Fiscal

Highlights Monetary policy remains accommodative in Japan, but will tighten on a relative basis if the Bank Of Japan (BoJ) stands pat. The BoJ’s margin of error is non-trivial, since a small external shock could well tip the economy back into deflation. Historically, the BoJ has needed an external shock to act, suggesting the path towards additional stimulus could be lined with a stronger yen. Our bias is that USD/JPY could weaken to 104 in the next three to six months, especially if market volatility spikes further. We are carefully monitoring any shift in the yen’s behavior, in particular its role as a counter-cyclical currency. If global growth eventually picks up, the yen will surely weaken on its crosses, but could still strengthen versus the dollar. Feature The powerful bounce in global markets since the December lows is sitting at a critical juncture. With the S&P 500 at its 200-day moving average, crude oil and Treasury yields plunging and the dollar taking a bid, it may only require a small shift in market prices to change sentiment sharply. The yen has strengthened in sympathy with these moves, but the balance of evidence suggests the possibility of a much bigger adjustment. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up, the yen could weaken on its crosses but strengthen vis-à-vis the dollar. This places short USD/JPY bets in an enviable “heads I win, tails I do not lose too much” position. BoJ: Out Of Policy Bullets For most of the 1990s, Japan was in a deflationary bust. In hindsight, the reason was simple: The structural growth rate of the economy was well below interest rates, which meant paying down debt was preferable to investing. Tight money also led to a structurally strong currency, reinforcing the negative feedback loop (Chart I-1). Chart I-1The Story Of Japan In One Chart Much farther down the road, the three arrows of ‘Abenomics’ arrived, ushering in a paradigm shift. Since 2012, Japan has enjoyed one of its longest economic expansions in recent history, having fine-tuned monetary policy each time private sector GDP growth has fallen close to interest rates. The result has been remarkable. The unemployment rate is close to a 26-year low, and the Nikkei index has tripled. But if the economy once again flirts with deflation, additional monetary policy options may be hard to come by, since there have been diminishing economic returns to additional stimulus. Chart I-2Stealth Tapering By ##br##The BoJ Chart I-32 Percent Inflation Equal Mission Impossible? The end of the Heisei era1 has brought forward the urgency of the above quandary. At its latest monetary policy meeting, the BoJ strengthened forward guidance, expanded collateral requirements for the provision of credit, and stated that it will continue to “conduct purchases of JGBs in a flexible manner so that their amount outstanding will increase at an annual pace of about 80 trillion yen.”2 But with the BoJ owning 46% of outstanding JGBs, about 75% of ETFs, and almost 5% of JREITs, this will be a tall order. The supply side obviously puts a serious limitation on how much more stimulus the central bank can provide. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. Total annual asset purchases by the BoJ are currently running at about ¥27 trillion, while JGBs purchases are running at ¥20 trillion. This is a far cry from the central bank’s soft target of ¥80 trillion, and is unlikely to change anytime soon. In recent years, the yen has become extremely sensitive to shifts in the relative balance sheets of the Federal Reserve and the BoJ. If the BoJ continues to purchase securities at its current pace, then the rate of expansion in its balance sheet will severely slow, and could trigger a knee-jerk rally in the yen (Chart I-2). The BoJ targets an inflation rate of 2%, but it is an open question as to whether it can actually achieve this. It pays attention to three main variables when looking at inflation: Core CPI, the GDP deflator, and the output gap. All indicators are pointing in the right direction, but the recent slowdown in the global economy could reverse this trend. It is always important to remember that the overarching theme for prices in Japan is a falling (and aging) population leading to deficient demand (Chart I-3). More importantly, almost 40% of the Japanese consumption basket is in tradeable goods, meaning domestic inflation is as much driven by the influence of the BoJ as it is by globalization. Even for prices within the BoJ’s control, an aging demographic that has a strong preference for falling prices is a powerful conflicting force. For example, over the years the government has been a thorn in the side of telecom companies, pushing them to keep cutting prices, given domestic pressures from its voting base. Transportation and telecommunications make up 17% of the core consumption basket in Japan, a non-negligible weight. This is and will remain a powerful drag on CPI (Chart I-4), making it difficult for the BoJ to re-anchor inflation expectations upward. On the other side of the coin, the importance of financial stability to the credit intermediation process has been a recurring theme among Japanese policymakers, with the health of the banking sector an important pillar. YCC and negative interest rates have been anathemas for Japanese net interest margins and share prices (Chart I-5). This, together with QE, has pushed banks to search for yield down the credit spectrum. Any policy shift that is increasingly negative for banks could easily tip them over. Chart I-4The Japanese Prefer Falling Prices Chart I-5Negative Rates Are Anathema To Banks Bottom Line: Inflation expectations are falling to rock-bottom levels in Japan, at a time when the BoJ may be running out of policy bullets. Meanwhile, the margin of error for the BoJ is non-trivial, since a small external shock could tip the economy back into deflation. The BoJ will eventually act, but it might first require a riot point. Go short USD/JPY. High Hurdle For Delaying Consumption Tax Since the late 1990s, every time Japan’s consumption tax has been hiked, the economy has slumped by an average of over 1.3% in subsequent quarters. For an economy with a potential growth rate of just 0.5-1%, this is a disastrous outcome. More importantly, similar to past episodes, the consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Foreign and domestic machinery orders are slowing, employment growth has halved from 2% to 1%, and wages are inflecting lower (Chart I-6). This is especially worrisome since the labor market has been the poster child of the Japanese recovery.3 The consumption tax is being hiked at a time when the economy is at the precipice of a major slowdown. Why go ahead with the consumption tax then? The answer lies in the concept of Ricardian equivalence.4 Despite relatively robust economic conditions since the Fukushima disaster, Japanese consumption has remained tepid. By the same token, the savings ratio for workers has surged (Chart I-7). If consumers are caught in a Ricardian equivalence negative feedback loop, exiting deflation becomes a pipe dream. Chart I-6A Bad Omen Increased social security spending: This will be particularly geared towards child education. For example, preschool and tertiary education will be made free of charge. Promoting cashless transactions: Transactions made via cashless payments (for example, via mobile pay) will not be subject to the 2% tax increase for nine months. Cashless payments in Japan account for less than 25% of overall transactions – among the lowest of developed economies. This incentive should help lift the velocity of money. Chart I-7Strong Labor Market, Weak Consumption Construction spending: This will offset the natural disasters that afflicted Japan last year. Construction orders in Japan accelerated at a 66% pace in March. The Abe government’s strategy has so far been to offset the consumption tax hike with increased domestic spending. The thinking is that once in a liquidity trap, the fiscal multiplier tends to be much larger. Some of these outlays include: Chart I-8Japan Needs More Fiscal Stimulus The new immigration law will also help. Foreign workers were responsible for 30% of all new jobs filled in Japan in 2017. Assuming public aversion towards immigration remains benign, as is the case now (these are mostly lower-paying jobs in sectors with severe labor shortages), the government’s target to attract 350,000+ new workers by 2025 will be beneficial for consumption. To be sure, this may not be enough. The IMF still projects the fiscal drag in Japan to be 0.1% of GDP in 2019 and 0.6% in 2020 (Chart I-8). This puts the onus back on the BoJ to ease financial conditions. A combination of easier fiscal and monetary policy will be a headwind for the yen. This could happen if the U.S./China trade war escalates, and twists the arm of the finance ministry. But the hurdle is high for the government to roll back the consumption tax, given significant spending offsets. The Yen As A Safe Haven Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence (Chart I-9). This is because with a net international investment position of almost 60% of GDP and net income receipts of almost 4% of GDP, volatility in markets tend to lead to powerful repatriation flows back to Japan. Real interest rates also tend to be higher in Japan in recessions as already-low inflation expectations fall further. Correlations do shift from time to time, but one longstanding rule of thumb still holds for yen investors: Buy the currency on any market turbulence. Some have suggested that the BoJ’s asset purchases are pushing investors out of Japan and weakening the safe-haven status of the yen. While plausible, our view is that other factors have been at play. First, tax changes led to repatriation of capital back to the U.S. in 2018. This unduly pressured foreign direct investment in Japan as well as other safe-haven countries like Switzerland. Second, Japan, by virtue of its current account surplus, runs a capital account deficit. This means that portfolio outflows are the norm. This is how it has managed to build the biggest net international investment position in the world. Only in times of severe flight to safety are those investments liquidated and brought home. More importantly, the time may now be very ripe for yen long positions, given rising suspicion towards the currency as a haven. To see why, one only has to return to late 2016. Back then, global growth was soft, the yen was very cheap and everyone was short the currency on the back of a dovish shift by the BoJ. Despite that backdrop, the yen strengthened by almost 10% from December 2016 to mid-2017, even as equity markets remained resilient. When the equity market drawdown finally arrived in early 2018, it carried the final legs of the yen rally. With U.S. interest rates having risen significantly versus almost all G10 countries in recent years, including Japan’s, the dollar has become a carry currency. It will be difficult for the dollar to act as both a safe-haven and carry currency, because the forces that drive both move in opposite directions. As markets become volatile and these trades get unwound, this will be a powerful undercurrent for the yen (Chart I-10). Chart I-9The Yen Remains A Safe Haven Chart I-10The Yen Has Financed Carry Trades Bottom Line: Every diversified currency portfolio should hold the yen as insurance against rising market volatility. What If Global Growth Picks Up? The eventual bottom in global growth is a key risk to our scenario. However, inflows into Japan could accelerate, given cheap equity valuations and improved corporate governance that has been raising the relative return on capital (Chart I-11). The propensity of investors to hedge these purchases will dictate the yen’s path. The traditional negative relationship between the yen and the Nikkei still holds, but it will be important to monitor if this correlation shifts during the next equity market rally. Over the past few years, an offshoring of industrial production has been marginally eroding the benefit of a weak yen/strong Nikkei. If a company’s labor costs are no longer incurred in yen, then the translation effect for profits is reduced on currency weakness. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Our contention is that the yen will surely weaken at the crosses, but could strengthen versus the dollar. USD/JPY and the DXY tend to have a positive correlation because the dollar drives the yen most of the time. Meanwhile, large net short positioning in the yen versus the dollar makes it attractive from a contrarian standpoint (Chart I-12). Chart I-11Japan: Better Governance, Higher ROIC Chart I-12Short USD/JPY: A Contrarian Bet Bottom Line: Short USD/JPY trades have entered into an envious “heads I win, tails I do not lose too much” position. Should the selloff in global risk assets persist, the yen will strengthen further. On the other hand, if global growth does eventually pick up later this year, the yen could weaken on its crosses but may actually strengthen versus the dollar. Housekeeping We are closing our short EUR/CZK position with a 4.7% profit. Interest rate differentials between the Czech Republic and the euro area have widened significantly, at a time when growth and labor market tightness could be fraying at the edges. Meanwhile, possible weakness in the dollar will be a risk to this position.   Chester Ntonifor, Foreign Exchange Strategist chestern@bcaresearch.com Footnotes 1 The Heisei era refers to the period corresponding to the reign of Japanese Emperor Akihito from 1989 until 2019. 2 Please see “Minutes of the Monetary Policy Meeting,” Bank of Japan, dated May 8, 2019, p.27. 3 Sample changes last year make it more difficult to have an apples-to-apples comparison for wages. 4 Ricardian equivalence suggests in simple terms that public sector dissaving will encourage private sector savings. Currencies U.S. Dollar USD Technicals 1 USD Technicals 2 Recent data in the U.S. have been negative: Total durable goods orders decreased by 2.1% in April. On the housing front, FHFA house price growth fell to 0.1% month-on-month in March. MBA Mortgage applications fell by 3.3% in May. Conference Board consumer confidence index improved to 134.1 in May. Dallas Fed Manufacturing activity index fell to -5.3 in May. Annualized GDP came in at 3.1% quarter-on-quarter in Q1, revised from the previous 3.2% but higher than the consensus of 3%. Q1 headline and core PCE both fell to 0.4% and 1% quarter-on-quarter respectively. DXY index increased by 0.6% this week. In the long-term, we maintain a pro-cyclical stance, and continue to believe that the path of least resistance for the dollar in down. In the short-term however, there is more room for the trade-weighted dollar to rise before eventually reversing, amid global data weakness and political uncertainties. Report Links: President Trump And The Dollar - May 9, 2019 Take Out Some Insurance - May 3, 2019 Currency Complacency Amid A Global Dovish Shift - April 26, 2019 The Euro EUR Technicals 1 EUR Technicals 2 Recent data in the euro area have shown improvement: Private loans increased by 3.4% year-on-year in April. Money supply (M3) increased by 4.7% year-on-year in April. Business climate indicator fell to 0.3 in May. Despite the weak business climate indicator, soft data in the euro area have generally improved in May: economic confidence rose to 104; industrial confidence increased to -2.9; services confidence climbed to 12.2. Lastly, the consumer confidence increased to -6.5. EUR/USD fell by 0.7% this week. During this weekend’s European Parliament election, the European People’s Party (EPP) won with 24% of the seats. However, 43 seats were lost compared with their last election result. The S&D party also lost 34 seats, together ending the 40-year majority of the center-right and center-left coalitions. Report Links: Take Out Some Insurance - May 3, 2019 Reading The Tea Leaves From China - April 12, 2019 Into A Transition Phase - March 8, 2019 The Yen JPY Technicals 1 JPY Technicals 2 Recent data in Japan have been negative: All industry activity index fell by 0.4% month-on-month in March. The leading index and coincident index both fell to 95.9 and 99.4 respectively in March. PPI services fell to 0.9% year-on-year in April, below the expected 1.1%. Labor market  and CPI data will be released after we go to press today. USD/JPY rose by 0.3% this week. BoJ Governor Haruhiko Kuroda has given two speeches this week, warning about the high degree of uncertainty, and potential downside risks worldwide. On the positive side, Kuroda thinks that EM capital outflows are less at risk than during recent financial crises, given a better framework for risk management. In the meantime, uncertainties remain regarding the U.S.-Japan trade disputes, especially vis-à-vis Japanese auto exports. Report Links: Beware Of Diminishing Marginal Returns - April 19, 2019 Tug OF War, With Gold As Umpire - March 29, 2019 A Trader’s Guide To The Yen - March 15, 2019 British Pound GBP Technicals 1 GBP Technicals 2 Recent data in the U.K. continue to outperform: Total retail sales increased by 5.2% year-on-year in April, surprising to the upside. BBA mortgage a pprovals increased to 43 thousand in April. GBP/USD fell by 0.8% this week. The uncertainties of Brexit increased with the resignation of Prime Minister Theresa May last Friday. With a Brexit decision not due until October 31, 2019, the U.K. has participated in the recent EU election. The newly formed Brexit Party led by Nigel Farage, won with more than 31% of the votes. This reflects a growing dissatisfaction with traditional parties within U.K. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Take Out Some Insurance - May 3, 2019 Not Out Of The Woods Yet - April 5, 2019 Australian Dollar AUD Technicals 1 AUD Technicals 2 Recent data in Australia have been mostly negative: ANZ Roy Morgan weekly consumer confidence index increased to 118.6 this week. HIA new home sales fell by 11.8% month-on-month in April. Moreover, building permits decreased by 24.2% year-on-year. Private capital expenditure in Q1 fell by 1.7% quarter-on-quarter. Building approvals fell by 4.7% month-on-month in April. AUD/USD fell by 0.2% this week. As we argued in last week’s report, we favor the Aussie dollar from a contrarian point of view. Despite the negative data points on the surface, the recent election result and dovish shift by RBA all support the Australian economy in the long-term. Moreover, the robust job market, rising terms of trade, and Chinese stimulus will likely put a floor under AUD/USD. Report Links: A Contrarian View On The Australian Dollar - May 24, 2019 Beware Of Diminishing Marginal Returns- April 19, 2019 Not Out Of The Woods Yet - April 5, 2019 New Zealand Dollar NZD Technicals 1 NZD Technicals 2 Recent data in New Zealand have been mixed: ANZ activity outlook increased by 8.5% in May, well above consensus. Building permits fell by 7.9% month-on-month in April. ANZ business confidence remained low at -32 in May. NZD/USD fell by 0.6% this week. The Financial Stability Report, released by RBNZ this week, highlighted the worrisome debt levels, particularly in the household and dairy sectors. Ongoing efforts are necessary to bolster system soundness and efficiency, according to RBNZ governor Adrian Orr. Report Links: Not Out Of The Woods Yet - April 5, 2019 Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Canadian Dollar CAD Technicals 1 CAD Technicals 2 Recent data in Canada have been positive: Bloomberg Nanos confidence index improved to 55.7, from the previous 55.1. Current account deficit increased to C$17.35 billion from C$16.62 billion, but it is lower than the expected C$ 18 billion. USD/CAD increased by 0.4% this week. On Wednesday, the Bank of Canada (BoC) held interest rates steady at 1.75%, as widely expected. Despite the recent trade uncertainties, the BoC views the slowdown in late 2018 and early 2019 as temporary, and expects growth to pick up again in the second quarter this year, supported by recovering oil prices, stabilizing housing sector, robust job market and easy financial conditions. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Into A Transition Phase - March 8, 2019 Swiss Franc CHF Technicals 1 CHF Technicals 2 Recent data in Switzerland have been mixed: Q1 GDP came in higher-than-expected at 1.7% year-on-year, from the previous reading of 1.5%. Trade surplus reduced to 2.3 million CHF in April, mostly due to the decrease in exports. KOF leading indicator fell to 94.4 in May. ZEW expectations fell in May to -14.3. USD/CHF appreciated by 0.7% this week. We favor the Swiss franc as a safe haven when market volatility rises. In the longer term, the high domestic savings rate, rising productivity, and current account surplus should all underpin the franc. Report Links: What To Do About The Swiss Franc? - May 17, 2019 Beware Of Diminishing Marginal Returns - April 19, 2019 Balance Of Payments Across The G10 - February 15, 2019 Norwegian Krone NOK Technicals 1 NOK Technicals 2 There is little data from Norway this week: Retail sales increased by 1.6% year-on-year in April. Credit expanded by 5.7% year-on-year in April USD/NOK increased by 0.9% this week. Our Commodity & Energy Strategy team believe that the energy market is underpricing the U.S. - Iran war risk, and overestimating the short-term effects of the trade war. In the long run, the Chinese stimulus, dollar weakness, and supply uncertainties should lift oil prices, which will support the Norwegian krone. Report Links: Currency Complacency Amid A Global Dovish Shift - April 26, 2019 A Shifting Landscape For Petrocurrencies - March 22, 2019 Balance Of Payments Across The G10 - February 15, 2019 Swedish Krona SEK Technicals 1 SEK Technicals 2 Recent data in Sweden have been mostly negative: Producer price inflation fell to 4.9% year-on-year in April from 6.3% in March. Consumer confidence fell to 91 in May. Moreover, manufacturing confidence fell to 103.7 in May. Trade surplus fell from 6.4 billion to 1.4 billion SEK in April. Q1 GDP came in at 2.1% year-on-year, outperforming expectations but lower than the previous 2.4%. USD/SEK has been flat this week. Swedish exports, a reliable barometer for global business confidence, fell from 133.4 billion SEK to 128 billion SEK in April, which is a total decrease of 5.4 billion SEK in exports, implying that the global growth remains in a volatile bottoming process. Report Links: Balance Of Payments Across The G10 - February 15, 2019 A Simple Attractiveness Ranking For Currencies - February 8, 2019 Global Liquidity Trends Support The Dollar, But... - January 25, 2019 Trades & Forecasts Forecast Summary Core Portfolio Tactical Trades Closed Trades

Highlights Global equities face near-term downside risks from the trade war, but should be higher in 12 months’ time. Its claims to novelty notwithstanding, Modern Monetary Theory is basically indistinguishable from standard Keynesian economics except that MMT assumes that changes in interest rates have no discernible effect on aggregate demand. This straightforward but unrealistic assumption allows MMT’s proponents to argue that the neutral rate of interest does not exist, that crowding out is impossible, and that while fiscal deficits do matter (because too much government spending can stoke inflation), debt levels do not. Despite its many shortcomings, MMT’s focus on financial balances and the role of sovereign-issued money is laudable. A better understanding of these concepts would have made investors a lot of money during the past decade. Today, most economies are still running large private-sector financial surpluses. This surplus of desired savings relative to investment has kept interest rates low, which have allowed governments to finance their budgets at favorable terms. As these surpluses decline, inflation will rise. Feature Greetings From Down Under I have been meeting clients in Australia and New Zealand this week. The mood has been generally negative on the outlook for both the domestic and global economies. As one might imagine, the brewing China-U.S. trade war has been a hot topic of discussion. We went tactically short the S&P 500 on May 10th, a move that for the time being effectively neutralizes our structurally overweight stance on global equities. As we indicated when we initiated the hedge, we will take profits on the position if the S&P 500 drops below 2711. Despite the darkening clouds hanging over the trade war, we still expect a detente to be reached that prevents a further escalation of the conflict. Both sides would suffer from an extended trade war. For China, it is no longer just about losing access to the vast U.S. market. It is also about losing access to vital technology. The blacklisting of Huawei deprives China of critical components needed to realize its dream of becoming a world leader in AI and robotics. The trade war