grown concerned by the deepening malaise in the domestic economy. Consequently, they have loosened policy, accelerating the issuance of local government bonds, letting the repo rate fall to 2.7% and cutting the reserve requirement ratio to 14.5%. Despite these measures, credit growth has continued to slow, hitting 16-year lows, and crucially, the shadow banking system is still contracting (Chart 1, left panel). While the supply of credit remains tepid, declining demand for credit is more concerning. China’s marginal propensity to save, as approximated by the gap between the growth of M2 and M1 money supply, is still rising. Historically, a rising marginal propensity to save leads to slowing industrial activity and slowing import growth (Chart 1, right panel). This implies that China will continue to weigh on global trade and global industrial activity. Thus, to turn growth around, Chinese policymakers will need to ease policy further. Chart 1AChinese Growth Will Slow Further (I) Chart 1BChinese Growth Will Slow Further (II) 2) Global Growth And Inflation Outlook Already, the outlook for Chinese growth points to additional downside to global growth – something EM carry trades financed in yen are already sniffing out (Chart 2, left panel). The deterioration in the performance of those carry trades further amplifies the negative impulse emanating from China. If high-yielding EM currencies depreciate versus funding currencies like the yen, money is leaving those economies. Hence, EM liquidity conditions are tightening and financial conditions are deteriorating, reinforcing the leading property of EM carry trades vis-à-vis global industrial activity. Chart 2ASlowing Global Growth And Inflation (I) Chart 2BSlowing Global Growth And Inflation (II) Moreover, as telegraphed by the relative performance of EM bonds to EM equities, global inflation is set to peak soon, and then decelerate (Chart 2, right panel). This is a natural consequence of the deflationary impact of slowing Chinese growth and tightening EM liquidity conditions – the two most crucial factors lying behind the softness in global growth. Thus, financial markets are likely to remain volatile, at least until global policymakers have changed their tune enough to reverse global growth and inflation dynamics. 3) The Fed Is On Track To Hike More Than The Market Believes In its latest set of forecasts, the Federal Reserve may have been forced to adjust how much it will hike interest rates over the coming years. Nonetheless, by the end of 2020, the FOMC still anticipates having to increase interest rates by more than the -8 basis points currently priced into the futures curve. We are inclined to side with the Fed. U.S. growth may be slowing, but it will remain above trend in 2019. Additionally, the U.S. economy is most likely already at full employment, thus inflationary pressures are building. For the Fed, the labor market remains the fulcrum of potential inflation. As the left panel of Chart 3 shows, both the Atlanta Fed Wage Tracker and BLS average hourly earnings are growing at an accelerating pace, giving the Fed ammo to hike rates further. Moreover, the highly interest-sensitive housing sector has been a great source of concern for U.S. growth. However, now that this year’s surge in mortgage rates is being digested, mortgage applications are once again rebounding (Chart 3, right panel). This suggests that real estate activity will stabilize. Hence, even if the Fed pauses, it will still surprise markets to the upside over the coming 24 months. Chart 3AGood Reasons To Keep Hiking In 2019 Chart 3BGood Reasons To Keep Hiking In 2019 4) The Dollar Can Rally Even If U.S. Growth Falls Off A Cliff In our assessment, U.S. growth will slow next year, but will nonetheless remain above trend. However, if we are wrong and U.S. growth weakens much more, the dollar is unlikely to crater. As Chart 4 illustrates, periods of broad growth weakness – as measured by our U.S. economic diffusion index – often generate a strong – not weak – dollar. U.S. growth weakness often happens as global growth deteriorates. Since the U.S. economy exhibits a low beta to global industrial activity – the segment of the economy that contributes most to the variance in GDP growth – it follows that if a shock is global, the U.S. is likely to perform better than the rest of the world, leading to a strong dollar. Today, the downside risk is that the U.S. catches the cold that has hit the global economy. Hence, if U.S. growth has significantly more downside, it would suggest that economies outside the U.S. would suffer even more. The dollar should perform well in this environment. Chart 4The Dollar Doesn't Really Care If U.S. Growth Slows 5) The Dollar Versus Global Growth And Global Inflation The most important question to forecast the path of the dollar is where we stand in the global growth and inflation cycle. As Chart 5 shows, the dollar tends to perform most poorly early in the business cycle, when global growth is picking up but inflation remains muted (bottom-right quadrant), and late in the cycle when global growth has begun to weaken but inflation remains perky (top-left quadrant). The best time to hold the greenback is during global downturns, when both global growth and inflation are decelerating (bottom-left quadrant). With global industrial activity on a downtrend and inflation set to roll over soon, we are entering the bottom-left quadrant. As a result, the greenback should continue to rally on a trade-weighted basis, gaining most against the commodity currency complex. The yen may be the one currency bucking this trend, as in recent years it has become even more counter-cyclical than the dollar. 