will not harm the U.S. as much as it will China, but it has still raised prices for American consumers, while lowering the prices of key agricultural exports such as soybeans. It has also hurt the stock market, which Trump seems to view as a barometer for his own success as president. If a trade detente is eventually reached, market attention will shift back to the outlook for global growth. We expect the combination of aggressive Chinese fiscal/credit stimulus and the palliative effects of falling global bond yields over the past seven months to lift growth in the back half of the year. As a countercyclical currency, the U.S. dollar is likely to weaken when global growth starts to strengthen. This will provide an opportune time to go overweight EM and European equities as well as the more cyclical sectors of the stock market. Are You Now Or Have You Ever Been A Member Of The MMT Movement? Last week’s report1 argued that a global deflationary ice age is unlikely to transpire because politicians will pursue large-scale fiscal stimulus to preclude this outcome. We noted that many countries are easing fiscal policy at the margin, partly in response to populist pressures. Even in Japan, the likelihood that the government will raise the sales tax this year has diminished, while structural forces will continue to drain savings for years to come. This will set the stage for higher inflation in Japan, something the market is not at all anticipating. Somewhat controversially, we contended that larger budget deficits are unlikely to imperil debt sustainability, at least for countries that are able to issue debt in their own currencies. This implies that any government with its own printing press should simply ease fiscal policy until long-term inflation expectations reach their target level. MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. A number of readers pointed out that our analysis sounded suspiciously supportive of Modern Monetary Theory (MMT). Are we really closet MMT devotees? No, we are not. Our approach shares some commonalities with MMT (so if you want to call me a “MMT sympathizer,” go ahead). However, it also differs from MMT in a number of important respects. As we discuss below, these differences have significant implications for market outcomes, particularly one’s views about the long-term direction of government bond yields. MMT: A “Special Case” Of Keynesian Economics Modern Monetary Theory is not nearly as novel as its backers claim. In fact, MMT can best be thought of as a special case of Keynesian economic theory where monetary policy is not just relegated to the back burner, but banished from the kitchen altogether. Outside of liquidity trap conditions, most economists believe that monetary policy is an effective aggregate demand management tool. MMT’s supporters reject this. In their view, changes in interest rates have no impact on spending. In the technical parlance of economics, MMT is basically the Hicksian IS/LM model but with a vertical IS curve and an LM curve that intersects the IS curve at an interest rate of zero (Chart 1). This seemingly small variation on the traditional Keynesian framework has far-reaching consequences. For one thing, it renders meaningless the entire concept of the neutral rate of interest. If changes in interest rates have no effect on aggregate demand, then one cannot identify an equilibrium level of interest rates that is consistent with full employment and stable inflation. Given their leftist roots, it is not surprising that most MMTers favor keeping rates low, preferably near zero. Higher rates shift income from borrowers to lenders. The latter tend to be richer than the former. Why reward fat cats when you don’t have to? Low rates also allow the government to spend more without putting the debt-to-GDP ratio on an unsustainable trajectory. If the interest rate at which the government borrows stays below the growth rate of the economy, the government can run a stable Ponzi scheme, perpetually issuing new debt to pay the interest on existing debt (Chart 2). In such a world, budget deficits only matter to the extent that too much fiscal stimulus can stoke inflation. The level of debt, in contrast, never matters. Interest Rates Do Affect Aggregate Demand Chart 3Mortgage Rate Swings Matter For The Housing Market Despite MMT’s efforts to deny any role for monetary policy in stabilizing the economy, the empirical evidence clearly shows that changes in interest rates do affect consumption and investment decisions. Housing activity, in particular, is very sensitive to movements in mortgage rates. The recent drop in mortgage rates bodes well for U.S. housing activity during the remainder of the year (Chart 3). The dollar, like most currencies, is also influenced by shifts in interest rate differentials (Chart 4). Changes in the dollar affect net exports, and hence overall employment. Once we acknowledge that interest rates affect aggregate demand, we are back in a world of trade-offs between monetary and fiscal policy. One can have easy monetary policy and tight fiscal policy, or tight monetary policy and easy fiscal policy. But outside of liquidity trap conditions, one cannot have both easy monetary and fiscal policies for a prolonged period of time without tolerating higher and rising inflation.   Chart 4Historically, The Dollar Has Moved In Line With Interest Rate Differentials The Perils Of Accounting Identities MMT proponents love accounting identities. They are particularly fond of saying that government deficits endow the private sector with additional wealth in the form of government bonds or cash. Unfortunately, the penchant to “argue by accounting identity” is almost always a recipe for disaster since such arguments usually fail to identify the causal forces by which one thing affects the other. For example, no competent economist would deny that an increase in the fiscal deficit must tautologically imply an increase in the private sector’s financial balance (the difference between the private sector’s income and spending). What MMT adherents fail to appreciate is that private-sector savings can increase either if incomes rise or spending falls. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. When an economy is depressed, fiscal stimulus is likely to increase employment. In such a setting, rising payrolls will boost incomes, leading to a larger private-sector surplus. In contrast, when the economy is operating at full employment, any increase in the private-sector surplus must come about through a decline in private-sector spending. That is to say, if the government consumes more of the economy’s output, the private sector has to consume less.  There is a huge difference between the two cases. MMTers tend to gloss over this distinction because they do not really have a theory for why the private-sector financial balance moves around in the first place. To them, private-sector spending is completely exogenous. It is determined by such things as animal spirits that the government has no control over. The government’s only job is to adjust the fiscal balance to ensure that it is the mirror image of the private-sector’s balance. Budget deficits cannot crowd out private-sector spending in this context because the government plays no role in determining how much the private sector wishes to spend. Investment Conclusions Economics gets a bad rap these days. Although most people would not go as far as Nassim Taleb who once mused about running over economists in his Lexus, it is fair to say that there is a lot of disillusionment towards the economics profession. Ostensibly heterodox theories like MMT help fill an intellectual void for those hoping to rewrite the economics textbooks for the 21st century. Ironically, what often gets overlooked is that the predictions made by standard Keynesian economic theory over the past decade have proven to be broadly accurate. Shortly after the financial crisis, when the world was still mired in a deep slump, Keynesian economics predicted that large budget deficits would not push up interest rates and that QE would not lead to runaway inflation. In contrast, Taleb said in early February 2010, when the 10-year Treasury yield was trading at around 3.6%, that Ben Bernanke was “immoral” and that “Every single human being should short Treasury bonds. It’s a no-brainer.” The study of financial balances is not unique to MMT, nor is MMT’s approach to thinking about financial balances the best one. Even so, a basic understanding of the concept would have prevented Taleb and countless others from making the mistakes they did. The fact that MMT has brought the discussion of financial balances, along with related concepts such as the role of sovereign-issued money in an economy, back into the spotlight is its greatest virtue. Today, most economies are still running large private-sector financial surpluses (Chart 5). Given that interest rates are so low, it is difficult to argue that budget deficits are crowding out private spending. This may change over time, however. Falling unemployment is boosting consumer confidence, which will bolster spending. U.S. wage growth has already accelerated sharply among workers at the bottom end of the income distribution (Chart 6). These are the workers with the highest marginal propensity to consume. Chart 5AMost Major Countries Run Private-Sector Surpluses (I) Chart 5BMost Major Countries Run Private-Sector Surpluses (II) Meanwhile, baby boomers are leaving the labor force. More retirees means less production, but not necessarily less consumption. Once health care spending is added to the tally, consumption actually increases in old age (Chart 7). If production falls in relation to consumption, excess savings will decline and the neutral rate of interest will rise. Chart 7Savings Over The Life Cycle When this happens, will governments tighten fiscal policy, as the MMT prescription requires? In a world where entitlement programs are politically sacrosanct, that seems unlikely. The end result is that economies will overheat and inflation will rise. Will central banks tighten monetary policy in response to higher inflation? That depends on what one means by tighten. Central banks will undoubtedly raise rates, but in a world of high debt levels, they will be loath to push interest rates above the growth rate of the economy. Interest rates will rise in nominal terms, but probably very little or not at all in real terms. In such an environment, investors should maintain below-benchmark duration exposure in their fixed-income portfolios, while favouring inflation-linked bonds over nominal bonds. Owning traditional inflation hedges such as gold would also make sense.    Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1          Please see Global Investment Strategy Weekly Report, “Ice Age Cometh?” dated May 24, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Highlights The view that the world will sink into a deflationary “ice age” hinges on the assumption that policymakers will make a colossal mistake by failing to do what is in their own best interest. Contrary to popular belief, governments always have a tool to increase inflation, even when an economy has fallen into a liquidity trap: It’s called sustained fiscal stimulus. Japan could have avoided its deflationary epoch if the authorities had eased fiscal policy more aggressively. Ironically, bigger budget deficits probably would have caused the government debt-to-GDP ratio to rise less than it did. The U.S. and China are unlikely to repeat Japan’s mistake. Actually, looking ahead, Japan may not repeat Japan’s mistake. The euro area is a tougher call given the region’s political and institutional constraints; but even there, a reflationary outcome is more likely than not. An intensification of the trade war will cause government bond yields to fall a bit further in the near term. However, yields are likely to be higher one year from now. Global equities will follow the same path as bond yields: Down in the near term, but up over a 12-month horizon. Feature I feel more confident than ever that the next phase of the Ice Age will soon be upon us. Much of the thesis has come from learning the hard deflationary lessons from Japan. Most commenters now accept the Japanification of mainland Europe has occurred, but they just cannot conceive that the same thing might happen with the US. My biggest conviction call is that US 10y bond yields will converge with Japanese and German yields in the next recession at around minus 1% (and US 30y yields will fall to zero or below) and that markets will panic as outright deflation takes an icy grip. -  Albert Edwards, Société Générale (May 2019) Fire Or Ice? If you were to ask most central bankers today whether it is better to err on the side of too much or too little inflation, chances are they would say the former. Their rationale would surely be as follows: If inflation rises to uncomfortably high levels, they can simply raise interest rates in order to cool the economy. In contrast, if inflation gets too low, and interest rates are already close to zero, monetary policy loses potency. It is better to have more control over the economy than less. This reasoning is correct on its own terms, but if one stands back and thinks about it, it is rather perverse to argue that deflation, which generally stems from a lack of aggregate demand, should be more difficult to overcome than inflation, which is usually the result of too much demand. After all, people like to spend money. Getting someone to work and produce should, in principle, be more difficult than getting them to consume. Inflation should be a bigger problem than deflation. So why do so many economists think otherwise? The Paradox Of Thrift There actually is a very good reason for this bias, one which John Maynard Keynes articulated more than 80 years ago. Keynes observed that when unemployment is rising, people are likely to try to save more due to fear of losing their jobs. Since one person’s spending is another’s income, this could create a vicious cycle where falling spending leads to lower aggregate income, and so on. Unfortunately, it is hard to save if you do not have a job. Thus, the decision by all individuals to save more could result, ironically, in a decline in aggregate savings.1 Keynes called this the paradox of thrift. At the heart of the paradox of thrift lies a deep-seated coordination problem. During an economic downturn, everyone would be better off if everyone else spent more money. However, since the spending of any one person only has a negligible effect on aggregate demand, no one has an incentive to spend more than is absolutely necessary. Keynes’ seminal insight was that a government could overcome this coordination problem by acting as a spender of last resort. Keynes argued that if the private sector decides to save more, the public sector should save less by running a bigger budget deficit. The result would be the preservation of full employment. Debt And Deliverance A common objection to the idea that governments should run bigger budget deficits to compensate for inadequate private-sector demand is that this will cause public-sector debt levels to swell to the point that a fiscal crisis becomes inevitable. The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. For countries such as Italy, this is a legitimate concern. If a country does not have a central bank that can serve as a buyer of last resort of government debt, it can end up facing a pernicious feedback loop where rising bond yields increase the likelihood of default, leading to even higher bond yields. These countries can, and often do, face speculative attacks on their bond markets (Chart 1). For countries that issue debt in their own currencies, this concern does not exist. This is because their governments can print money to pay for goods and services. Since the cost to the government of printing a $100 bill is negligible, the government can always conjure up demand out of thin air. Of course, there is a risk that the government will manufacture too much demand and inflation will rise. But if the goal is to prevent deflation, this is a feature not a bug. Once demand increases enough, the government can just pull the plug on further fiscal stimulus, and everyone can live happily ever after. Japan’s Experience Chart 2The 1990s Japanese Example Didn’t Japan try this approach and fail? No. Japan suffered the mother of all financial shocks in the early 1990s when the real estate and stock market bubbles simultaneously burst. This happened just as the working-age population was peaking, which made businesses even less eager to expand domestic capacity. The result of all this was a massive increase in excess private-sector savings. The government did loosen fiscal policy, but not by enough. Consequently, deflation eventually set in. As inflation expectations fell, real rates rose (Chart 2). Rising real rates put upward pressure on the yen and increased the government’s real debt financing costs. To make matters worse, falling prices made it more difficult for private-sector borrowers to pay back their loans. This further depressed spending. Ironically, had the Japanese government eased fiscal policy more aggressively to begin with, it probably would have been able to trim deficits later on. Nominal GDP would have also increased more briskly. As a consequence, the government debt-to-GDP ratio would have ended up rising less than it did. Today, Japan remains mired in a deflationary mindset. Twenty-year CPI swaps, a proxy for long-term inflation expectations, are trading at 0.3%, nowhere close to the Bank of Japan’s 2% target. Interest rates are stuck near zero, reflecting the fact that the economy continues to suffer from excess savings. Japan Needs Fiscal Stimulus, Not Austerity The solution to Japan’s problem is obvious: The government should just keep easing fiscal policy until long-term inflation expectations reach the BoJ’s target. Given Japan’s pathetically low fertility rate, a sensible strategy would be to offer subsidized housing and baby bonuses to any couple that has three or more children. It is impossible to know how big a budget deficit will be required to reset inflation expectations to a higher level. If people believe that the government is serious about easing fiscal policy by enough to get inflation up to target, real rates will collapse, the yen will fall, and private demand will rise. In the end, the government may not need to raise the budget deficit that much. Even if the Japanese government did have to increase the budget deficit substantially, this would not endanger the economy. As long as the interest rate at which the government borrows is below the growth rate of the economy, any budget deficit, no matter how large, will produce a stable debt-to-GDP ratio in the long run (Chart 3).2 Since there would be no need to ease fiscal policy by so much that the Bank of Japan is forced to lift interest rates above the economy’s growth rate, there is little risk that the debt-to-GDP ratio will end up on an unsustainable trajectory. Chart 4Japanese Excess Savings Are Starting To Recede Will the Japanese government heed this advice? While Q1 GDP growth surprised on the upside, this was mainly because of a strong contribution from net exports and inventories. Final domestic demand remains underwhelming. Stronger global growth will help Japan later this year, but we think there is still a 50/50 chance the planned VAT hike will be postponed. Looking ahead, the exodus of Japanese workers from the labor market into retirement will reduce private-sector savings. The household savings rate has already fallen from nearly 20% in the early 1980s to around 4% in recent years. The ratio of job openings-to-applicants has risen to a 45-year high (Chart 4). Falling private-sector savings will raise the neutral rate of interest, thus giving the BoJ more traction over monetary policy. Japan’s deflationary ice age may be coming to an end. Stimulus With Chinese Characteristics Like Japan, China has struggled to consume enough of what it produces. In the days when China had a massive current account surplus, it could export that excess savings abroad. It cannot do that anymore, so the government has consciously chosen to spur fixed-investment spending in order to prop up employment. Since a lot of investment is financed through credit, debt levels have risen (Chart 5). Much of China’s debt-financed investment spending has been undertaken by local governments and state-owned enterprises. This has made credit and fiscal policy virtually indistinguishable. While the general government fiscal deficit stands at a moderate 4.1% of GDP, the augmented deficit, which includes a variety of off-balance sheet expenditures, has swollen to 10.7% of GDP, up more than six percentage points since 2010 (Chart 6). Chart 5China: From Exporting Savings To Investing Domestically And Building Up Debt As we discussed a few weeks ago in a report entitled “Chinese Debt: A Contrarian View”, there is little preventing the Chinese government from further ramping up credit/fiscal stimulus.3 The fact that the trade negotiations are on the ropes only strengthens the case for additional easing. The government knows full well that it will gain negotiating leverage over the U.S. if the Chinese economy is humming along despite higher tariffs on Chinese imports. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Europe: Turning Japanese? Judging from the fact that German bund yields have fallen to Japanese levels, one might conclude that the Japanification of Europe is complete. There is, however, at least one key macro difference between the two regions: While long-term inflation expectations in the euro area have declined, they are still well above Japanese levels (Chart 7). As a result, real yields are quite a bit lower in core Europe, which gives countries such as Germany and France some cushion of support. Chart 7Despite Similar Nominal Bond Yields, Real Rates Are Still Much Lower In Germany Than Japan Chart 8Italian Bond Yields Are Still Worryingly High Bond yields remain elevated in Italy, though still below the levels seen last October, and far below their peak during the euro crisis in 2011 (Chart 8). Short of the creation of a pan-euro area fiscal union, Italy’s best hope is that Germany takes steps to reflate its own economy. The conventional wisdom is that the German psyche, ever focused on fiscal discipline, would never permit that to happen. This view, however, forgets that Germany had no trouble violating the Maastricht Treaty’s deficit cap of 3% of GDP in the early 2000s. Germany today sees little need to significantly loosen fiscal policy because years of wage repression, and more recently, a weak euro, have caused its current account surplus to swell to 9% of GDP. However, the country’s ability to push out its excess production to the rest of the world may become more limited in the future. The gap in unit labor costs between Germany and other euro area members has narrowed steadily in recent years. This development has coincided with a decline in Germany’s trade surplus with the rest of the euro area (Chart 9). If the common currency starts to appreciate and wage growth in Germany continues to outpace the rest of the region, the German government may have no choice but to loosen the fiscal screws. Chart 9Germany's Competitive Advantage Against The Rest Of The Euro Area Is Declining Chart 10U.S.: Federal Discretionary Spending Has Been Gaining Steam   U.S.: Ice Age Vs. Green New Deal While Trump’s tax cuts have gotten a lot of attention, an equally important development in recent years has been the rapid acceleration in federal government spending. From a contraction of 7% in 2013, real discretionary outlays are set to grow by 3% in 2019 (Chart 10). There is little reason to think that the U.S. budget deficit will shrink anytime soon. Taxes may go back up if the Democrats take control of the White House and sweep Congress next year. However, even in that scenario, any increase in tax rates is likely to be neutralized by higher social welfare spending – yes, including partial implementation of the green new deal. Meanwhile, government outlays on Social Security and health care programs such as Medicaid are on track to rise by 5.4% of GDP over the next thirty years (Chart 11). So far, an overstimulated U.S. economy has not produced much in the way of inflation. But with the unemployment rate down to a 49-year low, that could change over the next few years. Recent communications from FOMC members suggest a growing tolerance for a modest inflation overshoot of the 2% target. An outright increase in the Fed’s inflation target is unlikely in the near term, but could become a viable option if realized inflation moves above the Fed’s current comfort zone of 2%-to-2.5% for long enough. If that were to happen, raising the inflation target could turn out to be politically more expedient than engineering a deep recession in an effort to bring inflation back down. It will also help alleviate the rising real debt burden that will ensue from high deficits. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. The Fed is already facing political pressure from the Trump administration to keep rates low. Politics in the U.S. and in many other countries is moving in a more populist direction. Regardless of whether it is right-wing populism or left-wing populism that triumphs in the end, the outcome is likely to be the same: higher inflation. Historically, there is a clear inverse correlation between central bank independence and inflation (Chart 12). Investment Conclusions On the question of whether we are heading for a deflationary ice age or a period of inflationary global warming, we would put higher odds on the latter. Many of the structural factors that have produced lower inflation over the last few decades are in retreat. Globalization has stalled, and may even reverse course if the trade war intensifies (Chart 13). The ratio of workers-to-consumers globally is starting to shrink as the post-war generation leaves the labor force (Chart 14). Central bank autonomy is under attack, while fiscal policy is turning more expansionary. Chart 13The Age Of Globalization Is Over Chart 14The Worker-To-Consumer Ratio Has Peaked Globally To believe that politicians will not dial up fiscal stimulus in the face of a chronic shortfall of aggregate demand is to believe that they will act incompetently. Not incompetent in the low-IQ sort of way. Incompetent in the sense that they will act against their own self-interest. Voters want more employment. In the age of populism, it seems unlikely that politicians with ready access to the printing press will fail to deliver what the people want. We declared “The End Of The 35-Year Bond Bull Market” on July 5, 2016. As luck would have it, this was the very same day that the U.S. 10-year Treasury yield hit an all-time low of 1.37%. We expect global bond yields to reach a series of “higher highs and higher lows” over the coming years. Right now, we are witnessing a countertrend rally in bond prices. Yields could fall a bit further in the coming weeks if the trade war heats up. However, yields will be higher in 12 months’ time, provided that China and the U.S. begrudgingly reach a trade truce and global growth reaccelerates, as we expect. Global equities are likely to follow the same pattern as bond yields. Trade tensions could push stocks down about 5% from current levels (we are presently positioned for this by being tactically short the S&P 500 against an underlying structural overweight position). However, equities will move to fresh highs over a 12-month horizon as global growth picks up. The recent stock market correction caused our long European bank trade to be stopped out for a loss of 7%. We will re-enter the trade once we conclude that global equities have found a bottom. The dollar will probably strengthen a bit more in the near term, but as a countercyclical currency, the greenback will weaken in the second half of this year. This will provide a good opportunity to go overweight EM and European stocks in common-currency terms.   Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com   Footnotes 1      Another way to see this point is to recall that business spending normally declines when the economy weakens. Investment spending tends to move in lockstep with national savings (indeed, at the global level, the two must be exactly equal to each other). Thus, if consumer spending falls in response to the decision by households to try to save more, and this leads to lower investment, it will also lead to lower aggregate savings. 2      Please see Global Investment Strategy Weekly Report, “Is There Really Too Much Government Debt In The World?” dated February 22, 2019. 3      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019.   Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades

Feature In what has become a tradition, I met with Ms. Mea following client meetings in Europe last week. Ms. Mea is a long-term BCA client who has been following our Emerging Markets Strategy very closely over the years. It was our fourth meet-up in the past 18 months. Ms. Mea keeps our meetings interesting by always challenging our views and questioning the nuances of our analysis. The timing of our most recent meeting was particularly notable, as we had just received news that the latest U.S.-China trade talks had not produced an agreement. In light of this, Ms. Mea started our conversation with a question on the link between geopolitics and financial markets: Ms. Mea: Why have the U.S. and China failed to reach a trade accord when it is clear that without one, both global financial markets and business sentiment will be hurt? Answer: The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Their strategic national interests are not aligned at all. Therefore, any accord on trade and other geopolitical disputes will not be lasting. It is impossible to accurately forecast and time all turns of the negotiation process and the associated event risks. Therefore, an investment process should be informed and guided by a thematic approach. The U.S. and China are intertwined in a geopolitical confrontation that will endure for decades. Our theme has been, and remains, that China and the U.S. are in a long-term geopolitical confrontation that epitomizes a rivalry between an existing and a rising superpower. This suggests that the demands of one side will be unacceptable to the other. That makes any agreement unsustainable over the long run. In brief, there was a structural regime shift in the U.S.-China relationship last year. Yet global equity markets rallied this year on rising expectations of a major trade deal. Notably, most of the gains in EM equities since late December occurred on days when there was positive news on the progress of trade talks. Hence, the EM rally can largely be attributed to expectations of a trade deal. Not surprisingly, the failure to conclude a trade accord has quickly pushed EM share prices back down to their mid-January levels (Chart I-1). As such, the majority of investors who have bought the EM equity index since early this year lost a substantial part of their gains in the recent selloff.  Chart I-1EM Equity Index: Between Support And Resistance Given that these two nations are embroiled in a long-term geopolitical rivalry, it will be difficult to find solutions on trade and geopolitical disputes that can simultaneously satisfy both sides. Even so, this does not imply that global risk assets will be in freefall forever. Financial markets currently need to price in both (1) a geopolitical risk premium on a structural basis; and (2) the impact of trade tariffs on global business activity on a cyclical basis. Once these two components have been priced in, markets will become less sensitive to the ebbs and flows of tensions between the U.S. and China. Finally, China’s exports to the U.S. constitute only 3.5% of mainland GDP (Chart I-2). This is considerably smaller than capital spending, which makes up 42% of China’s GDP. Further, most of the investment outlays over the past 10 years have not been in productive capacity to supply goods to the American market. On the contrary, the overwhelming share of capital expenditures since 2008 have occurred in domestic segments of the economy rather than export industries. Certainly, the trade confrontation will weigh on consumer and business sentiment in China as well as reduce the flow of U.S. dollars to the Middle Kingdom, warranting RMB depreciation. Still, there are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. China’s exports to the U.S. constitute only 3.5% of mainland GDP. Ms. Mea: With no trade deal, the odds appear to be rising that the Chinese authorities will ramp up both credit and fiscal stimulus. Should investors not be looking through the near-term volatility and be buying EM risk assets and China-plays – because this stimulus will produce a cyclical recovery in the mainland economy? Answer: It is a safe bet that the Chinese authorities will encourage more credit creation and ramp up fiscal spending. The difficulty for investors is in gauging two unknowns: What is the lead time between the stimulus and economic growth, and what will be the multiplier effect of these stimuli. Lead time: Chart I-3 portends our aggregate credit and fiscal spending impulse. Based on the past relationship between turning points in this indicator and the business cycle in China, the latter is likely to bottom around August. Chart I-2Structure Of Chinese Economy Chart I-3China: Stimulus Works With A Time Lag   Chart I-4China's Stimulus And Financial Markets: 2012 Versus 2016 Multiplier effect: The impact of stimulus on the economy also depends on the multiplier effect. The latter is contingent on households’ and companies’ willingness to spend. If households and companies hasten the pace of spending, the economy can recover with little stimulus. If they reduce their expenditure growth, the economy may require much more stimulus. The majority of investors and commentators are comparing China’s current stimulus efforts with what occurred in 2016. However, our hunch is that the current Chinese business cycle might actually resemble the 2012-‘13 episode due to similarities in the multiplier effect. The size of credit and fiscal stimulus in 2012 was as large as in 2016. Nevertheless, the business cycle recovery in 2012-‘13 was very muted, as illustrated in Chart I-3 on page 3. Consistently, EM share prices and commodities did not stage a cyclical rally in 2012 as they did in 2016-‘17 (Chart I-4). Ms. Mea: It seems you are implying that differences between the 2012 and 2016 economic and financial markets outcomes are due to the multiplier. How does one appraise the multiplier effect? Answer: In a word, yes. Unfortunately, there is no easy way to forecast consumers’ and businesses’ willingness to spend – particularly in the midst of a clash between the positive effects of stimulus and the negative sentiment stemming from the ongoing U.S.-China confrontation. We have constructed indicators that measure the willingness to spend among households and companies in China. Our proxies for their marginal propensity to spend (MPS) are currently in decline (Chart I-5A and I-5B). Chart I-5AChina: Households' Marginal Propensity To Spend Chart I-5BChina: Enterprises’ Marginal Propensity To Spend   MPS does not affect day-to-day expenditures, but rather captures consumer spending on large-ticket items such as housing, cars and durable goods, as well as investment expenditures by companies. Consistently, mainland companies’ MPS leads industrial metal prices by several months (Chart I-5B). Chart I-6 illustrates the critical difference between 2012 and 2016 in terms of the impact of credit and fiscal stimulus. In both episodes, the size of the stimulus was roughly the same, but the manufacturing PMI did not really recover in 2012-’13, gyrating in the 49-51 range. In contrast, it did stage a cyclical recovery in 2016-‘17 (Chart I-6, second panel). In brief, the difference between the 2012 and 2016 episodes was the MPS by companies and households (Chart I-6, third and fourth panels). There are other predicaments unrelated to the U.S. import tariffs that Chinese policymakers are facing. These include the credit, money and property bubbles that we have written about extensively. Provided the not-so-upbeat sentiment among Chinese households and businesses due to their high debt levels and the ongoing trade conflict, the odds are that their MPS will remain weak for now. As a result, the impact of credit and fiscal stimulus on China’s business cycle will be muted for now. As such, more stimulus and longer lead time may be required to engineer a cyclical recovery. Interestingly, the current profiles of both EM and developed equity markets closely resemble their 2012 trajectories – both in terms of direction and magnitude (Chart I-7). Chart I-6China's Stimulus In 2012 And 2016: Beware Of Multiplier Effect Chart I-7Is 2018-2019 Akin ##br##2011-2012? Ms. Mea: So, you are suggesting risks to China-related plays and EM financial markets are skewed to the downside. How should one assess how much downside there is, and what should investors look for to gauge turnings points in financial markets? Answer: We continuously assess the investment landscape, not only based on our fundamental analysis of the global/EM/China business cycles but also on various financial market valuations, positioning and technicals. Let’s review where we stand with respect to these metrics.   Equity Valuations: EM stocks are not cheap. Our favored measure of equity valuations is the composite indicator-based 20% trimmed means of the following multiples: trailing and forward P/E, price-to-cash earnings, price-to-book value and price-to-dividend ratios (Chart I-8). On these metrics, EM stocks appear fairly valued. Nevertheless, these valuations should be viewed in the context of structural decline in EM corporate profitability. The measures of return on equity and assets for non-financial companies in EM are on par with their 2008 lows (Chart I-8, middle and bottom panels). When valuations are neutral, the equity market’s direction is dictated by the profit outlook. The latter currently remains negative for EM and Chinese companies (Chart I-9). Chart I-8EM Equities Are Not Cheap Chart I-9Downside Profit Surprises In EM And China   Currency Valuations: The U.S. dollar is only moderately (one standard deviation) expensive, according to the real effective exchange rate based on unit labor costs (Chart I-10). The latter is our most favored currency valuation measure. The greenback has been in a major structural bull market since 2011. Secular bull/bear markets do not typically end before valuations reach 1.5-2 standard deviations. We reckon that the cyclical and structural backdrop remains favorable for the dollar, and odds are it will overshoot before a major top sets in. Going forward, most of the dollar’s additional gains will not occur versus the euro or the Japanese yen – which are already modestly undervalued (Chart I-10, middle and bottom panels) – but against other currencies. In particular, commodity currencies of developed economies have not yet cheapened enough (Chart I-11). Typically, a structural bear market in commodities does not end until these commodity currencies become cheap. Hence, the current valuation profile of these commodity currencies is consistent with the notion that the secular bear markets in commodities prices and EM are not yet over. Chart I-10The Euro Is Fairly Valued, The Yen Is Cheap G3 Currency Valuations Chart I-11Commodities Currencies ##br##Are Not Cheap Yet   Unfortunately, there are no data for unit labor cost-based real effective exchange rates for the majority of EMs. However, it is a safe bet to infer that long- and medium-term cycles in EM currencies coincide with those of DM commodity currencies because they are all pro-cyclical. If DM commodity currencies have not yet bottomed, EM currencies remain vulnerable. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows. Ms. Mea: But the positioning in the U.S. dollar is long. How consistent is this with your view of further dollar strength? Positioning: While investors are long the U.S. dollar versus several DM currencies, they are short the greenback versus EM currencies. Chart I-12 illustrates the aggregate net long positions of both leveraged funds and asset managers in the BRL, MXN, RUB and ZAR. As of May 10 (the last datapoint available), investors were as long these EM high-beta currencies as they were at their cyclical peak in early 2018. As to emerging Asian currencies, ongoing RMB depreciation will drag emerging Asian currencies down. Notably, the Korean won has already broken down from its tapering wedge pattern. Concerning EM equities, investor positioning and sentiment was still very elevated before last week’s market turmoil. Chart I-13 demonstrates the number of net long positions in EM ETFs (EEM) by leveraged funds and asset managers. The last datapoint is also as of May 10. Chart I-12Investors Have Been Long EM Currencies Chart I-13Investors Have Been Bullish On EM Stocks   In short, investor sentiment on EM was bullish and long positions in EM were extended before the U.S.-China trade confrontation escalated again. Tell-tale signs and technicals: Market profiles can sometimes help us gauge whether an asset class is in a bull or bear market, and what the next move is likely to be. We have the following observations: U.S. dollar volatility is close to its record lows (Chart I-14). Following the previous three low-volatility episodes, EM shares prices in dollar terms dropped substantially over the ensuing 18 months – 60% in 1997-1998, 65% in 2007-2008 and 30% in 2014-2015. The rationale is that very low global currency volatility indicates that investors do not foresee a major tectonic macro shift. When this does inevitably occur, currency markets move violently. The RMB depreciation could be a tectonic macro shift that global markets are not prepared for. The absolute and relative performances of EM stocks resemble that of global materials stocks. Global materials are breaking below their long-term moving averages (technical support lines) in absolute terms, raising the odds that the EM equity index will do the same. Relative to the global equity benchmark, global materials have broken down to new cyclical lows. This could be a harbinger of EM relative equity performance making new lows (Chart I-15). Chart I-14U.S. Dollar Volatility And ##br##EM Equity Returns Chart I-15EM And Global Materials: Relative To Global Index Consistently, industrial metals prices as well as our Risk-on/Safe-Haven Currency Index have potentially formed a head-and-shoulders pattern and may be entering a major down leg (Chart I-16). Further weakness in these variables would be consistent with a risk-off phase in EM financial markets.   Finally, the relative performance of the MSCI China All-Share Index – which includes all onshore- and offshore-listed stocks – has relapsed relative to the global equity benchmark, failing to break above its long-term moving average (Chart I-17). This is a negative tell-tale sign, and often warrants considerable downside. Chart I-16A Head-And-Shoulder Pattern In Global Cyclical Markets? Chart I-17China All-Share Index: Absolute And Relative Performance   Ms. Mea: It seems to me that the RMB holds the key. What are your thoughts on the Chinese currency? Answer: There are several reasons why the RMB will likely depreciate. First, yuan depreciation is needed to mitigate the impact of U.S. import tariffs on Chinese exporters’ profitability. Authorities could use the RMB depreciation to fight back against U.S. import tariffs – a response that U.S. President Donald Trump will certainly not like. Second, the ongoing cyclical downturn in China and rising deflationary pressures also warrant a cheaper currency. Third, there is a vast overhang of money supply in China: The broad money supply is equivalent to US$30 trillion. More stimulus will only make this oversupply of yuans larger. This, along with the desire of mainland households and businesses to diversify their deposits into foreign currencies/assets, is like “the sword of Damocles” on the yuan’s exchange rate. Finally, the sources of foreign currency that previously offset capital outflows in China are no longer available. The current account surplus has largely evaporated. In addition, the central bank seems to be reluctant to reduce its foreign exchange reserves to fund capital outflows. In fact, at US$3 trillion, its foreign currency reserves are equivalent to only 10% of local currency broad money supply. All in all, we are structurally short the RMB versus the dollar. Chart I-18China, Commodities, & EM: Identical Cycles Ms. Mea: What are the investment implications? Where are we in the EM/China investment cycle? Answer: Our investment themes since early this decade have been that EM share prices and currencies are in a bear market, the U.S. dollar is in a structural bull market, and commodities are in a structural downtrend (Chart I-18). With the exception of 2016-‘17, these themes have played out quite well. These structural moves have not yet been exhausted. At the moment, we do not foresee a 2016-’17-type cyclical rally either. The failure of EM equities to outperform DM stocks and the resilience of the U.S. dollar during the risk-on period since early this year, give us comfort in maintaining a negative stance on EM risk assets. Importantly, a decade-long poor EM performance is likely to end with a bang rather than a whimper, especially when investors by and large remain bullish on EM. On the whole, we recommend trading EM stocks on the short side and underweighting EM equities in a global equity portfolio. Within the EM equity universe, our overweights are Russia, central Europe, Thailand, non-tech Korean stocks, Mexico, Chile, the UAE and Vietnam. Our underweights are Brazil, South Africa, Turkey, Peru, Indonesia, India, and the Philippines. Fixed-income investors should also position for higher volatility and weaker EM currencies, favoring low-beta versus high-beta markets. Russian and Mexican markets are our favored local currency and U.S. dollar bonds. Finally, we continue to recommend shorting a basket of the following EM currencies versus the U.S. dollar: ZAR, CLP, IDR, MYR, PHP and KRW. Our currency overweights are MXN, RUB, SGD and the THB as well as central European currencies. Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com   Equity Recommendations Fixed-Income, Credit And Currency Recommendations

Highlights Looking past the day-to-day noise of trade-related announcements, we view the underlying odds of an actual trade agreement this year to have fallen below 50%. For the purposes of investment strategy, China-exposed investors should now simply assume that the U.S. proceeds with 25% tariffs on all imports from China. Given this, investors should stop focusing strictly on the odds of trade war, and should instead start focusing on the likely net impact of the tariff shock and China’s inevitable policy response. Simulated and empirical estimates of the impact of a 25% increase in tariffs affecting all U.S.-China trade suggest that economic conditions in China are likely to deteriorate to 2015/2016-like levels. This implies that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. The preference of policymakers is to prevent another significant episode of releveraging, but the constraints facing policymakers suggest that one is unlikely to be avoided. We see a meaningful chance that this tension will be resolved by a classic market “riot” over the coming 3 months as financial markets force reluctant policymakers to capitulate. We would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a strictly cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately respond as needed. We recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade. Feature U.S. and Chinese negotiators failed last week to secure an agreement deferring the threatened increase in the second round tariff rate.1 The tariffs increased on Thursday at midnight for goods not already in transit to the U.S. (effectively doubling the existing tariffs), which was followed by the inevitable retaliation by China on Monday (scheduled to take effect on June 1). The retaliation, coupled with President Trump’s earlier warning that China should not do so, was taken by investors as a sign that 25% tariffs on all goods imported from China will soon be in place. As we go to press, the S&P 500, Hang Seng China Enterprises Index, and the CSI 300 are down 3.5%, 7%, and 6.9%, respectively, since President Trump’s May 5 tweet (Chart 1). Chart 1Investors Are Starting To Price In 25% Tariffs Affecting All U.S.