6) The Dollar Is A Momentum Currency One of the defining characteristics of the greenback is that from an investment-style perspective, it is a momentum currency. As the left panel of Chart 6 illustrates, among G-10 currencies, momentum continuation strategies work best for the USD. This is because of feedback loops present in the global economy. Chart 6BMomentum Still Flashing A Greenlight For The Greenback (II) Of the major economies, the U.S. is the least sensitive to global trade and global investment – a consequence of the low share of exports and manufacturing in GDP and employment. As a result, when global growth deteriorates, the U.S. economy experiences less of a slowdown and American rates of return decline less. Thus, money comes back into the U.S., lifting the dollar in the process. However, since there is USD 14-trillion in dollar-denominated foreign-currency debt, a rising dollar increases the cost of capital for these borrowers. The ensuing tightening in financial conditions hurts global growth, further enhancing the greenback’s appeal. The relationship goes in reverse once global growth improves. These powerful feedback loops explain why when the dollar strengthens, it remains stronger for longer than anyone anticipated, and vice versa when it weakens. Today, the momentum signal for the dollar remains positive (Chart 6, right panel). Along with slowing global growth, momentum was one of the key factors behind the dollar’s strength this year. If, as we expect, global inflation also weakens in the first half of 2019, the dollar will likely experience a beautiful first six months of the year. 7) Keep An Eye On Sino-U.S. Rate Differentials When one-year interest rate differentials between the U.S. and China widen, the DXY tends to strengthen (Chart 7, left panel). This is a reflection of global growth dynamics. U.S rates tend to rise relative to China when Chinese growth is decelerating. Since a slowing Chinese economy implies less intake of machinery and raw materials, a weaker China hurts Europe, Japan, EM and commodity producers a lot more than it affects the U.S. This lifts the dollar in the process. Moreover, so long as Chinese one-year interest rates keep falling versus the U.S., it also signals that any reflationary efforts by China have not yet had any impact on growth. Chart 7AU.S.-China Rate Differentials Point To A Stronger Dollar (I) Chart 7BU.S.-China Rate Differentials Point To A Stronger Dollar (II) This same rate differential between the U.S. and China also drives fluctuations in USD/CNY (Chart 7, right panel). Since falling relative Chinese rates are a symptom of a weaker Chinese economy, this relationship makes sense. Moreover, in recent years, more than against the dollar, Chinese policymakers have targeted the value of the CNY on a trade-weighted basis. Mechanically, if slowing Chinese growth flatters the trade-weighted dollar, it also forces USD/CNY up. This can further reinforce the strength in the broad trade-weighted dollar as a falling CNY is deflationary for the global economy. Because Chinese growth remains weak, we expect U.S. rates to continue to move higher vis-à-vis Chinese ones, lifting both the DXY and USD/CNY in the process. 8) EUR/USD: More Downside And A Complex Bottoming Process Ahead EUR/USD will suffer if global growth weakens and the dollar strengthens. On one hand, the European economy is much more sensitive to the Chinese and global industrial cycle than U.S. activity is. Our outlook for global growth therefore implies that the European Central Bank will find it difficult to raise rates in the fall of 2019, while the Fed is likely to surprise markets on the hawkish side. On the other hand, the simplest vehicle to bet on a strengthening dollar is to sell EUR/USD. Our fair-value model for EUR/USD currently pegs its equilibrium at 1.11 (Chart 8, left panel). However, EUR/USD never ends its downdrafts at its fair value – a consequence of its negative correlation with the dollar, a momentum currency that easily over- and under-shoots fair value. Thus, we expect the euro to find stability closer to 1.08. Chart 8AEUR/USD Will Bottom Later Next Year (I) Chart 8BEUR/USD Will Bottom Later Next Year (II) Moreover, inflationary dynamics do not suggest that EUR/USD is yet ripe for the taking. Since 2008, the gap between euro area and U.S. core CPI has been a reliable leading indicator for EUR/USD (Chart 8, right panel). In fact, this chart suggests that EUR/USD is more likely to bottom towards the second half of 2019; so as long as European inflation remains tepid, it will be hard for this currency to suddenly rebound and recoup the losses it has experienced this year. A complex bottom is more likely than a V-shaped one. 9) EUR/JPY: All About Bond Yields Even more so than USD/JPY, EUR/JPY remains beholden to trends in global bond yields (Chart 9). BCA’s view is that on a cyclical horizon of nine to 12 months, bond yields have upside. However, with global growth and inflation likely to decelerate further in the first half of 2019, safe haven assets could remain well bid over that timeframe. This implies the time to buy EUR/JPY is not now, and that a better buying opportunity will emerge once global growth stabilizes. Thus, we remain short EUR/JPY for the time being, a view we have held since the beginning of 2018. Chart 9Risks To Global Growth Equals EUR/JPY Downside 10) EUR/GBP Is At Risk At the current juncture, EUR/GBP is a binary bet: Either a hard Brexit comes to fruition, in which case U.K. real rates plummet and British inflation rises above 5%, creating a deeply pound-bearish environment. Alternatively, a soft Brexit (or even no Brexit) materializes, in which cases British real rates have upside, the Bank of England has a freer hand to combat inflationary pressures, and the pound can rally. With EUR/GBP currently trading toward the top of its historical distribution, we believe it is an attractive shorting opportunity (Chart 10). Marko Papic, BCA’s chief geopolitical strategist, assigns a less than 10% probability of a hard Brexit. As such, the pound is more likely to exist in a soft/no-Brexit world in 12 months than otherwise. This means the pound should be-revalued. Chart 10Sell EUR/GBP We prefer playing the pound’s strength against the euro rather than the dollar, as we expect the dollar to rally further in the first half of 2019, so cable would be swimming against the tide. Moreover, when the dollar strengthens, historically EUR/GBP weakens, as the GBP has a lower beta to the dollar than the euro does. Hence, our dollar view is also consistent with a lower EUR/GBP. Mathieu Savary, Vice President Foreign Exchange Strategy mathieu@bcaresearch.com Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Asset allocation: Start 2019 with an overweight to industrial commodities versus equities. Await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Equities: Start 2019 with a cyclical equity sector tilt, but become more defensive as the global economy inevitably flips into a down-oscillation later in 2019. Start tactically overweight Italy’s MIB versus the Eurostoxx. Bonds: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. Currencies: Start 2019 short EUR/JPY combined with long EUR/USD. There will be a great opportunity to buy the GBP, but not yet. Alternatives: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. Feature 2019 will present investors a mirror-image pattern to 2018. Through most of 2018, global growth was decelerating while inflation was accelerating. Now this configuration is flipping: global growth is rebounding while inflation is set to collapse. Growth To Rebound, Then Fade Global growth has entered an up-oscillation, for which the evidence is irrefutable: Industrial (non-oil) commodities are strongly outperforming equities, and rising even in absolute terms (Chart of the Week and Chart 2). Emerging markets are strongly outperforming developed markets (Chart 3). Financials are outperforming the broad equity market (Chart 4). Sweden’s manufacturing PMI – a bellwether of global activity – is rebounding strongly (Chart 5). Perhaps most importantly, China’s 6-month credit impulse has gone vertical (Chart 6). Chart of the WeekNon-Oil Commodities Are Strongly Outperforming Equities   Chart I-2Non-Oil Commodities Are Recovering In Absolute Terms Too   Chart I-3Emerging Markets Are Strongly Outperforming Developed Markets Chart I-4Financials Are Outperforming Chart I-5Sweden’s Manufacturing PMI Is Up Sharply Chart I-6China’s 6-Month Credit Impulse Has Gone Vertical Taken together, this is compelling evidence of a growth rebound, even if it is modest. Crucially, such up-oscillations tend to last at least six to eight months. Hence, equity sector performances, which always take their cue from global growth, will follow a mirror-image pattern in 2019 to that in 2018. Bottom Line: Start the year with an overweight to industrial commodities versus equities and a cyclical equity sector tilt, but prepare to fade to a more defensive tilt as the global economy inevitably flips into a down-oscillation later in 2019. Inflation Is The Dog That Will Not Bark There are not many things that are certain in the economy, but a racing certainty for early 2019 is that headline inflation will collapse. This is because the plunge in the crude oil price – 40 percent so far and getting worse by the day – is about to feed through into headline consumer price indexes (Chart 7 and Chart 8). Inevitably, it will seep through into core inflation too, via the impact on energy dependent prices such as transport costs. Chart I-7Headline Inflation Will Collapse In Europe Chart I-8Headline Inflation Will Collapse In The U.S. Coming at a time that central banks have professed a much greater reliance on “incoming data”, we can deduce that central banks will find it hard to tighten policy in the face of weaker headline and core inflation prints. Crucially though, the ECB and BoJ were not planning on tightening policy anyway, so the plunge in reported inflation will be much more impactful on the Fed. This makes the dollar vulnerable, leaving us a choice between the euro and yen as our preferred major currency. And on this head-to-head the yen still beats the euro given its lower political risk: Bottom Line: Start 2019 short EUR/JPY combined with long EUR/USD. Use ‘The Rule Of 4’ And Fractals To Predict Tipping-Points For Equities Investment strategists are obsessed with timing the next recession. The thinking is that by predicting the next recession they can predict the next equity bear market. The logic sounds fine, except that the causality rarely runs from economic downturns to financial market instabilities. The causality almost always runs the other way. Paul Volcker, arguably the greatest central banker of the modern era, correctly points out that the danger to the economy almost always comes from systemic financial disturbances. The last three downturns, in 2000, 2007 and 2011, all resulted from financial disturbances: the bursting of the dot com bubble, the gross mispricing of U.S. sub-prime mortgages, and the distortion of euro area sovereign debt markets respectively. Instead of timing the next recession to predict financial market instability, the correct approach is to flip the logic around and ask: is there a glaring source of financial instability that could cause the next recession? To which the answer is yes. The current glaring instability is the hyper-vulnerability of elevated risk-asset valuations to the global bond yield. Near the lower bound of bond yields, bond prices develop the same unattractive negative asymmetry as equities, removing the need for an equity risk premium, and justifying sharply higher equity valuations. But when the 10-year global bond yield rises back to around 2 percent – or equivalently when the sum of the 10-year U.S. T-bond, German bund and Japanese government bond approaches 4 percent ‘the rule of 4’ – the process viciously reverses: bond prices lose their negative asymmetry, re-requiring an equity risk premium and sharply lower equity valuations (Chart 9 and Chart 10). Chart I-9Equities Plunged In February After A Spike In Bond Yields Chart I-10Equities Plunged In October After A Spike In Bond Yields In 2019, just as in 2018, investors should use this dynamic to allocate tactically to equities versus cash as follows: 1. When the rule of 4 approaches 4 and the market’s 65-day fractal dimension signals an overbought rally, go underweight equities. 2. When the rule of 4 approaches 3 and the market’s 65-day fractal dimension signals an oversold sell-off, go overweight equities. 