-China Trade Stimulus Minus Shock Holding all else equal, the events of the past two weeks are strictly negative for Chinese economic growth and would thus justify a decisively bearish outlook for Chinese stock prices after the rally that has taken place over the past six months. However, all is not equal, because a substantial deterioration in the export outlook will invariably cause a response from Chinese policymakers. Over the coming few weeks, global investors are likely to remain highly focused on developments and announcements related to the trade conflict. But at this point, our geopolitical team believes that the conclusion of an actual trade agreement this year is now only a 40% probability. This underscores that China-exposed investors should, for the purposes of investment strategy, simply assume that the U.S. proceeds with 25% tariffs on all imports from China, and should broaden their focus to the outcome of a simple formula that describes the potential net outcome of this event. Two simple scenarios concerning this formula are outlined below: Scenario 1 (Bullish): Stimulus – Shock > 0 Scenario 2 (Bearish): Stimulus – Shock ≤ 0 In scenario 1, the impact of China’s reflationary efforts more than offsets the negative shock to aggregate demand from the sharp decline in exports to the U.S. In this scenario, investors should actually have a bullish cyclical outlook for China-related assets, even if the near-term outlook is deeply negative. Scenario 2 denotes a bearish outcome where China’s reflationary response is not larger than the magnitude of the shock, which includes a circumstance where the impacts are exactly offsetting (because of the higher uncertainty, and thus risk premium, that this would entail). “Solving” The Formula In order to “solve” this formula, investors need answers to the following three questions: What is the size and disposition of the likely shock to China’s economy in a full-tariff scenario? What kind of reflationary response is required in order to offset this shock? What are the odds that policymakers will deliver the required response? Simulated and empirical estimates of a 25% increase in tariffs affecting all U.S.-China trade suggest a sizeable economic impact. Charts 2 & 3 provide the IMF’s perspective on the first question. The charts show the simulated impact of a 25% increase in tariffs affecting all U.S.-China trade, and they estimate the near-term impact for China to be -1.25% for real GDP (-0.5% over the long-run) and -3.5% for real exports (-4.5% to -5.5% over the long run).   A recent IMF working paper came up with a more benign estimate of the first year impact, but a sizeable second year impact and a similar estimate of the long-term ramifications of tariff increases.2 Using a dataset with wide time and country coverage, the aggregate results of the study imply that Chinese output is only likely to fall about 0.2% in the year following the tariff increase. However, the cumulative shock to output increased sharply to roughly 1.6% in the second year of the tariff increase, with a negative yearly impact to output persisting for 5 years (with an average annual impact of -0.6% over the whole period, somewhat higher than the estimates shown in Charts 2 & 3). At the 90% confidence interval, the author’s estimates show that a tariff increase of this magnitude would imply a -1.7% average impact on output per year in the first two years following the increase. Chart 4The IMF's Shock Estimates Suggest A Serious Hit To China's Economy In order to answer the second question, investors need to have some sense of the relative magnitude of the estimates noted above. Chart 4 provides some perspective and highlights that the estimates above, were they to materialize, would do two things: Taking Chinese real GDP data at face value, it would cause the largest deceleration in China’s real GDP growth rate since 2012, when the economy slowed significantly and authorities responded forcefully. Based on the most recent data for Chinese real export growth, a 3.5% deceleration in export volume would push its growth rate to its lowest level since the global financial crisis. In practice, we doubt that China’s reported real GDP growth rate accurately reflects what occurred in 2015, and it is very possible that a similar deceleration happened in that year. However, economic similarity to the 2015/2016 episode implies that a similar policy response may also be required, a proposition that is supported by our MSCI China Index earnings recession model. Table 1 shows a set of earnings recession probabilities, based on a model that we presented in two recent reports.3 The scenarios express the odds as a function of new credit to GDP and our calculation of China’s export weighted exchange rate, and assume a substantial decline in the new export orders component of the official manufacturing PMI, and flat momentum in forward earnings. Table 1Our Earnings Recession Model Suggests That A 2015/2016 Style Response Is Needed To Counter This Shock The table clearly highlights that a significant further acceleration in new credit to GDP, coupled with a meaningful decline in the exchange rate, is needed in order to stabilize the earnings outlook. We have previously related stability in the outlook for earnings to stability in the economy itself, given the close correlation between Chinese investment-relevant economic activity and the earnings cycle (Chart 5). Given that new credit to GDP peaked at 31.5% during the 2015/2016 episode, it seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. Policymaker Preferences Vs. Constraints This brings us to our third question: What are the odds that policymakers will deliver the stimulus required to confidently overcome the upcoming shock? It seems reasonable to conclude that a 2015/2016-style policy response will again be required in order for policymakers to be confident that the shock will be overcome. If the answer was only dependent on the preferences of policymakers, the odds would be low. China has relied heavily on credit to stimulate its economy over the past decade, and Chart 6 highlights that this has come at a high cost. The BIS’ estimate of the debt service ratio of China’s private non-financial sector is already extraordinarily high relative to other countries, and another round of meaningful re-leveraging will just make this problem even worse. Chart 5Earnings Stability = Economic ##br##Stability Chart 6Further Leveraging Will Undoubtedly Make A Big Problem Even Worse   We documented in detail how this has created the risk of a debt trap for China’s state-owned enterprises in an August Special Report,4 and have presented evidence arguing that China’s policymakers appear to have good economic reasons to try and shift China’s economy away from extremely high rates of investment towards more consumption.5 This implies that restraining credit growth to avoid further leveraging has been a reasonable policy objective during periods of relative economic stability. However, policy decisions cannot be made in a vacuum, and this is true even in the case of China. As such, instead of preferences, investors should be focused on policymaker constraints in judging likely policy actions. Given the potential for second round effects, Chinese policymakers need to calibrate their policy response to ensure a positive net impact of the stimulus minus the shock. In our view, three factors point to the conclusion that Chinese policymakers face serious economic constraints in setting their policy response: Charts 2-4 highlighted that 25% tariffs on all U.S.-China trade would constitute a meaningful shock, but it is also the case that this shock would be coming at a time when Chinese economic momentum is already relatively weak. This suggests that policymakers will have to act quickly and decisively to put a floor under economic activity. Charts 7 & 8 suggest that there are meaningful second round effects on Chinese domestic investment from external sector shocks, which raises the possibility that the impact on Chinese economic activity may be larger than Charts 2-4 suggest. Chart 7 shows that while the contribution to official real GDP growth from net exports is small, Chart 8 shows that past changes in net export contribution are reasonably correlated with subsequent changes in the contribution to growth from gross capital formation. While it is possible that this relationship is not actually causal, taking it at face value implies that the IMF’s estimate of the impact on output could be exceeded if the contribution to growth from net exports declines by 0.4% or more (holding the contribution to growth from final consumption expenditure constant). Since 2018’s change in net export contribution declined by three times this amount (1.2%), the downside risks to domestic investment from effectively quadrupling U.S. import tariffs are clear. China does not have a flexible labor market, and its political system is highly sensitive to significant job losses. Chart 9 shows that the employment situation has already seriously deteriorated in lockstep with actual economic activity, further underscoring the need for policymakers to act urgently. Chart 9The Employment Situation Is Already Deteriorating, And Will Do So Further We are open to the idea that policymakers may be able to devise a stimulative response of similar reflationary magnitude to the 2015/2016 episode without resorting to a major credit overshoot, but we are currently unable to articulate what it might be. This is an area of ongoing research for BCA’s China Investment Strategy service, but for now we assume that a credit overshoot remains the ultimate line of defense for China’s policymakers that will be deployed if the pursuit of alternative strategies fail to quickly stabilize economic activity. Investment Strategy Conclusions In our view, focusing on policymaker constraints rather than their preferences is much more likely to guide investors towards the right strategy conclusions over a 6-12 month time horizon. However, in the near-term, policy mistakes can occur, and are much more likely to occur if policymakers react to the imposition of constraints rather than anticipate their arrival. Over the coming three months, we see meaningful odds that Chinese policymakers remain reluctant to allow another episode of significant releveraging in the economy. If we are correct in our assessment of the damage that the tariff shock is likely to cause, this would set up a classic market “riot”, where policymakers are forced by financial markets to capitulate and respond forcefully to the seriousness of the economic situation. Further RMB weakness is likely. Investors should hedge their exposure and go long USD-CNH. Chart 10Investors Have A Green Light To Bet On A Lower RMB Given this, we would not recommend a long position in Chinese stocks, either in absolute terms or relative to the global benchmark, for investors with a time horizon of less than 3 months. However, over a cyclical (i.e. 6-12 month) time horizon, we would recommend staying long/overweight on the basis that policymakers will ultimately deliver the stimulus required to more than offset the upcoming shock to external demand. This means that our long MSCI China Index, MSCI China A onshore index, and MSCI China Growth index trades relative to the global benchmark are explicitly cyclical in orientation, and may suffer meaningful further losses over the coming few months before ultimately recovering. As a final point, Table 1 highlighted that a meaningful decline in the exchange rate is likely required in order to stabilize the earnings outlook. Chart 10 shows that currency weakness persisted well past the trough in relative Chinese investable equity performance during the 2015/2016 episode, and we would expect a similar result in the current environment given the nature of the shock. As such, we recommend investors hedge the inherent RMB exposure from a long US$ cyclical position in Chinese stocks by opening a long USD-CNH trade today, with high odds of a break above 7 in the coming weeks. Jonathan LaBerge, CFA, Vice President Special Reports jonathanl@bcaresearch.com Footnotes 1 The first, second, third “round” of tariffs reference the $50/$200/$300 billion tranches of imported goods subject to U.S. tariff announcements since last summer. 2 IMF Working Paper WP/19/9, “Macroeconomic Consequences of Tariffs”, by Davide Furceri, Swarnali A. Hannan, Jonathan D. Ostry, and Andrew K. Rose. 3 Please see China Investment Strategy Special Report “Six Questions About Chinese Stocks,” dated January 16, 2019, and Weekly Report “A Gap In The Bridge,” dated January 30, 2019 available at cis.bcaresearch.com. 3 Please see China Investment Strategy Special Report “Chinese Policymakers: Facing A Trade-Off Between Growth And Leveraging,” dated August 29, 2018, available at cis.bcaresearch.com. 4  Please see China Investment Strategy Weekly Report “Is China Making A Policy Mistake?,” dated October 31, 2018, available at cis.bcaresearch.com.   Cyclical Investment Stance Equity Sector Recommendations