3. At all other times stay neutral. Bottom Line: With the rule of 4 now approaching 3, await an oversold sell-off signal on the 65-day fractal dimension to go tactically overweight equities versus cash. Britain Escalates EU Tensions, Italy De-Escalates The two points of political tension in Europe, the U.K. and Italy, have a common theme: brinkmanship with the EU. The Brexit tension remains high and may even intensify in early 2019 before a resolution. Hence, while 2019 will offer a great opportunity to buy the pound, it might require a little patience. In contrast, Italy is de-escalating its brinkmanship with Brussels over its budget deficit. Meanwhile the crux of Italy’s long-standing woes – its banking system – is also showing signs of healing. The proportion of bank loans that are non-performing is plummeting, while the solvency of the banking system continues to improve (Chart 11 and Chart 12). Chart I-11Italian Banks’ NPLs Are Plummeting… Chart I-12…And Italian Banks’ Solvency Is Improving Bottom Line: Initiate a bond yield convergence play: long 10-year Italian BTPs versus Spanish Bonos. And tactically overweight Italy’s MIB versus the Eurostoxx. Cryptocurrencies Will Rebound 60 Percent Cryptocurrencies are here to stay, because the underlying technology, the blockchain, is here to stay. Just as the internet’s major innovation was to decentralise and democratise information, the blockchain’s major innovation is to decentralise and democratise trust. Until now, counterparties without an established trust relationship could only transact through an intermediary who could provide the necessary trust overlay. But once each participant in a transaction trusts the blockchain itself, they no longer need to use a conventional intermediary, like a bank or a law firm. One major argument against the blockchain is that it is energy intensive and therefore prohibitively costly. But conventional intermediation also exacts a significant cost. Let’s say that the stock of excess savings that the banks intermediate to borrowers conservatively equals global GDP. If the risk-adjusted interest rate spread that banks charge for their intermediation role conservatively equals 1 percent, it means that this conventional intermediation is costing 1 percent of global GDP. Against this, global energy consumption equals roughly 5 percent of global GDP. So even if the blockchain consumed a fifth of the world’s energy, its cost might still be comparable to conventional intermediation. The plunge in cryptocurrencies during 2018 was exacerbated by the recent ‘hard fork’ in bitcoin protocol. But such hard forks are a necessary part of the evolutionary process – being analogous to a Darwinian mutation which eliminates the weakest protocols while allowing the strongest and fittest to thrive. In the latest fork, the battle was between those who want cryptocurrencies to remain a speculative asset with low long-term survival prospects, and those who want them to become a stable means of payment with high long-term survival prospects. A year ago almost to the day, we recommended selling bitcoin at a price of $18,000. Our rationale was that excessive herding required a price gap down to normalise liquidity. The subsequent decline in the price to $3500 today has rewarded that recommendation handsomely. But today, Litecoin and Ethereum are approaching an opposite tipping-point where the price may have to gap up to normalise liquidity (Chart 13 and Chart 14). Chart I-13Litecoin Is Oversold On A 65-Day Horizon   Chart I-14Litecoin Is Oversold On A 130-Day Horizon Bottom Line: A compelling buying opportunity for the cryptocurrencies Litecoin and Ethereum. For a 50:50 basket, target a return of 60 percent. And on that positive note, I am signing off for the year. I do hope that you have enjoyed reading this year’s reports, but more importantly that you have found value in them. This publication’s philosophy is to think out of the box, independently and unconstrained, never to shirk from challenging the received wisdom, and ultimately to provide successful investment ideas. We promise to continue this way in 2019! It just remains for me to wish you a very happy holiday season and a prosperous new year. Dhaval Joshi, Senior Vice President Chief European Investment Strategist dhaval@bcaresearch.com   Fractal Trading Model* As discussed in the main body of this report, this week’s recommended trade is to buy a 50:50 combination of Litecoin and Ethereum. Set a profit target of 60 percent with a symmetrical stop-loss. As also discussed in the main body of this report, remain tactically overweight Italy’s MIB versus the Eurostoxx. 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. * 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. Fractal Trading Model Recommendations Asset Allocation Equity Regional and Country Allocation Equity Sector Allocation Bond and Interest Rate Allocation Currency and Other Allocation Closed Fractal Trades Trades Closed Trades Asset Performance Currency & Bond Equity Sector Country Equity Indicators Bond Yields Chart II-1 Chart II-2 Chart II-3 Chart II-4 Interest Rate Chart II-5 Chart II-6 Chart II-7 Chart II-8

Special Report

Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead.     Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2      In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.    

Highlights So What? Our best and worst calls of 2018 cast light on our methodology and 2019 forecasts. Why? Our clients took us to task for violating our own methodology on the Iranian oil sanctions. Sticking to our guns would have paid off with long Russian equities versus EM. We correctly called China’s domestic policy, the U.S.-China trade war, Europe, the U.S. midterms, and relative winners in emerging markets. Feature It has been a tradition for BCA’s Geopolitical Strategy, since our launch in 2012, to highlight our best and worst forecasts of the year.1 This will also be the final publication of the year, provided that there is no global conflagration worthy of a missive between now and January 9, when we return to our regular publication schedule. We wish all of our clients a great Holiday Season. And especially all the very best in 2019: lots of happiness, health, and hefty returns. Good luck and good hunting. The Worst Calls Of 2018 A forecasting mistake is wasted if one learns nothing from the error. This is why we take our mistakes seriously and why we always begin the report card with our zingers. Our overall performance in 2018 was … one of our best. The successes below will testify to this. However, we made three notable errors. A Schizophrenic Russia View Our worst call of the year was to panic and close our long Russian equities relative to emerging markets trade in the face of headline geopolitical risks. In early March, we posited that Russia was a “buy” relative to the broad EM equity index due to a combination of cheap valuations, strong macro fundamentals, orthodox policy, and an end to large-scale geopolitical adventurism. This call ultimately proved to be correct (Chart 1). Chart 1Russian Stocks Outperformed In The End What went wrong? The main risk to our view, that the U.S. Congress would pursue an anti-Russia agenda regardless of any Russian sympathies in the Trump White House, materialized in the wake of the poisoning of former Russian military intelligence officer Sergei Skripal with a Novichok nerve agent in the United Kingdom. As fate would have it, the incident occurred just before our bullish report went to clients! The ensuing international uproar and sanctions caused a selloff. Our bullish thesis did not rest exclusively on geopolitics, but a thaw in West-Russia relations did form the main pillar of the view. Our Russia Geopolitical Risk Index, which had served us well in the past, was pricing as low of a level of geopolitical risk as one could hope for in the post-Crimea environment (Chart 2). Naturally the measure jumped into action following the Skripal incident. Chart 2Geopolitical Risk Was Low Prior To Skripal The timing of our call was therefore off, but we should have stuck with the overall view. The U.S. imposed preliminary sanctions that lacked teeth. While Washington accepted the U.K.’s assessment that Moscow was behind the poisoning, the weakness of the sanctions also signaled that the U.S. did not consider the incident worthy of a tougher position. There are now two parallel sanction processes under way. The first round of sanctions announced in August gave Russia 90 days to comply and adopt “remedial measures” regarding the use of chemical and biological weapons. On November 9, the U.S. State Department noted that Russia had not complied with the deadline. The U.S. is now expected to impose a second round of sanctions that will include at least three of six punitive actions: Opposition to development aid and assistance by international financial institutions (think the IMF and the World Bank); Downgrading diplomatic relations; Additional restrictions on exports to Russia (high-tech exports have already been barred by the first round of sanctions); Restrictions on imports from Russia; A ban on landing rights in the U.S. for Russian state-owned airlines; Prohibiting U.S. banks from purchasing Russian government debt. While the White House was expected to have such sanctions ready to go on the November 9 deadline, it has dragged its feet for almost two months now. This suggests that President Trump continues to hold out for improved relations with President Putin. A visit by President Putin to Washington remains possible in Q1 2019. As such, we would expect the White House to adopt some mix of the first five items on the above list, hardly a crushing response from Moscow’s perspective. The U.S. Congress, however, has a parallel process in the form of the Defending American Security from Kremlin Aggression Act of 2018 (DASKAA). Introduced in August by Senator Lindsey Graham, a Russia hawk, the legislation would put restrictions on Americans buying Russian sovereign debt and curb investments in Russian energy projects. The bill also includes secondary sanctions on investing in the Russian oil sector, which would potentially ensnare European energy companies collaborating with Russia in the energy sector. There was some expectation that Congress would take up the bill ahead of the midterm election, but nothing came of it. Even with the latest incident – the seizing of two Ukrainian naval vessels in the Kerch Strait – we have yet to see action. While we expect the U.S. to do something eventually, the White House approach is likely to be tepid while the congressional approach may be too draconian to pass into law. And with Democrats about to take over the House, and likely demand even tougher sanctions against Russia, the ultimate legislation may be too bold for President Trump to sign into legislation. The point is that Russia has acted antagonistically towards the West in 2018, but in small enough increments that the response has been tepid. Given the paucity of Russian financial and trade links with the U.S., Washington’s sanctions would only bite if they included the dreaded “secondary sanction” implications for third party sovereigns and firms – particularly European, which do have a lot of business in Russia. This is highly unlikely without major Russian aggression. We cannot completely ignore the potential for such aggression in 2019, especially with President Putin’s popularity in the doldrums (Chart 3) and a contentious Ukrainian election due for March 31. However, we outlined the constraints against Russia in 2014, amidst the Ukrainian crisis, and we do not think that these constraints have been reduced (they may have only grown since then). Chart 3Non-Negligible Risk Of Russian Aggression Regardless of the big picture for 2019, we could have faded the risks in 2018 and stuck to the fundamentals. Russia is up 17.2% against EM year-to-date. The lesson here, therefore, is to find re-entry points into a well-founded view despite market volatility. Chart 1 shows that Russian equities climbed the proverbial “wall of worry” relative to EM in 2018. Doubting Jair Bolsonaro Our list of mistakes keeps us in the EM universe where we underestimated Jair Bolsonaro’s chances of winning the presidency in Brazil. The answer to the question we posed in the title of our September report – “Brazil: Can