Highlights Even if higher tariffs are imposed tonight, there is a good chance that China and the U.S. will reach a temporary trade truce over the coming weeks. Contrary to President Trump’s assertion, U.S. companies and consumers have borne all of the costs of the tariffs. With the next U.S. presidential campaign less than one year away, the self-described “master negotiator” will actually need to prove that he can negotiate a trade deal. If trade talks do collapse, the Chinese will ramp up credit/fiscal stimulus “MMT style,” thus providing a cushion under global growth and risk assets. In fact, there is a very high probability that the Chinese will overreact to the risks to growth, much like they did in 2009 and 2016. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Feature Tariff Man Strikes Again Hopes for a quick end to the trade war were dashed last Sunday. President Trump threatened to hike tariffs on $200 billion of Chinese goods and begin proceedings to tax the remaining $325 billion of imports currently not subject to tariffs. Although details remain sketchy, U.S. Trade Representative Robert Lighthizer apparently informed the president that the Chinese were backtracking on prior commitments to change laws dealing with issues such as market access, forced technology transfers, and IP theft.1 This infuriated Trump. Trump’s announcement came just as Vice Premier Liu He and a 100-person Chinese trade delegation were set to depart for Washington. As BCA’s Chief Geopolitical Strategist Matt Gertken has noted, the relationship between the two sides was deteriorating even before Trump fired his latest salvo.2 The Chinese government was incensed by the U.S. request that Canada detain and extradite a senior official at Huawei, a top Chinese telecom firm. For its part, the Trump Administration was irked by China’s questionable enforcement of Iranian oil imports, the escalation of Chinese military drills around Taiwan, and the perception that China had not done enough to keep North Korea in check following the failed summit with Kim Jong-Un in Hanoi. It would be naïve to expect these ongoing geopolitical issues to fade anytime soon. The world is shifting from a unipolar to a multipolar one (Chart 1). In an environment where there are overlapping spheres of influence, geopolitical tensions will rise. Chart 1The Era Of Unipolarity Is Over That said, stocks still managed to advance during the first four decades of the post-war era even though the U.S. and the Soviet Union were at each other’s throats. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. Ultimately, we think they will get this reassurance for the same reason that the Soviets and Americans never ended up lobbing missiles at each other: It would have been a lose-lose proposition to do so. Yet, the path from here to there will be a bumpy one. Investors should expect heightened volatility over the coming weeks. As It Turns Out, Trade Wars Are Neither Good Nor Easy To Win There was never any doubt that Wall Street would suffer from a trade war. What was less clear at the outset was the impact that higher tariffs would have on Main Street. Despite President Trump’s claim that the tariffs paid to the U.S. Treasury were “mostly borne by China,” the evidence suggests that close to 100% of the tariffs were, in fact, borne by U.S. companies and consumers. What investors need today is some reassurance that the current trade spat will not degenerate into a full-out trade war that undermines global commerce. A recent NBER paper compared the prices of Chinese imports that were subject to tariffs and similar goods that were not.3 Had Chinese producers been forced to bear the cost of the tariffs, one would have expected pre-tariff import prices to decline. In fact, they didn’t. The tariffs were simply absorbed by U.S. importers in the form of lower profit margins and by U.S. consumers in the form of higher selling prices. This does not mean that Chinese producers escaped unscathed. The paper showed that imports of tariffed goods dropped sharply as U.S. demand shifted away from China and towards domestically-produced goods and imports from other countries. Chart 2Support For Protectionism Rises When Unemployment Is High One might think that the decision to divert spending from Chinese goods to, say, Korean goods would be irrelevant for U.S. welfare. However, a simple thought experiment reveals that this is not the case. Suppose that a 10% tariff raises the price of an imported good from $100 to $110. If the consumer buys this good from China, the consumer will lose $10 while the U.S. government will gain $10, implying no loss in welfare. However, suppose the consumer buys the same good, tariff-free, from Korea for $105. Then the consumer loses $5 while the government gets no additional revenue, implying a net loss in national welfare of $5. Things get trickier when we consider the case where the consumer buys an identical domestically-produced good for say, $107, in order to avoid the tariff. If the economy is suffering from high unemployment, the additional demand will boost GDP by $107. The consumer who bought the domestically-produced good will be worse off by $7, but wages and profits will rise by $107, leaving a net gain of $100 for the economy. When unemployment is high, beggar-thy-neighbor policies make more sense. This is a key reason why support for protectionism tends to rise when unemployment increases (Chart 2). Today, however, the U.S. unemployment rate is at a 49-year low. To the extent that tariffs shift demand towards locally sourced goods, this is likely to require that workers and capital be diverted from other uses. When this occurs, there is no change in overall GDP. Within the context of the example above, all that would happen is that consumers would lose $7, reducing national welfare by the same amount. In fact, it is even worse than that. The example above does not include the impact on welfare from any resources that would need to be squandered from having to shift workers and capital equipment from sectors of the economy that lose from higher tariffs to those that gain from them. Nor does the example include the adverse impact on national welfare from any retaliatory policies. Ironically, while the evidence suggests that U.S. tariffs did not have much effect on Chinese import prices, it does appear that Chinese tariffs had an effect on U.S. export prices. Agricultural prices are highly sensitive to market conditions. Chart 3 shows that grain and soybean prices fell noticeably in 2018 on days when trade tensions intensified. This pattern has continued into the present. It is not surprising that Senators Chuck Grassley and Joni Ernst, along with other senior Iowa politicians, penned a letter to President Trump imploring him to reach a trade deal in order to help the state’s farming communities.4 China’s Secret Weapon: MMT To be fair, the arguments above do not account for the strategic possibility that the threat of punitive tariffs forces the Chinese to open their markets and refrain from corporate espionage and IP theft. If Trump is able to wrangle these concessions from the Chinese, then he could remove the tariffs, creating an environment more favorable to American corporate interests. The problem is that China will resist conceding so much ground. True, a trade war would hurt Chinese exporters much more than it would hurt U.S. firms. However, China is no longer as dependent on trade as it once was. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006 (Chart 4). China also has plenty of tools to support the economy in the event of a trade war. Chief among these is credit/fiscal stimulus. As we discussed three weeks ago, investors are underestimating China’s ability to ramp up credit growth in order to support spending throughout the economy.5 High levels of household savings have kept interest rates below the growth rate of the economy (Chart 5). When GDP growth exceeds the interest rate at which the government can borrow, even a persistently large budget deficit will produce a stable debt-to-GDP ratio in the long run. Chart 4China Is No Longer As Dependent On Trade With The U.S. As It Once Was Chart 5China: High Levels Of Household Savings Have Kept Interest Rates Below The Growth Rate Of The Economy   The standard counterargument is that governments cannot control the interest rate at which they borrow. This means that they run the risk of experiencing a vicious circle where high debt levels cause bond yields to rise, making it more difficult for the government to service its debt. This could lead to even higher bond yields and, eventually, default. However, this argument applies only to countries that do not issue their own currencies. Since a sovereign government can always print cash to pay for the goods and services, it can never run out of money. Chinese exports to the U.S. account for only 3.6% of GDP, down from 7.3% of GDP in 2006. The main reason a sovereign central bank would wish to raise rates is to prevent the economy from overheating. If a rising fiscal deficit is the consequence of a decline in private-sector spending (which is something that would likely happen during a trade war), there is no risk of overheating, and hence, there is no need to raise interest rates. We are not big fans of Modern Monetary Theory, but at least on this point, the MMT crowd is right while most analysts are wrong. Investment Conclusions It is impossible to say with any confidence what the next few days will bring on the trade front. If the Trump Administration’s allegation that the Chinese backtracked on prior commitments turns out to be true, it is possible that some of them will be reinstated, thus allowing the negotiations to resume. This could prompt Trump to offer a “grace period” to the Chinese of one or two weeks later tonight before scheduled tariff hikes are set to occur. If tariffs do go up, what should investors do? The answer depends on how much stocks fall in response to the news. If global equities were to decline by more than five percent, our inclination would be to get more bullish. There are two reasons for this. First, the failure to reach a deal this week does not mean that the talks will irrevocably break down. The point of Trump’s tariffs was never to raise revenue. It was to force the Chinese into a trade agreement that served America’s interests. With less than a year to go before the presidential campaign kicks into high gear, the self-described “master negotiator” needs to prove to the American public that he can actually negotiate a trade deal. This means some sort of an agreement is more likely than not. Second, as noted above, China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. This will help cushion global growth and risk assets. Infrastructure spending tends to be more commodity intensive than manufacturing production. Thus, even if the Chinese government exactly offsets the loss of manufacturing exports with additional infrastructure spending, the net effect on global growth will probably be positive. China will respond aggressively with fresh stimulus if the U.S. slaps tariffs on its exports. In reality, there is a very high probability that the Chinese will do more than that. As the 2009 and 2016 episodes illustrate, when faced with a clear downside shock to growth, the government calibrates the policy response based on the worst-case scenario. Not only would a bout of hyperstimulus provide downside protection to the Chinese economy against a growth shock, it would also give the government more negotiating leverage with Trump. After all, it is much easier to brush away threats of punitive tariffs if you have an economy that is humming along. Investors should remain overweight global equities for the next 12 months, while positioning for a modestly weaker U.S. dollar and somewhat higher global bond yields. Peter Berezin, Chief Global Strategist Global Investment Strategy peterb@bcaresearch.com Footnotes 1      David Lawder, Jeff Mason, and Michael Martina, “Exclusive: China backtracked on almost all aspects of U.S. trade deal – sources,” Reuters, May 8, 2019. 2      Please see Geopolitical Strategy Special Alert, “U.S. And China Get Cold Feet,” dated May 6, 2019. 3      Mary Amiti, Stephen J. Redding, and David E. Weinstein, “The Impact of the 2018 Trade War on U.S. Prices and Welfare,” NBER Working Paper No. 25672, (March 2019). 4      “Young, Ernst Lead Iowa Delegation in Letter Urging President Not to Impose Tariffs,” Joni Ernst United States Senator For Iowa, March 7, 2018. 5      Please see Global Investment Strategy Weekly Report, “Chinese Debt: A Contrarian View,” dated April 19, 2019. Strategy & Market Trends MacroQuant Model And Current Subjective Scores Tactical Trades Strategic Recommendations Closed Trades