The Election Change Anything?” – was a definitive “yes.” Since the publication of that report, BRL/USD is up 2.9% and Brazilian equities are up 18.5% relative to EM (Chart 4). Chart 4Bolsonaro Rally Losing Its Luster Already To our credit, the question of Bolsonaro’s electoral chances elicited passionate and pointed internal debate. But our clients did not see the internal struggle, just the incorrect external output! A bad call is a bad call, no matter how it is assembled on the intellectual assembly line. That said, we still think that our report is valuable. It sets out the constraints facing Bolsonaro in 2019. He has to convince the left-leaning median voter that meaningful pension reform is needed; bully a fractured Congress into painful structural reforms; and overcome an unforgiving macro context of tepid Chinese stimulus and a strong USD. If the Bolsonaro administration wastes the good will of the investment community over the next six months, we expect the market’s punishment to be swift and painful. In fact, Chart 4 notes that the initial Bolsonaro rally has already lost most of its shine. Brazilian assets are still up since the election, but the gentle slope could become a steep fall if Bolsonaro stumbles. The market is priced for political perfection. To be clear, we are not bearish on Bolsonaro. We believe that, relative to EM, he will be a positive for Brazil. However, the market is currently betting that he will win by two touchdowns, whereas we think he will squeak by with a last-second field goal. The difference between the two forecasts is compelling and we have expressed it by being long MXN/BRL.2 Not Sticking To Our Method In The Case Of Iran Throughout late-2017 and 2018 we pointed out that President Trump’s successful application of “maximum pressure” against North Korea could become a market-relevant risk if he were emboldened to try the same strategy against Iran. For much of the year, this view was prescient. As investors realized the seriousness of President Trump’s strategy, a geopolitical risk premium began to seep into oil prices, as illustrated in Chart 5 by the red bar. Every time we spoke to clients or published reports on this topic, we highlighted just how dangerous a “maximum pressure” strategy would be in the case of Iran. We stressed that Iran could wreak havoc across Iraq and other parts of the Middle East and even drive up oil prices to the point of causing a “geopolitical recession in 2019.” In other words, we stressed the extraordinary constraints that President Trump would face. To their credit many of our clients called us out on the inconsistency: our market call was über bullish oil prices, while our methodology emphasized constraints over preferences. We were constantly fielding questions such as: Why would President Trump face down such overwhelming constraints? We did not have a very good answer to this question other than that he was ideologically committed to overturning the Iranian nuclear deal. In essence, we doubted President Trump’s own ideological flexibility and realism. That was a mistake and we tip our hat to the White House for recognizing the complex constraints arrayed against it. President Trump realized by October how dangerous those constraints were and began floating the idea of sanction waivers, causing the geopolitical risk premium to drain from the market (Chart 6). To our credit, we highlighted sanction waivers as a key risk to our view and thus took profit on our bullish energy call early. Chart 6Sanction Waivers Caused A Collapse In Oil Prices That said, our clients have taken the argument further, pointing out that if we were wrong on Trump’s ideological flexibility with Iran, we may be making the same mistake when it comes to China. However, there is a critical difference. Americans are more concerned about conflict with North Korea than with Iran (Chart 7), while China is the major concern about trade (Chart 8). Second, railing against the Iran deal did not get President Trump elected, whereas his protectionist rhetoric – specifically regarding China – did (Chart 9). Getting anything less than the mother-of-all-deals with Beijing will draw down Trump’s political capital ahead of 2020 and open him to accusations of being “weak” and “surrendering to China.” These are accusations that the country’s other set of protectionists – the Democrats – will wantonly employ against him in the next general election. Chart 9Protectionism, Not Iran, Helped Trump Get Elected Ultimately, if we have to be wrong, we are at least satisfied that our method stood firm in the face of our own fallibility. We are doubly glad to see our clients using our own method against our views. This is precisely what we wanted to accomplish when we began BCA’s Geopolitical Strategy in March 2012: to revolutionize finance by raising the sophistication with which it approaches geopolitics. That was a lofty goal, but we do not pretend to hold the monopoly on our constraint-based methodology. In the end, our market calls did not suffer due to our error. We closed our long EM energy-producer equities / EM equities for a gain of 4.67% and our long Brent / short S&P 500 for a gain of 6.01%. However, our latter call, shorting the S&P 500 in September, was based on several reasons, including concerns regarding FAANG stocks, overstretched valuations, and an escalation of the trade war. Had we paired our S&P 500 short with a better long, we would have added far more value to our clients. It is that lost opportunity that has kept us up at night throughout this quarter. We essentially timed the S&P 500 correction, but paired it with a wayward long. The Best Calls Of 2018 BCA’s Geopolitical Strategy had a strong year. We are not going to list all of our calls here, but only those most relevant to our clients. Our best 2018 forecast originally appeared in 2017, when in April of that year we predicted that “Political Risks Are Understated In 2018.” Our reasoning was bang on: U.S. fiscal policy would turn strongly stimulative (the tax cuts would pass and Trump would be a big spender) and thus cause the Fed to turn hawkish and the USD to rally, tightening global monetary policy; Trump’s trade war would re-emerge in 2018; China would reboot its structural reform efforts by focusing on containing leverage, thus tightening global “fiscal” policy. In the same report we also predicted that Italian elections in 2018 would reignite Euro Area breakup risks, but that Italian policymakers would ultimately be found to be bluffing, as has been our long-running assertion. Throughout 2018, our team largely maintained and curated the forecasts expressed in that early 2017 report. We start the list of the best calls with the one call that was by far the most important for global assets in 2018: economic policy in China. The Chinese Would Over-Tighten, Then Under-Stimulate Getting Chinese policy right required us, first, to predict that policy would bring negative economic surprises this year, and second, once policy began to ease, to convince clients and colleagues that “this time would be different” and the stimulus would not be very stimulating. In other words, this time, China would not panic and reach for the credit lever of the post-2008 years (Chart 10), but would maintain its relatively tight economic, financial, environmental, and macro-prudential oversight, while easing only on the margin. Chart 10No Massive Credit Stimulus In 2018 This is precisely what occurred. BCA Foreign Exchange Strategy’s “China Play Index,” which is designed to capture any reflation out of Beijing, collapsed in 2018 and has hardly ticked up since the policy easing announced in July (Chart 11). Chart 11Weak Reflation Signal From China Our view was based on an understanding of Chinese politics that we can confidently say has been unique: From March 2017, we highlighted the importance of the 2017 October Party Congress, arguing that President Xi Jinping would consolidate his power and redouble his attempts to “reform” the economy by reining in dangerous imbalances. We explicitly characterized the containment of leverage as the most market-relevant reform to focus on. We stringently ignored the ideological debate about the nature of reform in China, focusing instead on the major policy changes afoot. We identified very early on how the rising odds of a U.S.-China conflict would embolden Chinese leadership to double-down on painful structural reforms. Will China maintain this disciplined approach in 2019? That is yet to be seen. But we are arming ourselves and clients with critical ways to identify when and whether Beijing’s policy easing transforms into a full-blown “stimulus overshoot”: First, we need to see a clear upturn in shadow financing to believe that the Xi administration has given up on preventing excess debt. Assuming that such a shift occurs, and that overall credit improves, it will enable us to turn bullish on global growth and global risk assets on a cyclical, i.e., not merely tactical, horizon (Chart 12). Chart 12A Shadow Lending Surge Would Mean A Big Policy Shift Second, our qualitative checklist will need to see a lot more “checks” in order to change our mind. Short of an extraordinary surge in bank and shadow bank credit, there needs to be a splurge in central and especially local government spending (Table 1). The mid-year spike in local governments’ new bond issuance in 2018 was fleeting and fell far short of the surge that initiated the large-scale stimulus of 2015. Frontloading these bonds in 2019 will depend on timing and magnitude. Table 1A Credit Splurge, Or Government Spending Splurge, Is Necessary For Stimulus To Overshoot Third, we would need to see President Xi Jinping make a shift in rhetoric away from the “Three Battles” of financial risk, pollution, and poverty. Having identified systemic financial risk as the first of the three ills, Xi needs to make a dramatic reversal of this three-year action plan if he is to clear the way for another credit blowout. Trade War Would Reignite In 2018 It paid off to stick with our trade war alarmism in 2018. We correctly forecast that the U.S. and China would collide over trade and that their initial trade agreement – on May 20 – was insubstantial and would not last. In the event it lasted three days. Our one setback on the trade front was to doubt the two sides would agree to a trade truce at the G20. However, by assigning a subjective 40% probability, we correctly noted the fair odds of a truce. We also insisted that any truce would be temporary, which ended up being the case. We may yet be vindicated if the March 1 deadline produces no sustainable deal, as we forecast in last week’s Strategic Outlook. That said, correct geopolitical calls do not butter our bread at BCA. Rather, we are paid to make market calls. To that end, we would point out that we correctly assessed the market-relevance of the trade conflict, fading S&P 500 risks and focusing on the effect on global risk assets. Will this continue into 2019? We think so. We do not see trade conflict as the originator of ongoing market turbulence (Chart 13) and would expect the U.S. to outperform global equities again over the course of 2019 (Chart 14). This view may appear wrong in Q1, as the market digests the Fed backing off from hawkish rhetoric, the ongoing trade negotiations, and the likely seasonal uptick in Chinese credit data in the beginning of the calendar year. Chart 13Yields, Not Trade War, Drove Stocks Chart 14U.S. Stocks Will Resume Outperformance However, any stabilization in equity markets would likely serve to ease financial conditions in the U.S., where economic and inflation conditions remain firmly in tightening territory (Chart 15). As such, the Fed pause is likely to last no more than a quarter, maybe two at best, leading to renewed carnage in global risk assets if our view on Chinese policy stimulus – tepid – remains valid through the course of 2019. Chart 15If Financial Conditions Ease, Tightening Will Be Back On Europe (All Of It… Again) In 2017, our forecasting track record for Europe was stellar. This continued in 2018, with no major setbacks: Populism in Italy: Our long-held view has been that Europe’s chief remaining risks lay in Italian populists coming to power. We predicted in 2016 that this would eventually happen and that they would then be proven to be bluffing. This is essentially what happened in 2018. Matteo Salvini’s Lega is surging in the polls because its leader has realized that a combination of hard anti-immigrant policy and the softest-of-soft Euroskepticism is a winning combination. We believe that investors can live with this combination. Our only major fault in forecasting European politics and assets this year was to close our bearish Italy call too early: we booked our long Spanish / short Italian 10-year government bond trade for a small loss in August, before the spread between the two Mediterranean countries blew out to record levels. That missed opportunity could have also made it on our “worst calls” list as well. Pluralism in Europe: To get the call on Italy right, we had to dabble in some theoretical work. In a somewhat academic report, we showed that political concentration was on the decline in the developed world (Chart 16), but especially in Europe (Chart 17). Put simply, lower political concentration suggests that a duopoly between the traditional center-left and center-right parties is breaking down. Contrary to the conventional wisdom, we argued that Europe’s parliamentary systems would enable centrist parties to adopt elements of the populist agenda, particularly on immigration, without compromising the overall stability of European institutions. As such, political pluralism, or low political concentration, is positive for markets. Immigration crisis is over: For centrist parties to be able to successfully adopt populist immigration policy, they needed a pause in the immigration crisis. This was empirically verifiable in 2018 (Chart 18). Chart 18European Migration Crisis Is Over Merkel’s time has run out: Since early 2017, we had cautioned clients that Angela Merkel’s demise was afoot, but that it would be an opportunity, rather than a risk, when it came. It finally happened in 2018 and it was not a market moving event. The main question for 2019 is whether German policymakers, and Europe as a whole, will use the infusion of fresh blood in Berlin to reaccelerate crucial reforms ahead of the next global recession. Brexit: Since early 2016, we have been right on Brexit. More specifically, we were corrent in cautioning investors that, were Brexit to occur, “the biggest loser would be the Conservative Party, not the EU.” As with the previous two Conservative Party prime ministers, it appears that the question of the U.K.’s relationship with the EU has completely drained any political capital out of Prime Minister Theresa May’s reign. We suspect that the only factor propping up the Tories in the polls is that Jeremy Corbyn is the leader of Her Majesty’s Most Loyal Opposition. We have also argued that soft Brexit would ultimately prove to be “illogical” and that “Bregret” would begin to seep in, as it now most clearly has. We parlayed these rising geopolitical risks and uncertainties by shorting cable in the first half of the year for a 6.21% gain. Malaysia Over Turkey And India Over Brazil Not all was lost for our EM calls this year. We played Malaysia against Turkey in the currency markets for a 17.44% gain, largely thanks to massively divergent governance and structural reform trajectories after Malaysia’s opposition won power for the first time in the country’s history. Second, we initiated a long Indian / short Brazilian equity view in March that returned 27.54% by August. This was a similar play on divergent structural reforms, but it was also a way to hedge our alarmist view on trade. Given India’s isolation from global trade and insular financial markets, we identified India as one of the EM markets that would remain aloof of protectionist risks. We could have closed the trade earlier for greater gain, but did not time the exit properly. Midterm Election: A Major Democratic Victory Our midterm election forecast was correct: Democrats won a substantial victory. Even our initial call on the Senate, that Democrats had a surprisingly large probability of picking up seats, proved to be correct, with Republicans eking out just two gains in a year when Democrats were defending 10 seats in states that Trump carried in 2016. What about our all-important call that the election would have no impact on the markets? That is more difficult to assess, given that the S&P 500 has in fact collapsed in the lead-up to and aftermath of the election. However, we see little connection between the election outcome and the stock market’s performance. Neither do our colleagues or clients, who have largely stopped asking about the Democrats’ policy designs. In 2019, domestic politics may play a role in the markets. Impeachment risk is low, but, if it rears its head, it could prompt President Trump to seek relevance abroad, as his predecessors have done when they lost control of domestic policy. In addition, the Democratic Party’s sweeping House victory may suggest a political pendulum swing to the left in the 2020 presidential election. We will discuss both risks as part of our annual Five Black Swans report in early 2019. U.S. domestic politics was a collection of Red Herrings during much of President Obama’s presidency, and has produced strong tailwinds under President Trump (tax cuts in particular). This may change in 2019, with considerable risk to investors, and asset prices, ahead.     Marko Papic, Senior Vice President Chief Geopolitical Strategist marko@bcaresearch.com Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Roukaya Ibrahim, Editor/Strategist roukayai@bcaresearch.com Ekaterina Shtrevensky, Research Analyst ekaterinas@bcaresearch.com   Footnotes 1      For our 2019 Outlook, please see BCA Geopolitical Strategy Strategic Outlook, “2019 Key Views: Balanced On A Knife’s Edge,” dated December 14, 2018, available at gps.bcaresearch.com. For our past Strategic Outlooks, please visit gps.bcaresearch.com. 2      In part we like this cross because we also think that Mexico’s newly elected president, Andrés Manuel López Obrador, is priced to lose by two touchdowns, whereas he may merely lose by a last-second field goal.